Posts tagged Interest Rate Trends
Today’s WMF is brought to you by the number 10. It’s the tenth day of the month, and it’s a day when 10-year debt is front and center on the capital markets stage. Switzerland and Japan have already crossed over into 10-year NIRP Wonderland, offering investors the curious opportunity to lock in losses for a whole decade. Now Germany is flirting at the event horizon; the yield on the 10-year Bund is just one basis point on the positive side of the line. One year ago all three benchmark yields were above zero, and Germany’s comfortably so. The chart below shows that the zero boundary, once breached, has proven difficult to cross back into normal territory.
Why do yields continue to plumb the depths? This comes down, as always, to a supply and demand question. In Europe, in particular, a big part of the problem lies on the supply side. The ECB is the big player (or, less charitably, the Greater Fool), but there are limits on its bond buying activities. Specifically, the ECB cannot purchase bond issues when their yields fall below the ECB’s own deposit rate, which is currently set at negative 40 basis points. That requirement cuts the ECB off from an increasingly large chunk of Eurozone debt; consider that the yield on German five year Bunds is now minus 0.43%. So further out the curve the ECB goes, and down come the yields.
Additionally, the ECB can purchase a maximum of one third of any individual bond issue, so it is constrained by the supply of new debt coming onto the market. Some observers estimate that the inventory of German debt for which the ECB is eligible to purchase will run out in a matter of months. If the ECB wants to continue monthly QE purchases according to its current program it will then have to consider (and persuade ornery German policymakers to agree to) changes to the current rules.
Meet the New Risks, Same as the Old Risks
Of course, technical issues of bond inventories and ECB regulations are not the only factors at play. The risk sentiment dial appears to be pointing somewhat back towards the risk-off end, if not for any particularly new set of reasons. Brexit polls continue to occupy the attention of the financial chattering class, with the vote looming in 13 days and a close result expected. Investors seem to be digesting last week’s US jobs report from a glass half-empty standpoint – slower payroll gains bad for growth, while improving wages mean higher labor costs which are bad for corporate earnings. Japan delivered up some negative headline numbers this week including an 11 percent fall in core machinery orders. Again, none of this is new (and for what it is worth, we continue to think it more likely that we will wake up on June 24 to find Britain still in the EU). But animal spirits appear to be laying low for the moment.
The Stock-Bond Tango
The recent risk-off pullback in overseas equity markets, though, is having less impact here at home. Yes, the S&P 500 is off today – but earlier in the week the benchmark index topped its previous year-to-date high and remains just a couple rally days away from last year’s all-time high. The really curious thing about this rally though – and why it is very much relevant to what is going on in global bond markets – is that recently stock prices and bond prices have moved largely in tandem. This weird tango has resulted in 10-year Treasury yields at a four-year low while stocks graze record highs. As the chart below shows, this is a highly unusual correlation.
This chart serves as a useful reminder that just because something hasn’t happened before doesn’t mean that it can’t happen. In fact, what is going on in US stocks and bonds is arguably not all that difficult to understand. Investors are in risk-off mode but are being pushed out of core Eurozone debt in a desperate search for any yield at all. US Treasury debt looks attractive compared to anything stuck on the other side of that NIRP event horizon. And that demand is largely impervious to expectations about what the Fed will or will not do. Short term Treasuries will bounce around more on Fed rumors, but the jitters will be less pronounced farther down the curve.
And stocks? There is plenty of commentary that sees a significant retreat as right around the corner. Perhaps that is true, perhaps not. Pullbacks of five or 10 percent are not uncommon and can appear out of nowhere like sandstorms in the desert. But – as we have said many times over in recent weeks – we do not see a compelling case to make for a sustained retreat into bear country. The economy does not appear headed for recession, money has to go somewhere, and negative interest rates have the continuing potential to turn bond buyers into stock buyers. If a pullback does happen over the summer, we are inclined to see it more as a buying opportunity than anything else.
After the three year bear market of 2000 to 2002, stock indexes around the world enjoyed a sustained bull cycle with broad participation across all major regions from the US to Europe, from Latin America to developed and emerging Asia. Most major markets set all-time highs in October 2007. Then came winter, and then another spring.
We broadly think of the period from the 2009 market bottom to the present as another single, uninterrupted bull market. Indeed, as measured by the standard of the S&P 500 or any other major US stock index, that moniker fits. But – unlike 2000-02 and most prior bull markets – the same cannot be said for the rest of the world. For example the MSCI Europe, All Country Asia and Emerging Markets indexes, as shown in the chart below, have all failed to recapture their October 2007 high water marks. For much of the non-US world, the post-2009 period can be divided into two periods: a recovery from the 3/09 trough into the summer of 2011; and then a listless sideways performance from then to the present. In fact, all three of these non-US indexes remain today below their post-recovery 2011 high points.
As anybody with a diversified portfolio knows, the S&P 500 has been a devilishly unforgiving benchmark for most of the last four years, the bane of many an asset allocator and active stock picker alike. Is there anything about the unusual contours of this time period that suggests what might lie in store? Is it time to anticipate mean reversion and load up on non-US assets, or is it better to hunker down for ever more years of Pax Americana? We consider three alternative scenarios below.
#1: Central Banks Rule , World Catches Up
This scenario starts with the largely uncontroversial observation that central banks have been the headline story in risk asset markets since 2009 and especially since the Fed announced its second quantitative easing program – QE2 – in 2010, following up with QE3 in fall 2012. QE2 in particular is a textbook case study in how central banks move markets; one can picture then-Fed chair Ben Bernanke simulating an all-net jump shot with a smug “that’s how it’s done.” That year started off poorly for US stocks, with lots of volatility and a handful of pullbacks of 5 percent or more throughout the spring and summer. In August the Fed hinted that it was considering a second QE program, after QE1 ran out in June. That was all markets needed hear to stage a robust second-half rally (the formal QE2 announcement only came in November). QE2 firmly established the playbook for the Bernanke put: more liquidity from the Fed whenever markets run into trouble. Thus there was no great amount of surprise when QE3 played out in almost exactly the same way, in fall 2012, guiding markets over the so-called “fiscal cliff” and safely into the solid double-digit returns of the next two years.
Other central bankers came later to the stimulus party, but almost all eventually showed up at the punch bowl. The “world catches up” scenario posits that non-US markets will benefit from being in the springtime of their policy stimulus programs while the US settles into autumn. Even with a more dovish Fed stance on the cadence of rate hikes this year, policy divergence is still very much a reality. The key question is whether central bank stimulus today packs the same punch as it did in 2010 and 2012. If not, we may be looking at a second scenario.
#2: Central Banks Wane, World Swoons
It would be fair to say that market reaction to monetary stimulus policies this year has been all over the place, and perhaps nowhere more so than in Japan. When the Bank of Japan moved into negative interest rate territory last month there was a very brief moment when everything went according to plan: stocks up, domestic currency down. That reversed quickly, though. In the week following the BoJ announcement the Nikkei 225 plunged and the yen soared. The currency has set successive twelve month highs against the dollar since the policy decision was announced. Over in Europe, ECB showman Mario Draghi had somewhat better luck with the markets when he announced that the ECB would essentially pay banks to make loans through a loosening of terms for the existing long term refinancing operations (LTRO) policy.
But the ECB’s move raises the expectations bar. If cheap LTRO winds up not making much of a dent in real economic activity in Europe it will reinforce a growing belief among investors that central bank stimulus amounts to not much more than a temporary reprieve for risk asset markets. The Fed is in the crosshairs on this point as well. Much editorial chatter has been expended this week on the apparent divisions among FOMC members about the appropriate pace of rate decisions this year. If the market’s collective consciousness wraps itself around the idea that central bank puts have slipped out of the money, it will then be forced – heaven forbid – to take stock of growth and earnings prospects in the real economy. That could lead Mr. Market straight to the fainting couch. Or, alternatively, things could start looking up for growth and profits, producing a third possible scenario.
#3: Valuation Matters Again
The US economy is doing okay – not great, but okay. China has not (yet) lived down to fears of a hard landing in its economic transition. Europe is staying out of recession while some Eurozone economies such as Spain are doing quite alright, thank you very much. Brazil remains a basket case, but its neighbor Argentina is coming back into the mix after a long winter. India continues to grow nicely. Commodities markets are recovering. It is not out of the question that the world economy could emerge as a more pleasant place for companies to ply their trade. If this happens, we would expect a closer focus on valuation levels that in turn could favor bargain-hunting in those world markets that have underperformed the S&P 500 in recent years. This would be especially true if a strong dollar continues to be the major revenue and profits headwind for US companies (though we should note that the dollar has lost some of its force as of late, particularly against the yen and the Aussie dollar).
Of course, it is just as plausible that none of these scenarios will come to pass. Associating cause with effect is never easy in financial markets, and this year has been particularly problematic for the professional soothsayers of our industry. The fact is, though, that in a global economy it is unlikely that the asset performance of one country will dominate the landscape forever, even if that country is the largest and most influential. Sooner or later, those geographically diversified portfolios will likely have their day. Some advance preparation may not be a bad idea.
Amid the volatility and daily event fetishes that have driven asset markets hither and yon this year, the US economy continues to steadily plod along. The data points are a mixed bag: missed GDP and productivity numbers here, consumer confidence and retail gains there. But the overall picture is relatively healthy. Importantly, there are some bright spots in the long-elusive area of wage and price gains. Hourly wage growth was, in fact, the one positive takeaway in an otherwise unimpressive jobs report at the beginning of this month. Now this morning’s January inflation report shows prices growing slightly ahead of consensus. Core inflation (excluding food and energy) is up 2.2 percent on a non-seasonally adjusted year-on-year basis, its highest level in four years.
The oil price collapse has kept the all-inclusive headline inflation number well below core inflation for the past year and a half. That may be changing. The energy index component of today’s CPI report was negative 6.5 percent – the lowest decline since November 2014. Year-on-year headline CPI for January was twice the December level: 1.4 percent up from 0.7 percent. The chart below illustrates the recent trend in prices. If oil prices manage to stabilize, we can expect to see the headline number converge ever closer to core CPI.
Stay, Raise or Cut?
It is somewhat ironic that the next FOMC meeting concludes on March 16, the very same day on which the BLS will release the February CPI data. It is not totally implausible to imagine that headline CPI will be close to or even at that magic 2 percent threshold when FOMC members peruse the 8:30 am BLS release that day. They will already have digested new information on personal consumption expenditure (PCE – 2/26) and hourly wages (3/4) by then. Recent data on retail sales, industrial production, capacity utilization and consumer confidence indicate the potential for an upside surprise in those PCE and wage numbers.
On balance the news is net-positive for the economy, but that may not translate to a much-desired adrenaline boost for the stock market. The Fed is not sitting on the “horns of a dilemma”, as the fella said, but on the shaky tripod of a trilemma. Should they stand pat with rates where they are now? Push ahead with another 25 basis point hike as a sign of confidence in the economy’s continued recovery? Or – and this is highly unlikely but at least in the realm of possibility given global developments – contemplate a reversal? Interest rate policy divergence among leading economies has not gone down well with markets since the Fed’s last move in December. The global stampede towards the Pleasure Island of negative interest rates makes the Fed’s decision all the more tricky, irrespective of the conclusions they would normally draw from domestic data.
El Niño and Mr. Market
Lurking behind this policy trilemma is a capital market environment that perhaps resembles nothing more than US East Coast weather patterns this winter. We’ve had heat waves along with record levels of snowfall here in the nation’s capital, and temperatures that fluctuate from frigid to tropical seemingly overnight (we woke up in the teens today and are preparing for upper sixties tomorrow). That’s intraday volatility worthy of the S&P 500 – which registered three consecutive days of gains over one percent earlier this week after falling by more than one percent in three of the previous five days. Now, to be sure, we have not yet seen the displays of outright panic that so often accompany pullback environments. In the first eleven trading days of August 2011 the market gained or lost more than four percent five times. And the maximum peak-trough drawdown to date remains far short of the minus 19 percent low point of the 2011 event. So far.
But the threat of a deeper downturn lurks behind every X-factor that pops into and out of existence each day. The FOMC explicitly called out their concerns in January’s post-meeting communiqué, referring to the “global economic and financial developments” keeping them up at night. It is a pretty good bet that these “developments” are not going away between now and March 15-16. If more US economic data surprise on the upside between now and then, it is going to be a very difficult call for Chairwoman Yellen & Co.
It’s just a natural continuation of conventional monetary policy, say the central bankers who have unleashed the hounds of negative interest rate policy – NIRP – into the capital markets. The Swedish Rijksbank is the latest to join the club, setting the key bank overnight repo rate at minus 0.5 percent. Even stranger than the rate itself was the accompanying announcement, part of which read thus: “Growth in the Swedish economy is high and unemployment is falling, which suggests that inflation will rise in the period ahead”.
Got that? Sweden’s economy, in fact, is growing at a clip of around 3.5 percent, or more than twice that of the Eurozone. If US GDP were growing by anything close to that rate it’s a pretty sure bet that Janet Yellen & Co. would be hiking rates with nary a second thought. What possible reason could there be for Sweden, then, to send rates below zero? “Global uncertainty” was the phrase the Rijksbank deployed in that same press release, along with a vague reference to recent inflationary weakness. “Everybody else is doing it” seems to be the underlying context, though, and that has the makings of a potentially dangerous trend.
Wonderland Not So Wonderful
We took note in this column a couple weeks back of the Bank of Japan’s joining Club NIRP. Now, as with any easy money policy, two key motivating incentives for negative rates are a weaker currency (to improve trade conditions) and higher domestic asset prices. How’s that working out for Japan so far? Consider the chart below, showing recent trend performance in the Japanese yen and the Nikkei 225.
In fact, the currency and the stock market have both done exactly the opposite of what the BoJ would have hoped. The Nikkei 225 has fallen by more than sixteen percent since the beginning of February, while the yen has strengthened by 8 percent against the dollar. Oops. The point to make here is simply this: NIRP is not, as claimed, simply an extension of the conventional easy money continuum. It is a whole new territory, an unknown land where the normal rules of finance do not necessarily apply. That NIRP is going viral around the globe is, in our opinion, cause for considerable concern.
Here Be Dragons
There are many facets to our concern about the NIRP contagion. A central one is its impact on the financial sector. The fruits of this impact are already visible in the form of a global bear market for the shares of financial institutions. Banks have to hold a certain fraction of their liquid assets in the form of central bank reserves. When the cost of holding these reserves goes up they need to make up the difference elsewhere, either in raising lending rates (counterproductive to growth) or in venturing into riskier lending areas (counterproductive to risk-adjusted capital adequacy). Again – a key objective of any easy money policy is to funnel money back into the economy via bank lending and accelerate its velocity. All the quantitative easing of the last six years has failed to accomplish this objective. It seems a great stretch to imagine that, suddenly, credit demand is going to materialize out of nowhere in response to negative rates. The banks, meanwhile, will have to figure out how to adjust their business models to remain profitable.
The reasoning behind NIRP is also flawed in terms of its capital markets objectives. Negative interest rates have spread into a widening swath of fixed income instruments, primarily (though not exclusively) government bonds. Five year German Bunds currently trade at negative yields, as does the Swiss ten year note. That’s right – if you buy a Swiss government bond and hold it to maturity you are guaranteed to lose money. What NIRP does, then, is to take low-risk assets and make them riskier – a complete perversion of standard capital market theory.
No Country for the Prudent Investor
Bear in mind that institutional investors like pension funds and insurance companies are required by their investment policy statements to hold sizable percentages of low-risk assets in their portfolios. Part of the NIRP objective is to make safer assets less attractive to stimulate purchases of riskier assets like stocks. But a prudently managed pension fund cannot simply take itself out of short term bonds and dump the money into small cap stocks. In this way, again, NIRP is counterproductive.
Finally, NIRP could potentially achieve the opposite of what it wants in terms of guiding inflation back up to those elusive 2 percent central bank targets. Think again about that ten year Swiss government bond we discussed a couple paragraphs above. Nominal bond yields are comprised of two sections: an expected real return (i.e. what the investor expects to earn from the investment after inflation); and inflationary expectations. Say for example that a certain ten year bond yields five percent and that inflation is expected to run at two percent for the next ten years. So that bond’s real return would be three percent and the inflation expectations component would be two percent. Easy math.
In light of that example, what does a yield of negative 30 basis points (about where the Swiss ten year is today) tell us about investor expectations? Only that for a rational investor to hold that security, the investor would have to believe that the most likely price trend for the next ten years would be deflation. If the average price of goods and services in the economy were to fall by one percent annually for the next ten years then it would make sense to invest in a bond, the slight negative return of which would still preserve purchasing power. Of course, deflation is exactly what financial policymakers want to avoid.
Expectations matter in explaining economic behavior and outcomes. The advanced-math models central bankers use in arriving at policy decisions have been shown to be demonstratively poor in accounting for the expectations factor. Want proof? Go back to that chart showing what the yen and the Nikkei 225 did in the aftermath of the BoJ’s NIRP decision. Expectations matter, and central banks ignore them at their – and our – peril.
Negative interest rates – or “Wonderland” as we have come to call them – up to now have been a distinctly European fashion. The common currency Eurozone has them. So do non-currency zone neighbors Switzerland and Denmark. Nowhere else did they exist – until now. The Bank of Japan surprised markets on Friday with an announcement that it plans to lower its key interest rate to -1.0 percent. BoJ head Haruhiko Kuroda’s decision to “go European” reflects a country determined to battle its way out of near-deflation, but with a limited set of weapons in its policymaking arsenal. The most recent batch of headline statistics – also released yesterday and today – have little to show for all the slings and arrows of Abenomics over the past four years. Without meaningful structural reform to accompany its monetary policy, Japan will find it difficult to regenerate sustainable growth.
Three Tiers of Confusion
Japan’s new negative rate regime is somewhat confusing in its details. It appears that Japanese rates can be somewhat like Schrödinger’s cat – both positive and negative at the same time. Specifically, the negative rate does not apply to the ¥250-odd trillion of existing bank reserves. The majority of these will now be classified as “basic balance” reserves and they will continue to earn interest at the prevailing 0.1 percent rate. Then there will be a second, smaller tier of reserves that earn zero percent. Finally, the negative rates announced today will pertain only to a third tier of “policy rate balance” reserves – essentially, any excess bank reserves generated by future quantitative easing activity. The practical impact of negative rates remains unclear in terms of what volume of bank reserves might eventually fall into that third tier.
Japanese for “Jawboning”
The optics around the rate program may be less about quantifying its impact, and more about sending a signal to markets that Japan’s monetary policymakers are serious about pulling back from the deflation trap which has threatened the economy’s fortunes off and on for the past couple decades. The chart below shows headline Japanese inflation (their headline CPI measure excludes food but includes energy) over the past five years.
Prices in Japan topped out in 2014 shortly after the increase in the consumption tax in April of that year (one of the Abenomics arrows). The government has been forced to push out the expected timing on its 2 percent inflation target time and again. It is likely that Kuroda, by choosing a negative rate decision at this time rather than an expansion of the existing ¥80 trillion per year quantitative easing program, wants to demonstrate that he has more than one policy tool at his disposal. Indeed, the BoJ in its announcement today took pains to not rule out either additional QE or a further rate cut deeper into negative territory if future conditions so warrant.
That Elusive Structural Reform
All the QE and negative interest rates in the world, however, will amount to little more than a tempest in a teapot if Japan is unable to move forward more aggressively with its structural reforms – that elusive third arrow of the Abenomics program. Some efforts have been made – for example, some modest reforms to the country’s excessively coddled agricultural system. Agreeing to participate in the regional Trans-Pacific Partnership with the US and other Asia Pacific economies is also a good step. But Japan continues to suffer from structural problems decades in the making – excessive saving, low household consumption, glacial progress for women in the workplace, and a refusal to countenance sensible immigration reform prominent among them.
Japan needs a “Meiji moment”. In the Meiji era of the nineteenth century the country embarked on a spectacular national program to reinvent itself from a feudal backwater to a leading industrialized nation. It later regrouped from the destruction of the Second World War to produce the miracle economy of the 1950s – 1970s. Today the Nikkei 225 stock index, at around 17,500, remains at a level less than half its peak at the end of 1989. It will take a sustained commitment to deep structural reforms, alongside fiscal and monetary stimulus, to regain that 40,000 all-time high water mark.