22nd November 2014 by The Harried House Hunter
Current bond yields price in a much lower trajectory for short term interest rates over the medium term than seen in previous economic cycles. This one is different because it started with a great financial crisis and there is lots of debt in the system. Yet growth in the US has recovered and the economy is cruising. Still the Federal Reserve (Fed) is not ready to normalise policy even if it is working on what needs to be done and what is the best way to communicate. The risk to the bond market is that there may eventually be the expectation that real rates will need to be positive again and that the term premium should rise given the uncertainty over growth, inflation and monetary policy over a longer time horizon. A yield of 2.3% for 10-year debt looks like the wrong price. We (and many others) have said this many times before, but like a stopped clock, that view is bound to be right at some point (isn’t it?).
Two per cent jobs growth and negative real rates – can it last? – I don’t normally include charts in this note, despite the fact that I must have created more power-point chart packs than I care to remember. However, I wanted to discuss the chart below this week because I think it serves a purpose as being a good reference for the current narrative on the US economy. It shows the annual growth rate of employment, measured by the total level of non-farm employment (I wonder why we never consider the poor farmers) against the real Federal funds rate (Fed funds rate). Over a long period of time the two time series track each other, as you would expect. The employment growth indicator is a proxy for overall economic growth while the real Fed funds rate is a proxy for the stance of monetary policy. Periods of strong employment growth mean the economy is doing well, the labour market is tightening and there are inflation concerns and these periods are associated with tighter monetary policy (a higher real interest rate). On the contrary, when employment growth slows or turns negative, monetary policy is eased.
Real rates couldn’t be cut enough without QE – If we focus on the last few years we have quite a story. The economy went into recession after the financial crisis and employment growth collapsed. Indeed, during 2009 the employment growth rate fell to -5% as the unemployment rate itself rose to 10%. In the post-war period the unemployment rate was only higher during the 1980s recession and the decline in employment growth was the most severe in 2009 than at any time since the 1930s. The GDP growth rate fell to -4% during the same period. Of course the Fed responded by cutting interest rates sharply but it couldn’t get real interest rates low enough because inflation was also falling. During the 1970s real interest rates fell by more than they did in 2009 but that was at a time of rising inflation. This time around the Fed had to cut rates to as low as possible and also think about how to generate an increase in inflation so that real rates fell and remained low in response to the sharpest decline in growth seen in decades. Hence, quantitative easing and the persistence of negative real interest rates for the last five years.
Divergence between real growth and real rates – Focus on the blue line though. Employment growth has recovered and has been growing at a year/year rate of close to 2% in recent months. The unemployment rate has fallen below 6% and surveys suggest that job creation continues to be quite robust across the economy. There is also starting to be some evidence that wages are at last reacting to the reduced level of slack in the labour market. Yet the Fed funds rate remains near zero and the Federal Open Market Committee (FOMC) continues to be very hesitant discussing the potential for interest rate hikes in 2015. Market participants are not convinced of this either, and there continues to be a bearish narrative from many market commentators who latch on to any piece of slightly weaker economic data or dovish comments to support a conclusion that rates will remain lower for even longer.
No risk premium in long bonds – Bond yields also remain low as a result of the view that the Fed will continue to be extremely accommodative. Looking at the forward market, the implied path of short-term interest rates suggest that they will remain below 3.0% for the next decade. Of course, 3.0% seems a long way from where we are today but if the Fed is successful in generating 2% inflation and at some point feels that real interest rates should be positive, then it is not such a outlandish expectation. Indeed, in economic expansions it is more usual that real short term interest rates would be close to 2%. This points to 4% Fed funds if inflation averages 2% during an economic expansion. So the current 10-year treasury bond yield implies a very optimistic path for short term interest rates over the medium to long-term and virtually no term premium (the premium for holding longer term debt). In the context of the divergence between real growth and real interest rates the conclusion is that treasury yields are too low and should rise over the medium term.
Could it be global QE, monetisation of deficits, playing Russian roulette with inflation? – This is no surprise of course. Many bond investors have taken this view for a few years now and betting on a rise in interest rates has been a money loser for the most part. The argument that the Fed will not raise interest rates in 2015 rests on the notion that there are downside risks to growth (stronger dollar, weakness in export markets, existence of high levels of debt) and/or that inflation will remain extremely low (energy prices, demographics, over-capacity in global manufacturing). No interest rate hikes because of these reasons implies that the only policy tool the Fed has to respond to renewed weakness in growth would be to re-start QE and increase further its holdings of US treasuries. The Keynesian phrase “pushing on a string” comes to mind. What would a world be like if the Fed restarts QE, the Bank of Japan’s balance sheet becomes as big as the Japanese economy, the European Central Bank (ECB) decides to buy sovereign bonds and, because everyone else is doing it, the Bank of England also goes back to buying gilts? Monetisation anyone?
Let it roll – Maybe I am too simplistic and base my core world views too much on what I studied at university many years ago. As my kids always tell me, the world has changed. The internet makes markets more competitive and that may mean inflation remains low permanently. But permanently negative real interest rates surely means that macro-prudential limits will be tested. There is an incentive to borrow if nominal growth expectations are higher than nominal borrowing costs. If there is a reason why rates remain lower for longer it is because the world is still too indebted. Not many countries have seen debt levels reduced and there is probably an ongoing need to make financing debt as easy as possible. If the real value of debt can be eroded by higher inflation, all the better. It’s interesting that equity markets have hit new highs this week in response to decent US economic data and the “let it roll” attitude of the FOMC.
2015 – Next week’s Thanksgiving holiday marks the real run-in to year-end. I expect it will be a pretty good year for retailers given that there are some 2.6 million more people in employment now than a year ago. Energy prices are lower and wages are higher. People have made money in equities and bonds and housing. Household debt levels have also stabilised and are pretty much unchanged over the last five years. So expect Black Friday to be a big one. For me it is all about thinking how to communicate our views on the market for 2015. There will be plenty going on – potential interest rate increases in the US and UK, potential QE in Europe, general elections in the UK (May) and in Spain (by December) with EU membership being a key topic. My initial thoughts on fixed income strategy are that the losing duration trade of the second part of 2014 could become a winning trade in the early part of 2015; that Europe will offer investors a safe-haven in terms of capital preservation with yields lower than in the UK and the US and unlikely to rise as much; that some crowded trades will disappoint (European peripherals); that high yield and emerging markets will attract investors looking for yield enhancement, although in the short term idiosyncratic risk in high yield may mean that prices sell off a bit more; and that investors should seriously look at trades that protect them from a policy mistake (like buying credit protection or inflation protection). As always, and unlike the 2014/2015 premier league season, the markets will be fascinating.