The thin red line – negative interest rates

Negative interest rates are back in the headlines again. Markets have begun to price-in a chance that both the US Federal Reserve and the Bank of England will be forced to cut rates and break the zero bound in an attempt to support their economies and offset growing disinflationary pressures. But how likely is this and why is it being talked about now?

The policy of taking interest rates into negative territory was most notably adopted by the ECB in the aftermath of the sovereign crisis. Having always been seen as taboo or more of a theoretical exercise, this was one of the many “red lines” that Mario Draghi crossed as part of his “whatever it takes” mantra. The concept was that by offering negative interest rates on deposits, investors would instead take their cash and spend or invest it, thus bolstering economic activity and inflation. 

While some others followed, the major central banks chose not to, instead relying on a variety of asset purchase schemes to support their economies. By 2019, it felt that, collectively, Central Bankers had lost faith in the benefits of negative rates and instead talked of “normalising” rates – in the case of the ECB; or exiting negative rates completely – in the case of the Swedish Riksbank. Adamant that their economy would be better off without negative interest rates, the Riksbank hiked rates to zero in December last year, not because their economy needed higher rates, but simply because they viewed the costs of sub-zero rates as outweighing any benefits.

The reason negative rates are being talked about now is clear – the unprecedented economic collapse that we are in the midst of is asking a lot of Central Banks, causing some to wonder whether they are running out of ammunition and that further interest rate cuts may in fact be needed. With the US Fed and Bank of England both at the effective lower bound, any further cuts would require them to cross the zero bound. In the last week both Jerome Powell and Andrew Bailey have had to answer questions on this topic. Of course, “Central Banking 101” teaches you to never rule anything out completely and while they both pushed back on the need to do it now, it was not a “no, never” response. This way, front-end rate expectations will remain anchored as markets cannot completely dismiss the chance of negative rates.

Do I think they will cut rates into negative territory? Both the Fed and the Bank of England still have a lot of flexibility in their QE programmes and the Fed, in particular, has shown itself to be very creative when stimulus is required. Adding to that the lack of clear evidence of the benefits of negative rates, then I think they will choose to explore other avenues if needed. 

For those countries who have less flexibility on asset purchases, there may be no alternative. The Reserve Bank of New Zealand (RBNZ) is a recent addition to the QE club, but with only a relatively small bond market available to them, they may exhaust their QE buying and be forced to look elsewhere. In fact, the RBNZ asked its domestic banks to be “operationally ready” to deal with negative rates by year-end. A case of planning for the worst, perhaps?

While others may do so, ultimately I don’t think the US and UK will cut rates into negative territory – but with a slew of mixed messages coming from the Bank of England, my confidence in that view is decreasing. If negative rates are still seen as a “red line”, it appears to be a thin one that may get all the more thinner. In the face of this crisis it seems nothing can be completely discounted.

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Talking Bonds (video)

What’s our fixed income strategy for the next month? With central bank cuts and softening macroeconomic data influencing bond markets recently, one of our Fixed Income Fund Managers, Colin Finlayson has given us his insight in to the main areas of focus for the Kames Fixed Income Strategy over the next month.

Government bonds win at the game of trade tariff tennis

August was a memorable month for fixed income investors for a number of reasons.  The sharp decline in bond yields was sparked by an escalation in the trade tensions between the US and China.  The trade dispute and the risks around it have been known for some time.  They have been top of the list of factors that investors and economists have been concerned about since the back end of 2018.  Everyone agreed that tariffs were a negative for global growth but the extent of the impact was uncertain – a known-unknown, if you will.

For much of this year, the US – primarily via Tweets from President Trump – appears to have been the aggressor, setting the agenda and terms for any deal to be done.  This changed in August when the Chinese began to take action and engage in a spot of trade tariff tennis. They successfully raised the stakes by applying tariffs of their own on US imports, but they then served up an ace.  By allowing the renminbi to devalue versus the dollar (at least temporarily), they jolted the market, evoking memories of the summer of 2015.  By their willingness to play hardball and retaliate, the Chinese have raised the stakes and in the eyes of the market at least, have increased the probability of the downside risks being realised.

Increasingly it looks like the only winner in this game could be government bonds.  The escalation of the trade spat has been great news for government bonds as demand for them has sky-rocketed – August saw the highest total return for US Treasuries (3.6%) since November 2008, with UK gilts delivering an even higher return (3.8%).  Record low yields have now been seen across Europe too, with 30-year German bonds moving into negative territory for the first time.  With the US Federal Reserve citing trade as the key downside risk to their forecasts, the market reaction isn’t particularly surprising.

Can government bonds repeat this performance?  They may be hard pushed to do so, but at the same time a meaningful reversal doesn’t appear to be forthcoming.  In this head-to-head between Presidents Trump and Xi, neither side looks likely to forfeit the match, and the doubling-down of rhetoric could see it going to five sets before a “winner” is declared.  Until then, government bonds will continue to wear the crown.

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Still feeling lucky…?

In an economic sense, Australia has often been referred to as the “lucky country”. This, after all, is the country that has not been in recession (defined as two consecutive quarters of negative growth) since 1991 and who, by all accounts, had a “good crisis” while the rest of the developed world suffered an economic heart attack in 2008.  The “luck” that they benefitted from over the last 30 years was centred on their mining boom, where dozens of mining projects were undertaken that created jobs and wealth for the domestic workforce, with a ready-made buyer of their commodities in the form of China – ensuring that Government coffers were well stocked via the higher tax take.  All was right with the world.  But, as we all know, nothing lasts forever.  The end of the mining boom was well flagged with other areas of the economy now needed to fill the gap.

Source:Bloomberg, 31st December 2018

Before the rest of the economy had a chance to fill that gap, a new cloud has emerged on the horizon.  As in the UK, the housing market in Australia was often highlighted as one with unstainable valuations and over indebted households – but in the cities of Sydney and Melbourne, the level of house prices was always explained away as a supply and demand story.

In early 2018, serious questions were starting to be raised on the outlook for the housing market and risks a slowdown would bring to household wealth, consumption, and, in turn, construction jobs.  Having reduced the demand from foreign investors through regulatory changes, next we saw a pullback in the provision of credit for mortgages from domestic banks.  This caused the historically robust demand to decline at a time when the supply of houses and apartment blocks was still rising.

What started as a campaign by a couple of economists soon began to gather support and momentum as their forecasts became reality.  House prices peaked in late 2017 and fell steadily through 2018, before contracting in second half of the year.  The collapse in building approvals that has continued into this year implies that house prices may have further to fall.

Source:Bloomberg, 31st January 2019

With the spill over effects into the broader economy clear, the Reserve Bank of Australia (RBA) could only ignore the risks for so long.  Having maintained a hiking bias for much of the past 12 months, the RBA changed its tone in February, moving to a neutral stance in response to the weaker outlook for growth. Today’s Q4 GDP print of only 0.2% QoQ validated this move and has opened the door to the potential for multiple interest rate cuts – only 3 months ago rate hikes were being  both priced in and expected.  Time will tell whether the central bank will act as aggressively as the market expects, but for now, the balance of risks are firmly skewed to the downside with the chance of a credit crunch ticking higher. The Kames range of portfolios will look to benefit from this as we can position for expected rate cuts to be delivered.

The speed of the slowdown in growth has been sharp, coming at a time when global growth is also slowing and the timing of this domestic generated weakness has created something of a perfect storm for the Australian economy.

For now, it feels like the Australian economy may finally be running out of luck.

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Bank of Canada – no change but much to talk about

At its latest policy meeting, the Bank of Canada opted to leave rates unchanged at 0.50%, as was widely anticipated. The accompanying statement was marginally less dovish than expectations at best. All in all, nothing really earth shattering. For me, it’s the undertones within the outlook for the Canadian economy that are of most interest.

Canada has had its share of macro concerns so far this year – both domestic and external. On the external side, the importance of the US to the Canadian economy means that it is particularly sensitive to any changes in US fiscal and trade policies. Much of the focus on the potential renegotiation of NAFTA has been on the impact for Mexico, while little has been said about the implications for Canada. One would assume that given the zero-sum-game nature of global trade, that anything that is positive for the US will, in turn, be negative for Canada. Throw in the uncertainty over any potential Border Tax and you start to see the headwinds that Canada may face in trading with its most important trading partner.

On the domestic side, the housing market has attracted some concern. House prices in both Vancouver and Toronto have been rampant, raising fears of a collapse. These fears have been heightened by the plight of Home Capital Group, a mortgage lender that required a capital injection to stave off a run on deposits following accusations that it had previously misled investors. Funding problems at a “specialised” lender understandably grabbed headlines and prompted caution.

All of these factors weighed on sentiment and pushed the currency and bond yields lower – as such, a lot of downside is now “in the price”. Is it all bad news for Canada? Not necessarily. We may yet see the benefits from a rebound in US growth from both its traditional Q1 lull and via any increase in fiscal spending that (eventually) comes through. History has shown that a strong US economy is ultimately beneficial to Canada, although often with a lag. The optimism around a fiscal splurge in the US has receded somewhat, but if the White House can manage to get a deal done, this can only be good news for the Canadian economy in the future.

Given these cross-winds, the Bank of Canada has been forced to walk a careful path with the bias thus far being towards the downside risk. With pessimism being so negative for much of this year, the chance of an upside surprise in the months ahead is growing – this is something the market isn’t priced for.

History Repeating – divergent economic data

History has a habit of repeating itself.  We often hear “it’s different this time” only to find that events at least rhyme if not repeat the past.  A good example is US GDP data: Q1 GDP data has been weaker than expected in the US in each of the last few years and it proved to be so again this year. The latest GDP report showed only 0.7% growth on an annualised basis – which was below the consensus forecast of 1%, even after downward revisions to those expectations in recent weeks.  This was the latest in a series of data “misses” in the US so far this year.

Interestingly these disappointments have occurred as economic data elsewhere has remained robust.  The chart below shows the difference between the economic surprises in the US compared to Europe (how many data releases come in either above or below the “official” consensus).

Source: Bloomberg as at 2 May 2017

So what’s going on?  Is the US now lagging Europe?  The answer is “not necessarily” – it has a lot to do with the level of expectations. The optimism that followed the US election pushed both consumer and business confidence surveys to multi-period highs and left expectations overblown.  The inevitable normalisation in this “soft data”, along with some misses on the hard data side, has driven the surprise indices lower.

In Europe the opposite is true – expectations have been so depressed for so long that the recent uptick in data (from a low base) has been enough to beat the consensus.  This feels like the start of the European economy entering into a new phase where investors will need to be focussed more on upside rather than downside risks.

For the US, it’s not all doom and gloom.  The Fed commented last night that they see the weaker data in Q1 as “transitory” with their growth forecasts still in place.  With expectations having been pared back in recent weeks, maybe the scene is set for the US economy to now surprise on the upside.

German yield curve on a rollercoaster ride

The shape of the German yield curve has seen a rollercoaster ride in the last 12 months.  The ECB’s QE programme caused the curve to flatten as the national Central Banks bought their allotted amount of bonds across the curve, with the ECB’s rules excluding the buying of any bonds yielding less than the deposit rate. This “rolling flattening” caused 30yr and 5yr German yields to compress by around 70bps in the first 6 months of 2016.  In Q4, though, the ECB decided to tweak their rules by reducing the allocation to long dated bonds while crucially allowing bonds to be bought below the -0.40% deposit rate.  Data released last night shows that the Bundesbank has made the most of these changes by shortening the average maturity of its buying from 12 years to almost 4 years!  This, along with buying by the SNB amongst others, helped push 2yr yields to -0.95% – a new low – and the curve to its steepest level since 2015.

Is this an opportunity to oppose the move and position for a flattener?  I’m not so sure.  The Bundesbank buying plans are unlikely to change and with political uncertainty on the rise, the demand for “safe” German bonds i.e 2 and 5yr bonds, can continue.  The short end will ultimately be vulnerable to a re-pricing once improved economic data encourages the ECB to taper further but, for now,  the momentum and flow of buying favours a steepening bias.  The flattener may have to wait on the side-lines for a few months before it gets its turn to ride the rollercoaster.