Posts tagged Interest Rate Trends
Rate hike chatter is back front and center in the wake of this morning’s relatively strong jobs numbers. Payroll additions exceeded expectations while hourly wages, which historically correlate closely with Fed policy, also ticked up ahead of consensus. Today’s data do not make for a complete picture, and the Fed will probably wait to digest the Q2 GDP release before putting a definitive mark on the rate hike calendar. But it is fair to say that the odds of September-time frame action have improved with today’s release.
So we have a potentially volatile cocktail made up of the Fed, Eurozone bonds gone wild, and an expensive, sideways-trading stock market looking for direction. Are these the ingredients for a hefty pullback in US stocks? We would not rule out the possibility. We would also not be inclined to run for the hills were such a pullback to happen. A brief look at market history will explain why.
Pullbacks, Bulls and Bears
A reversal of 5 percent or more in the stock market is a headline-grabbing event, engendering a climate of fear. Most of the time, though, the fear is overblown. We define a “pullback event” as a reversal of 5 percent or more, followed by a recovery of 5 percent or more. Since 1950 there have been 177 such pullback events on the S&P 500, or about one every four and a half months on average. Occasionally the pullback led to a broader bear market environment, notably in the double recessions of the early 1970s, the 2000-02 tech collapse and then the Great Recession of 2008-09. Most pullbacks, though, were relatively shallow and brief. The chart below illustrates the price performance of the S&P 500 since 1950, with the vertical grey bands indicating US economic recessions.
What this chart illustrates is that major pullbacks outside of recession-related bear market environments are anomalies. The most severe of these anomalies was the Crash of 1987, when US stocks dropped more than 20% in a single day. The events which drove that crash were largely unrelated to prevailing economic fundamentals, and would have been very difficult to predict ahead of the event. As deep as that reversal was, though, shares had recovered their losses and set new highs within one year. In a similar vein, markets tumbled on two non-recession related occasions in the 1960s and once in the latter stage of the 1990s bull market. Since the 2009 market bottom there have been two relatively significant events – a 16 percent reversal from April to July in 2010, and a 19 percent drop from July to October in 2011. Even in the latter instance, though, the market bounced back to a new high just three months after hitting bottom.
Growth Does Not Cause Bear Markets
So what does all this mean for today? Isn’t it possible that a pullback sometime this summer or fall could lead to a larger bear market? It is possible, of course. There are thousands of variables at play in the market every day, any combination of which could potentially bubble up to the surface at any time, cause havoc and eventually drag the economy into recession. What we think highly unlikely, though, is that a rate hike per se would usher in a prolonged period of misery. If a rate hike happens, it will happen because the Fed is convinced that underlying economic growth is strong enough to merit a rate hike. And economic growth is not a catalyst for a bear market.
Yesterday, IMF head Christine Lagarde warned the Fed not to raise rates in 2015, citing “too much uncertainty” in the global environment and darkly opining that the Fed’s credibility would be on the line if it were to unwisely move ahead. We understand the sentiments driving Mme. Lagarde’s comments, but believe they are misplaced. The Fed’s mandate is to guide US monetary policy towards the objectives of stable prices and full employment. It is not to placate jittery market sentiment around the world. If the data suggest that a measured rate hike is the appropriate policy for this mandate, then that is the right thing to do. Have faith in markets to adjust accordingly.
And if stocks do freak out and retreat by 5 or 10 percent? More likely than not, that would be welcome news for opportunity-starved value investors, ourselves included.
Well, that was interesting.
On April 20, all the chatter among bond traders was about the imminent plunge of 10-year German Bund yields into negative territory. Instead they were caught off guard by a sudden, steep and seemingly inexplicable reversal. The 10-year yield doubled within two days, on its way to a stunning eightfold gain by mid-May. Meanwhile the 5-year yield, which had languished in negative territory since the beginning of the year, broke through the zero bound on its way to a peak of 0.11%. Other assets reacted accordingly. US Treasury yields jumped, the euro broke out against the dollar, and commodity prices gained.
No Friend, This Trend
Then, just as quickly as it began, it was all over. As the chart below shows, the sharp reversals that began in late April reached a peak in mid-May. With barely a pause to enjoy the view from on high, the reversals reversed. Eurozone yields, the euro and commodities fell in tandem. The 10-year Treasury also pulled back from its mid-May high though, interestingly, the 2-year yield remains elevated.
All this has resulted in a collective head-scratching among market observers, particularly with regard to what drove that initial sudden spike in Bund yields. Some pointed to liquidity concerns as a result of increased ECB purchases, while others posited the incongruence of negative yields with somewhat improving Eurozone growth and inflation prospects. A handful of weaker than expected data points in the US may have helped the dollar’s decline. None of these explanations, though, make a convincing case for the timing and magnitude of the reversal. A more plausible explanation may simply be technical: a bevy of algorithms were programmed to kick in when the 10-year Bund approached zero, and traders duly piled on.
Back to the Periphery
Another curious feature of the April-May reversal was its concentration in the core, rather than the periphery, of Eurozone yields. Peripheral spreads actually tightened against the Bund during this period. The chart below shows the year-to-date trend of the Spanish 5-year benchmark issue relative to the 5-year Bund. Spanish yields rose by less than Bunds through mid-May, but the spread has widened notably since then.
This chart may indicate that things are returning to “normal” in Europe. As investors return their focus to the deteriorating situation in Greece, the risk premium on peripheral debt like Spain increases while the Bund resumes its traditional safe-haven role. The slow pace and contentious nature of the negotiations between Greece, its EU partners and the IMF have increased the potential for a so-called “Grexit”. That day of reckoning is not yet at hand – the IMF has given permission for Athens to delay its June debt payments until the end of the month. But after more than three months of negotiations there is little evidence of convergence towards mutual agreement.
Meanwhile, Back in the US…
If the chart above illustrates a reversion to more typical core-periphery spreads in Europe, we believe it also indicates that US rates will likely decouple from trends in the Eurozone. There was no particular reason for Treasuries to join the European April-May trend; if anything, consensus opinion here has pushed the likely timing of a Fed move further back into the second half of this year, if not later. We will have a better sense shortly as to whether the US weakness is a first quarter phenomenon or a more chronic ailment. That, in turn, will give us a better sense as to where rates here are headed.
Shock and awe? That would be the right term to apply to the Swiss National Bank when it lifted the floor off the Swiss franc’s conversion rate against the euro last week. Any time currencies trade up or down in high double digits in the course of a single day should qualify in the annals of capital markets S&A.
Mario Draghi and the European Central Bank? Not so much. The announcement of the €60 billion quantitative easing program, to last at least through September 2016, was impressive to be sure, but it was also widely expected. European equities rallied, yields compressed and the euro continued its descent against the dollar, but all in modest single digits. What remains to be seen is whether Helicopter Mario’s efforts will bear fruit in bringing about a meaningful change in direction to the Euro area’s beleaguered economies. What seems likely, in the near to intermediate term, is a continuation of the Dire Straits Economy on both sides of the Atlantic. Money for nothing and your bonds for free.
Incredible Shrinking Yields
Your value equation as a fixed income investor is pretty simple. You want to preserve purchasing power. You want to be compensated for deferring until tomorrow the consumption opportunities of today. And you want an additional something in exchange for whatever risks come with the investment. That’s basically it. Now, consider the sovereign yield trends over the last three years in two countries – the U.S. and Spain – in the chart below.
How times have changed. Three years ago the spread between the 10 year Treasury and the 10 year Spanish sovereign was more than 5% - reasonable, it would seem, given the considerable risk prevailing at the time that the Eurozone would break up and Spain, as one of the troubled peripheral economies, would be adrift in a storm of Biblical proportions. Today the spread is negative – Spain’s benchmark debt yields less than the U.S. The same is true for almost every other Eurozone country. Yields are low and continue to shrink. What does this tell us about that fixed income value equation – purchasing power protection, the time value of money and risk spreads?
Deflation Trumps All
Mostly, it seems to tell us that bond investors have a very dim view of the prospects for growth, anywhere in the world. The negative spreads between Treasuries and Euro area debt have very little to do with relative risk factors and almost everything to do with the distorting effects of deflationary expectations on traditional valuation models. Deflation turns the first two components of the value equation – purchasing power and time value – on their heads. If inflation is zero or lower you don’t lose purchasing power. If prices are actually going to be cheaper tomorrow than they are today then you don’t need any extra inducement to defer consumption. If today’s yields reflect a rational consensus about future economic prospects, that consensus apparently is that there’s not going to be much growth, anywhere, anytime soon.
What About the Growth Narrative?
But isn’t that consensus out of line with the growth story, at least in the U.S.? We had real GDP growth of 5% in the 3rd quarter last year and 4.6% in the quarter before that. The last time we had real growth at that level was in 2003 – when the 10 year Treasury was yielding around 4% and inflation was 2%. Unemployment is lower today than it was in 2003. All chatter about a “new normal” notwithstanding, is 3%-plus real GDP growth truly compatible with sub-2% intermediate term interest rates?
There is no certain answer to that question, but as long as inflation remains all but invisible it would probably be a good idea to let the bond market lead this dance. Rates in Europe may not be far from their lower bounds, but there is still room on the downside. After all, even at a 1.4% nominal yield, real rates are still higher in Spain, where inflation is negative, than they are in the U.S. And if recent history serves as any guide, we can expect quite a bit of that QE money tossed out of the ECB’s fleet of helicopters to land in asset markets in the U.S., including Treasuries.
“Rates will Rise” was the mantra at the beginning of 2014. “Lower for Longer” seems an appropriate corollary for the current times.
The monthly jobs report came out this morning, telling us that U.S. nonfarm payrolls added 252,000 new able bodies to the workforce. Meanwhile the headline unemployment number dropped to 5.6%, the lowest since June 2008. This would appear to be good news, indicating that the growth narrative for the U.S. economy remains intact. But there are some soft spots lurking below the cheery headlines. Indeed, the net effect of today’s report may be to give the Fed further pause before moving ahead with a rate hike.
Money…That’s What I Want
What is missing from the jobs equation is wage growth. Average hourly earnings decreased slightly in December to $24.57/hour. For the year as a whole average wage growth more or less tracked inflation. Purchasing power on balance was neither lost nor gained. Weak wage growth indicates that there is still considerable slack in the economy, despite the headline growth signals. Employers appear to be under very little pressure to respond to wage demands, even with an unemployment rate 1.1% lower than it was one year ago. In the absence of upward pressure from rising wages it is difficult to see what could spark any significant inflationary pressures. Household budgets remain unchanged; families merely reallocate spending priorities (or use savings at the gas pump to pay down more debt) rather than increasing consumption. This, arguably, gives Chairwoman Yellen et al more room to hold off on rates should they feel the need to.
Maybe the Bond Market is Right, After All
This muted-inflation environment seems to be what the bond market expects. Consider the current yield on the 10 year Treasury as compared to headline and core (ex-gas and groceries) inflation. The chart below shows the relationship between nominal yields and inflation over the past twenty years:
The narrow spread between yields and inflation suggests that the collective wisdom of the bond market, such as it may be, has a very dim view of growth prospects for at least the intermediate term. After all, if the incremental investor is willing to accept a nominal yield of 2% - about where the 10-year currently trades – that investor is apparently not losing sleep over loss of purchasing power. If you think the Fed funds rate will sit over 3% in several years’ time then it makes little sense to hold a long-dated asset and clip 2% coupons every year. Of course this is all subject to change – one would expect to see yields spike northward in light of any new data confirming stronger growth. But for now that catalyst has not manifested – and today’s jobs report is likely to do little to change that perception. Indeed, the 10 year yield has subsided yet again in the immediate wake of the jobs report.
PPR: Productivity and Participation Rate
Growth comes about in two ways: from a growing population with a steady or increasing percentage of labor force participation, or from productivity (more goods and services produced per capita). But another data point in today’s jobs report reaffirms the disquieting trend of decreasing labor force participation. The participation rate for December was 62.7%, its lowest level in past thirty years. The chart below plots labor force participation against productivity (output per hour) over this time period.
There are a variety of explanations for the decreased participation, from discouraged workers to a higher number of retirees. It’s not all about retiring boomers, though – as Michael McDonough tweeted this morning, the labor participation rate for the 65 and over contingent has actually increased slightly over the past decade (purple line on the chart). We at least want to see this trend stabilize before getting too excited about growth prospects.
The productivity story is not all bad – after all, low growth in wages translates to lower unit labor costs, which translates to higher productivity. Looking ahead, though, we should hope that these successive waves of “disruptive efficiencies” touted by Silicon Valley wags really help boost increased output of goods and services.
Revelers around the world are still shaking out the post-New Year’s Eve cobwebs, but ECB Chairman Mario Draghi rang in the year with words of sober clarity. Deflationary risk in the Eurozone is significantly higher than it was six months ago, Draghi told the German Handelsblatt, and may require “measures at the beginning of 2015” to confront the challenge. Markets are widely interpreting “measures” to mean a full-blown quantitative easing for the Eurozone. The euro continues its downward trend, hovering just above 1.20 to the dollar, in the year’s first day of trading. Yields on key benchmark Eurozone bonds continue their race to the bottom.
Meanwhile, On the Other Side of the Pond…
The world seen by Janet Yellen from her office in the Eccles Building, the Fed’s Washington DC headquarters, is starkly different from that described by the ECB’s Draghi. Having wound down QE, the Fed is now faced with the challenge of charting a low-drama course to higher rates. The difference between Draghi’s world and Yellen’s world is clear in the chart below. This shows the direction of the U.S. 2 year Treasury over the past twelve months versus that of the German 2 year Bund:
Short term rates in the U.S. finished 2014 not far from their 52-week high marks, while 2 year Bunds established new 52-week lows. German short term rates have been below zero since August – yes, negative interest rates are an established feature of the new monetary order in Europe. In their parallel worlds Draghi and Yellen each face considerable challenges: the ECB chair must convince markets that policy coordination in the fractious Eurozone is achievable, while Yellen must avoid spooking the markets into the kind of tantrum that her predecessor Ben Bernanke unleashed when he uttered the word “taper” in May of 2013.
What Flavor of QE?
Even if markets expect European QE to be established, the question remains as to what variety is going to be effective. Broadly speaking there are two ways to carry out a quantitative easing policy. The approach undertaken by the ECB to date, through mechanisms like the Long Term Refinancing Operations (LTROs) launched in early 2012, relies on bank intermediation. The idea is that banks are supposed to take cheap money, turn around and lend it out to businesses in need of capital for growth. In practice, though, a greater slice of the LTRO funds remained on the banks’ balance sheets than went into new loan creation. In a low-demand, low-growth environment like the Eurozone there is only so much stimulus that can be applied through bank intermediation.
The other way to accomplish QE is to take a page from the Fed, and inject the stimulus money directly into the economy via open market asset purchases. A comparison of headline numbers between the U.S. and the Eurozone would seem to support this as the preferred approach: on the basis of GDP, employment, retail sales, manufacturing and any number of other figures, the U.S. economy’s trajectory over the past several years has been superior to that of the Old Continent. But such comparisons may also be misleading. There is no clear consensus as to how much of the U.S. recovery may be attributed to QE, the range of views extending from “a fair bit” to “none whatsoever”. QE by itself is unlikely to be a magic bullet: fiscal and other regional and national policies need to also be growth-oriented. That is no easy feat in the 19-member Eurozone.
Faction Before Blood
Perhaps the most difficult roadblock the ECB’s Draghi faces in harmonizing the right flavor of QE with supportive national policies is that of the deep-seated rifts between Europe’s economic policy factions; most notably, the austerity faction led by Germany and other “Northern” nations, and the stimulus faction popular among disgruntled voters in countries where 20%-plus unemployment remains the norm – and that cuts across a wide swath of diverse territories and national identities.
Both the austerity faction and the stimulus faction put forth spirited arguments for their side’s merits versus the other. The austerity argument – that it is folly to deal with a problem of too much debt by creating yet more debt – is logically compelling. But the stimulus camp perhaps holds the trump card: until deflation risk is tamed for once and for all, other approaches will not bring the region back to health before more wrenchingly harsh standard of living declines have played out.
For the U.S., these factional battles are much more than a parlor game to be observed at a distance. Our economy is strong, but not so strong as to be unaffected by the travails of our major trading partners. An aggressive QE approach by the ECB is, we believe, likely to be in our best interests. It may also make it easier for Fed chair Yellen to maneuver her policy ship with the agility necessary to minimize collateral damage in asset markets as rates start to rise. On the policy front, it promises to be a high-stakes 2015.