ECB negative rates may be counter-productive by encouraging cash hoarding
12th June 2016 by Chris Iggo
The Federal Reserve (Fed) may not hike rates next week but financial conditions are easier today than they were in December at the time of the first move. Unless there is more evidence that the US economy is slowing down, markets will have to price in some increases in rates after June. However, the Fed is going to take it slow and steady and the outlook is not that damaging for bond investors. Indeed, with the benchmark of cash being zero or negative, our view is that bonds are still attractive. If you need yield and are worried about risk, short duration strategies are an attractive way of getting exposure to bond market income. Yes, there are longer term concerns about returns, but in the short term with confidence in the global economy still weak, fixed income can’t be ignored.
- Pass or play? – Regular readers will know that a few weeks ago I expressed the view that the US Federal Reserve would opt to raise interest rates again in June. That view was backed by numerous comments from Fed officials suggesting that conditions were appropriate for another very small increase in the Fed Funds rate. However, last week’s employment report for May put the skids under that view and it now seems that there is a strong chance that the Fed will pass in June. I can’t, for the life of me, believe that serious central bankers think a rate hike a month apart makes a huge difference to how the economy will operate over the next couple of years, but the view now seems to be that an increase in July could be seen. Employment expanded by only 38,000 in May and this was taken by the markets as a signal to bet that June is off the cards. I was once told by a senior official at the US Treasury in Washington that they didn’t really pay too much attention to any individual monthly non-farm payroll headline jobs number given the “white noise” or margin of error was estimated to be as much as 200,000 per month. Given that the unemployment rate fell to its lowest recorded level since November 2007 and hourly earnings growth remained at an annual rate of 2.5%, there is little evidence that the economy is rolling over. I have some sympathy with the view that the closer you get to full employment the more difficult it is to create new jobs. There are just not enough skilled available workers, especially when the participation rate in the labour market has fallen for structural and other reasons in recent years. I might be wrong and the 38,000 increase in employment might be the first sign of the economy going into a downturn, in which case the Fed won’t be raising rates in July or September or at any time in the foreseeable future. But I don’t believe that is the case. If the former explanation is the right one, then wage growth should continue to pick up from current levels.
- 2% target? – We will see next week what the Fed decides to do at its June meeting. A decision not to change policy may be partly in anticipation of any market volatility surrounding the UK referendum. On the basis of the current mode of anticipating market events, markets will probably take the view that if the UK vote is to remain in the European Union (EU) and the June payroll number is back in the 150,000 to 200,000 range, then the Fed will hike on July 27th. But for this to be correct it has to be the case that the Fed is convinced that the economy and financial markets can cope with a very modest tightening of financial conditions. Since the last rate hike the dollar is weaker by around 4% on a trade-weighted basis, equity prices are higher by 3-5% and 10-year borrowing costs have fallen by around 60 basis points (bps). Yes, that’s right, financial conditions are easier now than they were when the Fed hiked in December. The unemployment rate has fallen by three tenths of a percent and inflation is higher. What’s more, I’m not convinced that negative interest rates is a policy that would be adopted willingly in the United States and if this is to be avoided, the Fed needs to have some leeway on rates by the time the next downturn comes. If inflation is going to be 2% then the economy suggests that’s where the Fed Funds rate should be too.
- Get shorty – However, we know the Fed will take its time and is hardly worried about being behind the curve at this stage. As such, the environment remains supportive for bond markets from an interest rate point of view. This is more the case when we consider the global situation as interest rate increases in Europe and Japan are still years in the distance. Negative rates are increasingly becoming the benchmark against which investors judge prospective returns, hence the lack of hysteria in the last couple of weeks as 10-year German bund yields have fallen to within a whisker of zero percent (0.029% as I write). I was discussing the outlook with private bankers in Madrid this week and the message was that the environment made for very difficult conversations with their clients. Holding cash is not very rewarding but convincing investors that a 1% return on high grade bonds in Europe is an attractive return is a hard sell. In the end, however, investors have little choice. If capital preservation is a key priority but some return is needed, the bond market is the best bet. Short duration strategies – investing in bonds with an average of 2-3 years left to maturity – is an attractive way of getting access to returns from investment grade, high yield and emerging market debt. These types of strategies display less volatility than the overall market, provide some natural liquidity as a result of the constant flow of maturing debt, and do have less sensitivity to movements in markets yields because of the low duration. Given that markets are prone to bouts of volatility as a result of the mini-sentiment cycles, short-duration bond strategies are a lower risk way of getting exposure to the higher beta parts of the bond market such as high yield and emerging market debt.
- US and UK yields are attractive relative to Europe – The macro environment is generally supportive for bonds. Valuations, in absolute terms, remain expensive but in comparison to cash there are pockets of value in the bond market. High yield and emerging markets remain two of my more favoured sectors while, as you may recall, I have also been an advocate of buying long dated US Treasuries (yield to maturity of 2.47% at the moment) as both a hedge against credit and equity exposure but also to benefit from the global monetary situation and the tendency of yield curves to be in a flattening mode. Sentiment and technical factors are positive too. In Europe, the big technical influence on the market is the European Central Bank (ECB) and this week it began to buy corporate bonds. The volumes are limited so far but there has already been an impact on the market with credit spreads narrower by some 8-10bps over the last month. Given the underlying move in government bonds in Europe, this means that the average yield on European investment grade is now well below 1% and more and more of the market is trading with a negative yield. This is not great for new investment in the European bond market but it is a great environment for borrowers. It also makes the dollar and sterling markets look incredibly more attractive. The average yield on sterling credit is just under 3% and, despite “Brexit” concerns, the market has rallied strongly in recent weeks. A “Remain” vote should see the British pound regain some value and this could be a further boost to the UK credit market. In the US, where there are more fundamental concerns about Fed rate hikes and leverage in the corporate sector, the market has also performed well and still retains a 3% yield on many of the representative credit benchmarks. The main worry I have about Europe is that the ECB’s policy is ultimately contributing to the problems it is trying to solve. Negative rates might make people hoard cash, collapsing the velocity of money and keeping aggregate demand very weak. As a piece by Deutsche Bank made clear this week – and it is a sentiment I have a lot of sympathy with – in the end we need government spending to boost demand as monetary policy is running out of steam. So while the European high yield market is attractive at the moment, should the negative consequences of current monetary policy start to become more evident, credit risk will rise in Europe. Credit markets in the US and UK are preferred as a result.
- Know your bonds and they will do the job for you – For the moment I am bullish on bonds despite the low yields. The fascinating thing about this job is that one can always find interesting opportunities. It is not a homogenous market as there are a range of risks coming from bonds of different maturities, from different countries and sectors and of different credit quality. I genuinely believe that with the right research, the right approach to portfolio management and risk analysis, one can deliver bond strategies that provide a return consistently well above that of cash with a volatility level that is significantly below that of the equity market. The key components are diversification and understanding of the interaction of interest rate, inflation and credit risk through the business cycle. It’s not just about allocating to different sectors, it’s about understanding the behaviour of different parts of the market. A 30-year Treasury might be “uber-safe” from a credit point of view but that does not mean it won’t be volatile just as a single-B rate high yield bond might have a much higher default rate but can deliver returns that are closer to equities. I guess the message here is, despite the longer term risks posed by negative yields and the potential for capital losses at some point, for now the bond market should be taken seriously by investors who are perhaps sitting on cash and are not convinced that the equity market can deliver the returns that have been seen in the past.