Posts tagged Interest Rate Trends
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.
On this holiday-shortened week we like to take a brief pause from the focus on day-to-day trends that normally fill up the pages of our Weekly Market Flash, and reflect on things at a more expansive level. 2014 has had its ups and downs, but mostly it has been a kind year to investors. As is our custom, we offer here some of the events and developments of the year that cause us to give thanks.
Spirit of America
Once again the U.S. has been the bright spot – among major economies the lone bright spot really – in continuing and strengthening the post-2008 recovery. Every quarter we closely analyze the performance of companies in our portfolios and listen to their management teams comment on the three months gone by and the outlook ahead. We are – not always, but generally – impressed by resourcefulness and discipline we hear on these calls and continue to believe that high quality U.S. stocks are attractive for long term portfolio performance. It’s easy to become disillusioned with institutions both public and private in our day and age. But we’ll take the American model over anything else we see out there.
Foreign Bond Investors
Back in January there was as clear a consensus as ever there was on Wall Street that interest rates were headed higher. The 10-year Treasury yield was over 3% and the Fed had just announced it would start reducing its monthly intermediate and long term bond purchases. Twelve months later, the 10-year yield is closer to 2% than 3% - this despite a continual stream of good macroeconomic numbers, corporate earnings and consumer sentiment. What’s keeping rates so firmly entrenched at historical low levels? A major contributing factor has been a massive wave of bond purchases from investors in Europe, Japan and elsewhere. 2.3% is a pretty lousy yield, except when compared to the sub-1% yields to be had from Bunds, JGBs or the like. We sense that the music will likely stop at some point – making for some tricky terrain – but the day is not yet at hand.
Cool Heads, Low Vol
A year ago, the S&P 500 rang out 2013 with not only the highest total return since 1997, but the highest risk-adjusted return in, well, forever. Too good to continue? Well, volatility stayed in the valley for most of 2014 as well. The CBOE VIX, a broad measure of market risk, currently trades more than a third below its long term historical average. The handful of pullbacks we have seen this year – and the attendant spike in headline risk – have been exceedingly brief and mostly shallow. The biggest risk event of the year played out over a few days in the middle of October, and still failed to break through the -10% threshold that would have signified a technical correction. Why so tame? The “Yellen put” is a favorite answer: the belief that the Fed will always step in. We think a bit differently. When the tailwinds seem stronger than the headwinds, as we believe is currently the case, investors will use pullbacks as an excuse to buy at slightly cheaper valuations, not to panic and run for the fire exit.
We may be thankful, but we are not complacent. 2015 will no doubt present its own special set of challenges, and we have to be ready to meet them head on. In the meantime, though, let us all take a few to focus on the people and things in our lives we cherish. May each and every one of you have a very happy Thanksgiving.
European Central Bank Chairman Mario Draghi is spending a few days this week in the pleasant late-summer climes of Jackson Hole, Wyoming, site of the annual central bank symposium hosted by the Kansas City Fed. Chances are, he won’t be spending too much time savoring the many recreational delights of this Rocky Mountains resort as he tries to present a strong, consistent and reassuring message to the world about Europe’s financial and economic prospects. Those prospects look anything but promising these days. Talk of a “lost decade” brings to mind the specter of Japan: stagnant growth, waning competitiveness and mounting debt. Draghi has done a masterful job to date in projecting confidence: his “whatever it takes” pronouncement in 2012 was arguably the most important three-word utterance by a Roman since “veni, vidi, vici”. But words and confidence alone may not suffice in navigating the current rough waters.
Bond Market Surrealism
All those problems would logically make the Eurozone a riskier bet for investors than the more stable U.S. After all, our economy has regained and surpassed its pre-2008 size, while Europe’s economy remains smaller than it was before Lehman Brothers collapsed. Yet a remarkable thing has been happening in Europe’s bond markets: yields have plummeted to common currency-era lows. As the chart below shows, the benchmark 10-year Eurozone yield has fallen below 1% in recent days, even as the Euro has also continued a sharp downward trend.
We have noted in other commentaries that low bond yields in other developed economic regions like the Eurozone and Japan have been a driving factor in keeping U.S. yields down. The 10-year Treasury yield currently sits around 2.4%. That is much lower than most market observers expected at the beginning of this year, but it’s fairly attractive when compared to the sub-1% levels elsewhere. Riskier assets normally trade at a positive spread to the risk-free rate, but in the Wonderland that is today’s credit markets that seemingly impregnable financial axiom stands on its head. And the Euro’s decline adds the variable of lower purchasing power to the mix. All this raises the question: why are Eurozone rates so low, and who is crazy enough to be buying?
Mario and the Banks
Much of the answer to that question has to do with the policy measures Draghi and the ECB have focused on up to now. The centerpiece of this policy is the ungainly acronym TLTRO, for “targeted long term refinancing operations”. Basically, these are series of ultra-cheap loans provided by the ECB to European banks, for the purpose of encouraging banks make their own loans, in turn, to European businesses.
But in reality, not much in the way of TLTRO funds have found their way into commercial lending markets. Rather, the banks have used the cheap loans to invest in European sovereign debt. Why is the Spanish 10-year benchmark yield virtually the same as the U.S. Treasury yield? Because Spanish banks have loaded up their balance sheets with Spanish government debt, locking in as pure profit the difference between the cheap TLTRO paper they borrow and the sovereign yields they purchase.
Time for QE, Euro Style?
This practice directly challenges the original logic of the TLTRO program. If European sovereign yields are unsustainable from a fundamental valuation perspective, and if most of this paper is concentrated on the balance sheets of European banks, a painful unwinding could follow. The betting among investors currently is that the ECB will take pre-emptive actions to forestall this outcome by implementing its own version of quantitative easing – buying bonds in the open market in the manner of the U.S. Fed, the Bank of England and the Bank of Japan.
A massive QE effort – and there is no guarantee that even Super Mario could jawbone this policy through the EU bureaucracy – would likely add to downward pressure on yields, at least in the near term. But the policy may not work. First, as already noted, rates are already low, and much lower than justified by the fundamentals. There may not be much tangible benefit to squeeze out of whatever additional bond buying can accomplish.
Second, European businesses do not rely on the bond market for their financing anywhere nearly as much as U.S. corporations do. QE has been a boon to U.S. enterprises, enabling them to raise money through bond issues at extremely low rates. In Europe, businesses borrow more from banks than from the bond market – and as we noted above, the banks have not been enthusiastic lenders since 2008.
There are fears in some corners that if European asset markets falter the contagion could spread elsewhere. That is possible, but in our opinion a more likely outcome in the near term would be the continued relative appeal of other markets, including the U.S. and perhaps the recently surging emerging markets. Investors need only look to Japan – the Nikkei 225 is still less than 40% of its peak value 25 years ago – to see what a prolonged freeze can do to portfolios. Mario Draghi, arguably more than anyone else at Jackson Hole, has his work cut out for him.