3 isn’t a magic number…

Having done some research on the properties and history of the number three, nothing has pointed towards its hypnotic features. I will duly update Wikipedia to immortalise this point.

I am very puzzled by the level of attention that the US 10-year yield at 3% is receiving. I appreciate that it is a nice round number not seen for some time. But why should High Yield be concerned about 3.01% and relaxed about 2.87%, for example? In macroeconomic terms nothing has changed.

Chart 1 below shows the history of the 10-year US Treasury yield since 1962. Until the global financial crisis, 10-year yields never reached below 3%.

Chart 1: US 10-year yield history

Source: Bloomberg.

The increase in US funding costs is relevant, but everything needs to be put into context – financial conditions may have been tightening, but very modestly and remain well below the recent peak, as shown in Chart 2.

Chart 2: US financial conditions

Source: Bloomberg.

Aside from that, the US economy (unlike the UK) is much more exposed to long-term rates, in particular 30-year mortgages. At 4.5%, the Freddie Mac 30-year mortgage rate is simply back to its average over the 2007 to 2018 period, and well below the 5.25% average of the 2000 to 2018 period. From the trough (3.3% in November 2012), this level is just over 1% higher.

The bottom line is, the move in 10-year yields by itself has a limited impact on the US economy. Consumer confidence indicators are the highest they have been in 18 years – see Chart 3 – and that is despite uncertainty surrounding trade policies.

Chart 3: US consumer confidence index

Source: Bloomberg.

But in broader terms should we be concerned?

There are certain areas that deserve attention in my view:

1. The dollar. Since the peak in December 2016, the US dollar has depreciated by 12%. Strong economic growth, higher commodity prices, ample amounts of liquidity and a weak dollar have created a very benign environment for dollar funding. This is particularly beneficial for emerging markets. The dollar has recently appreciated (see Chart 4) and if that was to continue it would be a concern (for me, more so than 10-year US Treasury yield).

Chart 4: Trade-weighted US dollar

Source: Bloomberg.

2. Liquidity is vast, but less so than in previous years. The removal of policy accommodation is in motion. Central banks will not panic if volatility is higher, spreads are wider or equities are lower. A reappraisal of risk premiums will be welcomed by the US Federal Reserve. In other words, the ‘Powell put’ is nowhere near current levels.

3. Stock selection is becoming a key determinant of performance. What you do not own becomes as relevant as what you own. Holding companies that only exist thanks to central bank liquidity will be costly over the coming years.

4. The opportunity cost of owning equity or credit risk is no longer zero. US investors can invest in positive real yielding assets with little duration and credit risk. The yield grab in the US might unwind as safe haven assets become a consideration. If I was an US domiciled investor, Treasuries would certainly feature in my pension pot.

Summarising the above: we should be paying more attention to the evolution of the dollar and more broadly financial conditions. For now, nothing indicates that the end of the cycle is imminent (in fact the cycle is still young in Europe and in emerging markets) but the time of simply buying the highest yielding assets is behind us.

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A fiscal deficit to make your eyes water

Last week the Congressional Budget Office (CBO) updated its deficit estimate, in order to incorporate the recent tax reform and spending agreements.

The fiscal outlook for the US is simply eye watering. The CBO projects the deficit to increase from 3.5% in 2017 to 4.9% for fiscal year 2021. However the forecast is based on overly optimistic growth assumptions. We are of the view that US growth for this year will be healthy and above potential, but 3.3%, as the CBO is forecasting, appears too high. The Bloomberg consensus is 2.8%, while I personally think that 2.5% is more reasonable. Using more realistic growth assumptions, the fiscal deficit for 2019 to 2021 will range between 5 to 5.5%.

Having a large fiscal deficit is not without precedent. Only going back to 2009 the deficit was 10%. But what is certainly unprecedented is this degree of (unnecessary) fiscal stimulus at this point in the economic cycle.

We can debate all day long about the correct level of the NAIRU (the non-accelerating inflation rate of unemployment) – which is 4.6% according to the Fed, versus 4.1% unemployment. But what cannot be put into question is that the economy is close to full employment, that business and consumer confidence indicators are close to all-time highs, that investments are increasing and that the current level of debt is historically elevated as a proportion of GDP. In other words, fiscal loosening is not something that the US requires at this moment in time!

The chart below shows the unemployment rate (rhs, inverted) versus the deficit (lhs) over time. At the current level of unemployment you would expect the US to run a fiscal surplus. In contrast, as the projections show, it will run an even larger deficit.

Chart 1: US fiscal deficit deteriorating

Source: Bloomberg as at 15 April 2018. Projections forecast to December 2020

Aside from the economic rationale (or lack of) of these policies, a large deficit will have implications for the funding requirements in the US. Going back to the CBO estimate, the US Treasury will require an additional $1.7 trillion of funding between 2018 and 2025. To put this number into context, China, the largest holder of US Treasuries, owns $1.3 trillion of them.

It is also important to remember that further financing needs will also be required as the Federal Reserve reduces its balance sheet further. At the current pace, Jeffries estimates that this will add an additional $750bn between FY 2018 and 2021. So overall the US government will have to find a home for an additional $2.5 trillion of Treasuries over the coming years.

There is much debate about the impact that this will have on Treasury yields. Personally I have no concern for the US being able to fund this amount of debt – but I do not think it will be done at current levels. Once the visible hand of the central banks (ECB and BoJ) is lifted, the clearing price will be higher. So far, it has only been the T-Bill market that has been showing signs of indigestion, but eventually longer tenors will have to reward investors with a greater premium (term and inflation) for the lack of frugality of the US government.

One final thought: Mr D. Trump frequently complains about current account deficits with China (among other economies). What he fails to appreciate is that a large proportion of the reserves accumulated have been invested in Treasuries, greatly reducing the cost of the US debt. Reserve diversification (over the last few quarters flows are returning to the euro area) and a greater relevance of the renminbi as a reserve currency might also represent a further challenge for the US government.

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Italian Election Results

As expected the Italian election produced an inconclusive result. None of the political parties obtained an absolute majority and we are likely to face a long period of uncertainty. In 2013 it took two months to form a government.

A positive…

  • The Five Star Movement did not obtain an absolute majority. The probability of this happening was always very remote.

The negatives…

  • The Five Star Movement was the most voted party with 32% of the votes. They performed better than expected.
  • The Lega party (former Northern League) gained 17% of the votes. Importantly they obtained more support than Forza Italia (Berlusconi’s party).
  • The populist parties obtained more than 50% of the votes and are likely to be present in the government.
  • The centrist parties lost ground to the populist ones. The Democratic Party result was particularly weak; Renzi is likely to resign.

Within the likely scenarios, today’s result is towards the most negative outcome. From here the greatest risk is that Five Star forms a coalition government with Lega. This is very unlikely but not impossible. The most likely outcome is a long period of uncertainty (constant headlines – probably unhelpful ones) leading to a government with Five Star or Lega the main actors and maybe protagonists.

The European Central Bank and the Bank of Italy are still buying BTPs (Italian bonds) on a daily basis, which is likely to provide some support in the market. In April there is a large amount of maturities that will require reinvestment, so the technical environment is benign for European bonds. Aside from this and given the relatively muted reaction, the ECB will likely be unfazed with this result. Ultimately the result reflects the will of the Italian people.

Fundamentally the situation is likely to deteriorate in Italy. Political risk will remain elevated in the coming months. Economically looser fiscal policy (with an already elevated debt to GDP level) and a more confrontational stance versus Europe are likely to put off some investors (such as Japanese investors). This should result in higher BTP yields and wider spreads versus core and semi-core markets.

In conclusion, the electoral result is not positive for Italian assets. Uncertainty will require a larger credit premium. As active managers this is something we will aim to profit from: this morning we have reduced our Italian risk and in unconstrained portfolios have sold Italy versus Spain on the expectation it will underperform in the near term.

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Winter is Coming!

The Jon Snow (King in the North in Game of Thrones) of fixed income markets has suggested that the end of the bull market is upon us. We only partially concur.

We agree that Treasury yields are still too low. Economic fundamentals are as benign as they have been for a number of years, and if anything are becoming more supportive. Accommodative monetary policy (the Fed funds rate remains well below the neutral rate, and for those that believe in the stock of purchases as the central banks seem to, the size of the Fed balance sheet is 20% of US GDP) along with stimulatory fiscal policy (an increasing and already large fiscal deficit) and ultra-loose financial conditions will ensure that, domestically, the US continues on its current path. Inflation remains an anomaly, but we are gaining confidence that the downside surprises are temporary.

Having said that, we believe that in order for Treasury yields to move meaningfully higher (say a move that takes the 10-year yield above 3%) we will need more than a break in the trend line of the 10-year yield chart. We require the fixed income anchor to be removed.

Over the last few years, Treasuries have greatly benefited from policies implemented by the European Central Bank (ECB) and the Bank of Japan (BoJ). Only when the BoJ moves away from its 10-year yield control target at 0% can global bond markets come back to fundamentals, can the term premium regain some value, and can 10-year Treasuries move into a new regime.

Until this happens, Treasury yields will increase – but will continue to look too ‘shiny’ in a relative-value world. After all, Treasuries are possibly the one asset in fixed income where investors get exposure to a fairly symmetric risk/reward outcome. Therefore, there is a place in a well-balanced portfolio for the ultimate safe-haven asset – at least until other core yields regain a degree of symmetry.

Last week the market got very excited about China diminishing or stopping the purchase of US Treasuries. It is certainly possible that it has been decided to reduce the allocation of reserves to the dollar in favour of other currencies. However, aside from political posturing, it is hard to imagine China selling Treasuries – it has too many of them, approximately $1.2 trillion. That would be equivalent to Daenerys Targaryen turning a flaming dragon against her own people. Something she would never do!

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Make sure to challenge the core…

January is a time for getting back to normality – better eating, early rises and often, going back to the gym. While those gym-goers are challenging their core strength, we are challenging our core macro views as we head into the New Year.

2017 was the most positive environment for the global economy since the 07-08 financial crisis. Growth was above potential, but was also balanced and synchronised across developed and emerging markets. Importantly for financial markets, the strong growth was accompanied by a healthy but modest level of inflation.

Forward looking indicators remain encouraging and global real growth looks like it will maintain the current 3.5% to 3.7% pace. Growth is also now less reliant on household consumption as investments are increasing.

This is a relatively benign view so we are asking ourselves – what challenges this base case? We consider the following downside risks and potential upside surprises in 2018.

Downside risk! China:
In recent years China has been the master of recalibrating monetary and fiscal policies. But its task is becoming more challenging as authorities try to shift from an investment-driven economy to a consumer-led one, impose controls on the housing market, whilst achieving a level of economic growth that is more sustainable in its composition. Total debt has reached alarming levels (financial imbalances are a primary concern for the authorities) and geopolitics (including tensions with the US) are increasing.

The central case is a lower but still healthy level of growth: the risk is that the recalibration of policy does not produce the desired effect and growth drops below 6%.

Downside risk! Protectionism:
Protectionist policies became an obsession for the market in late 2016. These fears seem to have dissipated despite little progress in the NAFTA negotiations and ever more prevalent tensions between China and the US.

The need to avoid a conflict with North Korea makes a trade war unlikely. Nevertheless Mr D. Trump is arguably the most unpredictable US president in history; trade is an area where he has a degree of flexibility and where he could express his frustration. A disruption of global trade or the proliferation of protectionist policies represent a meaningful downside risk to growth, especially for open economies like China, Europe, Japan and some of the emerging market economies.

Upside surprise? Investment:
The improvement on the composition of growth and the noticeable pick-up in global capital goods orders and capital expenditure is encouraging. Looking beyond the very short term, investment is an essential ingredient to improve productivity. Debt-funded consumption simply brings future demand into the present and increases the debt burden of future generations. Investment increases potential GDP. This is particularly relevant in those economies that face challenging demographic dynamics.

Upside surprise? Europe:
Despite the recent strength, I see more room for positive surprises in Europe. Unlike the US, the economic cycle in Europe is very young. The deleveraging process has just concluded. A positive credit impulse will support activity as consumers and businesses (where confidence is at multi-year highs) increase their credit demand.

These dynamics are among those we will be keeping a close eye on into 2018.

Should we be preparing for recession?

There is a lot of focus in the press about the flattening of the US curve and what it means for the economic cycle.

In Chart 1 below I’ve included the yield differential between 30-year and 5-year US Treasuries over time, and marked recessionary periods in grey. You can see the differential falls – i.e. the curve flattens – into each recession.

The US 5/30s curve has been falling pretty relentlessly for some time. From 3% in November 2010 it has stayed below 2% since March 2014 and since September this year has fallen below 1% to around 70bps today. Does this mean we can expect a recession soon?

Chart 1 – US 5/30 curve and recessions

Source: Bloomberg

The fact that economic recessions have been preceded by a flattening of the yield curve is a pure mathematical reality. As the Federal Reserve increases rates it would be expected that eventually the average of the Fed funds rate will be higher in the short term, e.g. 2-year, than in the longer term, e.g. 10-year. A longer tenor will include not only the average of the current rate hike cycle, but also the likelihood of cuts in the future. The curve will be flat or inverted.

This however ignores the term premium associated with longer tenors. A rational investor not only would demand the average of future base rates but also a premium to compensate for the risk of default, high inflation or lack of fiscal frugality. This term premium varies over time, but currently it is low or negative (a discussion for another day).

In order to determine the impact that central bank policy will have on economic activity, it is essential to understand the ‘neutral’ level of rates. To the extent that the Fed funds rate is still below the neutral rate (that is the level of interest rates that makes the desire to save and invest equal), higher rates are only a removal of accommodation, not a tightening of monetary policy. Therefore the economy will continue growing above the level of potential. It would be only when rates overshoot this neutral rate that we should see a slowdown in activity and eventually higher unemployment.

In the current economic cycle (now lasting over 100 months – the second longest in history) we will eventually get there, but it is not a short-term risk. US financial conditions are looser than when the Fed started hiking in 2015 (as shown in Chart 2 below). Funding costs for corporates are lower, long-term mortgages are not far off their lows, the trade-weighted dollar has depreciated and equities are not far off all-time highs. In other words, the economy has not really felt higher borrowing costs and therefore should continue growing strongly, supported by favourable domestic (including looser fiscal policy) and global dynamics.

Chart 2 – Federal funds rate versus financial conditions index

Source: Bloomberg, Goldman Sachs US Financial conditions index. Fed funds is Federal Funds Target Rate – Upper Bound.

To conclude, statistically a recession is getting closer, it would be silly to assume that the current economic cycle will last forever (indeed it may be that 2017 was as good as it gets for the global economy), but in the short term, irrespective of the flattening of the curve, it is hard to see a meaningful risk of recession.


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No Hope for hay fever

Last week Yuriko Koike, the leader of Japan’s ‘Party of Hope’ and the main opposition to Japanese Prime Minister Shinzo Abe, unveiled her “12 zeroes” manifesto. The promise of ‘zero’ hay fever caught my attention: a welcome claim for the 25 million sufferers in Japan, but astonishing that politicians can claim to defy Mother Nature! If we made such a pledge in our marketing materials I suspect the regulator would have something to say about it…

What has also caught my attention of late is the impressive level of activity in Japan. Second-quarter real GDP was 2.5%, which is meaningfully above the assumed potential of 0.5 to 0.75%. Even more encouraging was the composition of growth, with private consumption and investment activity strong. The Tankan survey – a quarterly survey of business confidence – points towards a continuation of this trend into the second half of the year, as shown in Chart 1.

Source: Bloomberg

This pick-up in business activity is not unique to Japan. The rotation towards investment has been highlighted by central banks, in particular by the Bank of England in its August inflation report and its governor Mark Carney, who recently pointed out the increase in capital goods orders in advanced economies (Chart 2). I believe that this development is one of the most encouraging macroeconomic events that we have seen in a while.

Source: Macrobond. Capital goods are tangible assets such as buildings, machinery, equipment, vehicles and tools that a company uses to produce goods or services.

Global corporate profitability and elevated business confidence point to a changing dynamic in business investment, but only time will tell if this is the beginning of a trend. If so, we should expect higher productivity, healthier potential growth and less depressed neutral terminal rates – all of which will have an impact on monetary policy.

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Disappointing data and its dovish implications

Rates specialist Juan Valenzuela considers the latest US data release and how this could mean a more dovish Fed at its September meeting.

US data released on Friday undoubtedly disappointed. June CPI was weaker than expected – a negligible undershoot in itself, but the fourth time over four months that inflation data has surprised to the downside. Retail sales were also worse than expected; the weakness in private consumption is puzzling in light of strong employment data, a high savings ratio, good consumer confidence and a solid wealth effect.

Nevertheless this could have dovish implications for the Fed – a rate hike in September is much less likely and there is a chance that Fed members start revising down their dots for 2018 and 2019. With the market only pricing 50bps of hikes for 2018 and 2019, versus 150bps implied by the Fed projections, there remains a large discrepancy.

Where the Fed may keep to the hawkish side is by announcing a reduction of its reinvestments in September. Weaker inflation and retail sales should not be enough to derail this considering that financial conditions are looser (despite higher rates) and asset valuations ever higher, as risk markets remain unreactive to a pending reduction of the balance sheet.

The impact of the above on the US Treasury market is of most interest to us however. Treasury yields should still move higher, but driven by a generic move higher in global yields (global growth remains healthy and above potential) rather than a hawkish Fed. The focus on balance sheet management over hiking rates means that a flatter US curve is less likely from here – especially if the US Treasury considers issuing longer tenors. Finally, US inflation break-evens still benefit from suppressed valuations and if weaker inflation drives the Fed to commit more firmly to its inflation target, they should do well (keeping in mind that the base effects are less supportive now compared to Q4 2016 or Q1 2017).

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UK employment is not the full story

The dilemma for the Bank of England (BoE) intensifies in light of this morning’s May employment figures. UK unemployment has fallen further to 4.5%, versus the BoE forecast at 4.7%. To find a similarly low level you have to go back to the mid-70s, as shown in Chart 1. Moreover, the current level of unemployment is below where the BoE sees the natural level (the level of unemployment below which inflation should rise), all at a time when monetary policy is at emergency levels and inflation is well above the target.

Chart 1: UK unemployment

Source: Bloomberg as at 11 July 2017

And unlike in the US where the participation rate has been coming down, in the UK it has been increasing. Over the last three months the economy has created an impressive 175,000 jobs, taking the overall employment figure to 32m people, 324,000 higher than last year. The employment rate is 74.9%, the highest since comparable records began in 1971.

But employment is not the full story.

Real disposable income for UK consumers continues to be challenged by elevated headline inflation and low earnings. Leaving aside employment, the macroeconomic data has been surprising to the downside (Chart 2). The weak Q1 GDP at 0.2% will likely be followed by only a marginally better Q2 at 0.3%, and below what the BoE was expecting in its inflation report.

Chart 2: UK Economic Surprise Index
Source: Bloomberg as at 11 July 2017

On balance, the BoE has gained back some optionality. The market is now listening to its rhetoric and reacting to the macroeconomic data. In a speech on 20 June, MPC member Haldane complained about market complacency – but the market is no longer pricing the first rate hike in 2020 (a full hike is now priced for May 2018) so expectations appear to be much more reasonable.

I do believe that a removal of some of the emergency measures adopted in August 2016 is becoming more likely. But in the near term I don’t expect this to be a rate hike as the conditions set by the central bank are unlikely to be met. The economy remains weak and I am not hopeful that investment and exports will be strong enough to compensate for the weakness in consumption, while the chances of a smooth negotiation of Brexit are very slim. Instead, the BoE will leave the door open to a rate hike, but focus its efforts on the unwind of macro prudential measures, such as the countercyclical buffer and Term Funding Scheme.

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Challenging consumption in the US

We should not totally dismiss the weakness in Q1 GDP in the US. Private consumption disappointed – no question about it – while inventories detracted 1% over the quarter. But there were also reasons to celebrate. We saw a healthy increase in investments – and since an improvement in productivity requires capital investments, this is the main route to higher potential growth and a higher neutral rate of interest.

Furthermore, in contrast to the hard data, the soft data has not dipped materially and still points towards 2-2.5% growth, a level of growth that will continue eroding the limited amount of slack that exists in some areas of the economy. More globally, GDP growth ex-US is around 3.5%, a level of activity very much towards the upper-end of the range since the global financial crisis.

Arguably, the most relevant piece of data that we got on Friday (28 April) was the Employment Cost Index, which increased by 0.8% in the quarter (a level not seen since 2007) versus market expectations of 0.6%. This data, along with hiring relative to job openings from the JOLT report (the ratio continued moving lower) and the hiring difficulties across several districts highlighted in the latest Beige Book, point towards a full employment market – and one that could finally see pricing pressures (i.e. wage inflation).

We are likely to continue to see unemployment coming down (currently at 4.5% versus the 4.7% long-run level according to the Fed). The three-month average nonfarm payroll is still above 170k, a number that should naturally come down towards 50-100k as the Fed has been signalling for a while. Some might say this will be countered by a meaningful increase in the participation rate. But I think this is unlikely. The structural reasons that brought it down are not going away – after all, the baby boomers are not getting any younger.

Putting all the above together – healthy employment, better compensation along with elevated confidence – challenges the validity of the weak private consumption figures in last Friday’s Q1 US GDP release.

Pointing to healthy levels of economic growth

The March survey PMIs (Purchasing Managers’ Index) continue to point towards healthy levels of economic growth. Encouragingly, the pick-up in activity is very broad-based across developed and emerging market economies.

In GDP terms the current level is associated with a global real GDP above 4% (global nominal GDP above 6%). This level of output compares positively versus recent years.

Below we provide a summary of the Global Manufacturing PMIs.

Source: Bloomberg as at 9 February 2017

In the latest dataset, over 75% of the countries’ PMI indices were above 52, showing a good level of expansion, while just three economies were below 50, a level associated with a contractionary environment. This compares to a year ago when the proportion of countries above 52 was less than 50%.

In the coming months we will find out if this is simply a cyclical improvement or we are finally moving towards a structurally healthier level of global activity.

But for now the story is very encouraging.