Posts tagged Interest Rate Trends
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.
Stocks threw a mini-tantrum earlier in the week after Fed Chairwoman Janet Yellen made it pretty clear that she really, really wants to get that first rate hike on the board in December. Today’s jobs release from the Bureau of Labor Statistics goes a very long way to help make the Chairwoman’s wish come true. While the headline number of 271,000 new jobs is impressive enough, given expectations for just 180,000, it is the wage number that should really move the dial very close to rate hike certainty. As the chart below illustrates, year on year wage growth is stronger than it has been since the beginning of 2010, and the first real upside breakout over this time period.
To be clear, this is just one month’s worth of data. But the 2.5 percent year-on-year growth in wages finally seems to square with much of the anecdotal evidence dribbling in from corporate earnings calls this quarter, from the likes of Wal-Mart among others. Wages do seem to be gaining traction. The unemployment rate, at 5.0 percent, is half its level at the height of the jobless trend and just ten basis points above the 4.9 percent level often cited as the full employment threshold. This recovery has been decidedly low-wage up to now, and even at 2.5 percent it remains below pre-recession norms. But some degree of normal cause-and-effect still prevails in this economy. With higher wages should come higher prices, sooner or later. In her recent comments Yellen has conveyed a line of sight to that elusive 2 percent inflation target. That target is finally starting to come into our sight range as well.
So the stars seem to be aligned. Yes, a truly miserable November jobs report – and we would imagine the misery threshold to be somewhere around 50,000 or fewer payroll gains – could put plans back on ice. Another stock market meltdown could do the same. But with the default scenario now fully pricing in a rate hike, our attention floats across the pond to Europe. ECB Chairman Draghi appears ready to expand the current quantitative easing program if need be, probably by extending the planned September 2016 end date. Heading further east, the Bank of Japan passed on further easing in its deliberations last week. But the consensus opinion among observers is that, barring some unexpected stimulatory impact from one of Abenomics’ fiscal arrows, monetary action will once again need to ride to the rescue there. All this would appear to point to the very real possibility of policy divergence among the world’s principal developed regions. That has never happened, so we will be headed into uncharted waters as we transition into 2016.
Growth Trumps Rates
Yes, we have used the “Growth Trumps Rates” headline in previous commentaries, but it is a useful reminder for us that we would rather live in a world of rising interest rates and economic growth than zero-bound rates and stagnation. We do not think growth here at home should necessarily be stymied by monetary policy divergence, should that come to pass. The Eurozone economy has managed to slightly outperform what were admittedly fairly low expectations at the beginning of the year. If Chairman Draghi believes an extra shot of QE will move it further back from the deflation cliff, then so be it. A continued headwind for US exports, to be sure, but we would expect the impact on GDP to be largely offset by brisker consumer spending at home, helped along by improving wages.
This scenario in turn feeds into the “quality rally” thesis we have set out in recent weekly commentaries. This thesis sees companies able to demonstrate competitive advantage – evidenced for example by double-digit top line growth despite FX headwinds, emerging markets softness and other challenges – as likely to outperform their peers. To some extent this trend is already underway. A December rate hike should provide confirmation for this new phase of the bull market. The training wheels are coming off, and future price gains should be more about the good old metrics of free cash flow generation and strategic execution than about QE and zero percent rates.
The Fed did the right thing yesterday. Below trend inflation, modest wage growth, tepid productivity and sub-80 percent capacity utilization all point to a US economy that, while growing, is far from running hot. The urgency for an immediate rate hike simply was not there. Given the elevated threats evident elsewhere in the world, why risk it? That was the clear message in the communiqué which accompanied yesterday’s FOMC decision to leave rates where they are and live to fight another day. By explicitly calling out “recent global economic and financial developments” Yellen & Co. articulated the reality that what happens elsewhere in the world can have a direct impact on US prices and jobs, the twin components of the Fed’s mandate.
Data-Driven vs. Time-Driven
But the decision to stand pat at zero lower bound carries its own set of risks, first and foremost of which may be the Fed’s own credibility. The lead-up to the September meeting was particularly confusing. On the eve of the announcement the professional community was – at least according to the received wisdom – about evenly split as to whether or not there would be a rate hike. Fed funds futures markets seemed to be pricing in no action, but the 2 year Treasury was yielding over 80 basis points, a 52 week high, reflecting at least some degree of rate hike expectations (the 2 year promptly retreated back below 0.70 percent following the announcement). Observers were having trouble reconciling two somewhat conflicting positions: the “data-driven” mantra invoked by nearly all FOMC members in their various public comments, and the time stamp of “later this year” suggested by Chairwoman Yellen in previous comments, back before the Shanghai Composite began its nosedive this summer.
That earlier time stamp comment was what gave the September meeting such a frisson of breathlessness, being one of only two remaining FOMC meetings this year to be followed by a press conference (the next meeting, in October, will not include a press conference where Yellen could articulate the reasoning behind any action taken and thus is deemed a less likely venue for such action). In the wake of yesterday’s decision, we now know that data trumps the calendar, and we know that the data set extends well beyond US borders. What remains unknown is how those “global economic and financial developments” will specifically factor into the calculus going forward. Is the Fed now central banker to the world? Yes, to the extent that international growth rates and currency bourses affect US jobs and prices, and therefore domestic monetary policy. What actual global developments need to take place for the Fed to be confident about moving forward? That remains to be seen. The waiting game is, if anything, foggier today than it was leading into the September meeting. That has the potential to further roil already jittery asset markets as we head into the final quarter of the year.
Behind the angst about when rates will start rising is a deeper concern about growth. For all the unconventional firepower central banks around the world have thrown at the problem, the fact remains that global growth is well below trend. Europe is still struggling to maintain positive growth, China’s actual – as opposed to published – growth rate is a deepening mystery and many key emerging markets are in outright contraction. In this environment the burden of global growth engine has fallen on the US. The problem is that our own growth is below trend and will likely remain so without a more robust pace of activity elsewhere in the world. Consider the following chart, showing real year-on-year US GDP growth for the past forty years, going back to 1975:
Average baseline trend growth today is lower than at any time in the past forty years. Now, resumed growth elsewhere in the world could help reverse this trend. Many of the largest companies that make up the S&P 500 derive more than half their total revenues from markets outside the US. As those markets grow, so do our own fortunes. This is why those “global developments” are important enough for the Fed to explicitly call them out. If the current growth malaise is cyclical – and if keeping rates historically low helps us work through the cycle without falling back into recession – then one could reasonably expect trend growth to turn back up.
Of course, there is no certainty that the current lack of growth in the world is cyclical. There is no shortage of opinion out there that “winter is coming”, to use the popular Game of Thrones vernacular. This view holds that the downturn in world output is structural, not cyclical, and likely to be with us for some indefinite time to come. The Fed’s credibility likely hangs in the balance as to which of these views will ultimately prove to be correct. Given what we know today, though – and much as we would like to see conditions normal enough to move away from zero lower bound – holding off on rates in light of elevated economic risks was in our opinion the right thing to do.
Interest rates are once again the trending topic as anticipation for the Fed’s June policy meeting next week grows. Last week we considered the potential impact of a Fed rate hike on equities and the possibility of a pullback. This week we shift the focus to what the Fed action might mean for your fixed income portfolio. Back at the beginning of the year, most economists predicted that the Fed would decide to raise rates in June – meaning next week. But after a string of weak economic data the consensus was pushed back, possibly even to next year. That being said, recent data including nonfarm payrolls and this week’s retail sales have been strong. A September rate move looms large, meaning that it is important to make sure that the fixed income portion of your portfolio is positioned accordingly.
Investors say Junk Bonds are indeed “Junk”
An article in the Financial Times this week focused on outflows in high yield bond ETFs since the beginning of June, citing rising rates as a driver. This does not necessarily mean that you should get rid of your high yield exposure in anticipation of rising rates. High yield (or junk) bonds have been found in the past to be less interest rate sensitive than other investments. Rising rates can indicate an improving economy, which in turn means a better environment for companies with poor credit ratings (those companies are the ones issuing high yield bonds). For these and other reasons, junk bonds tend to trade more like equities than bonds – the Barclays US Corporate High Yield Bond Index is 74% correlated to the S&P 500 versus only a 16% correlation to the Barclays US Aggregate Bond Index over the past five years.
In fact, for much of the past year high yield prices have actually moved in the same direction as benchmark interest rates. As rates fell through the second half of last year, junk prices fell as well. When rates rose on the back of good economic news in February of this year, high yield prices performed well. Where this pattern broke decisively was just a couple weeks ago, when the 10-year yield spiked and junk bonds tanked. In other words, if recent outflows are being driven by rate perceptions, that would seem to be more of an anomaly than the “junk bonds fall when rates rise” rule suggested by the Financial Times’ article.
There are two sides to every coin, and more risks to take into account than the directions of interest rates. Call risk affects any bond with call features, and this includes the vast majority of high yield bonds. Most high yield bonds have a maturity of 10 years but are callable at 5 years. In a falling rate environment these bonds tend to get called because the borrowers can then reissue the same bond with a lower interest rate, meaning their borrowing costs fall. In a rising rate environment the opposite will happen – the bond won’t get called because it would have to be reissued at a higher duration. Investors holding callable bonds can get the worst of both worlds – lower duration when rates fall and higher (i.e. more negative price sensitivity) when rates rise. When positioning portfolios for a rising rate environment it is important not to ignore the implications of call risk.
Ever heard the disclosure “past performance is not indicative of future results”? The above chart illustrates why that regulatory disclosure is always worth keeping in mind. Even though junk bonds have historically performed more in line with equity markets than with fixed income, over the past eight months the correlation has been spottier than usual. Junk bonds mirrored equities until October, when stocks experienced a deep pullback. High yield followed stocks down, but then kept falling while the S&P 500 pulled a stunning V-shaped recovery.
Why the divergence? A considerable number of junk bond issuers are energy exploration and production companies, and the energy sector led the broader market down as oil prices were plunging. So even though the S&P 500 enjoyed a sharp recovery, investors dumped high yield bonds fearing a rise in energy-related default risk. A similar story happened back in 1999 and 2000: during the period of high volatility leading up to the implosion of the tech sector in 2000 (which also happened to be when a rate hike program was in place) junk bonds had a negative return and underperformed other asset classes.
When in Doubt, Diversify
Because it has been awhile since the last Fed policy decision to raise rates (eleven years to be exact), it is difficult to predict how the scenario will play out this time. The more recent data we have on rate hikes happened in the context of a 30 year macro bull market for bonds. If we are about to enter a secular rising rate environment (and we don’t know for sure if this is the case), the most recent comparable data we have to work of off is from 1951 – 1981 – it is safe to say that the world is vastly different now than it was back then. Quite possibly, we are entering into a whole new world of rising rates.
There are some logical assumptions we can make, though. Investments that are less interest rate sensitive (as indicated by shorter effective durations) are more likely to perform better in a rising rate environment. High yield bonds fall into this category, but as we saw above there really are no guarantees. It is more prudent to adjust your allocation accordingly in different market environments rather than to either eliminate an asset class altogether or double down on the one you think (based on past performance) likely to do best.
Floating rate debt, short-term fixed rate issues, agency & non-agency mortgage backs and asset backed securities can potentially help immunize your exposure to interest rate risk. As noted above, don’t forget about call risk. The bottom line is that when the terrain is uncharted, a well-diversified portfolio is likely to be the best way to avoid missteps.
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.