November’s Bank of England MPC meeting is set to send base rates 25 bps higher. Ever since MPC member Andy Haldane’s comments in June, markets have started to price in rate rises. Comments from another member, Vlieghe, further surprised the market and his rate rise stance has been broadly supported by the Bank’s Governor, Mark Carney.
Markets have accepted a rate rise for November as a foregone conclusion and if nothing else a totemic moment. A generation has not seen rates go up in the UK; the last rise was over 10 years ago in June 2007.
What is a matter for debate in markets is the rate rise after November’s – and the simplest way of gauging this is the counting of the votes of the nine MPC members.
The slimmest majority at 5-4 would leave the market unsure that there might be a ‘next’ rate rise in short order and believe that it was ‘one (rate rise) and done’. After all a 0.25% increase only reverses the cut made immediately after the Brexit referendum vote in 2016.
An (unlikely) vote of 9-0 would show a unified MPC worried about ongoing inflation and the capacity for low unemployment to feed through to wage pressures. An 8-1 would fall into this camp too, as David Ramsden’s most recent comments suggest he is not for higher rates. No-man’s land is 7-2 and yesterday John Cunliffe commented that a rate hike was an “open question” suggest his vote could go either way.
But a 6-3 vote would see a committee viewed as not necessarily gunning for further rate rises. Suffice to say, as ever, market watchers are desperate to read the tea leaves for future rate hikes…but it seems all done for November, bar the counting.
On the face of it, the US Federal Reserve shouldn’t have surprised the markets last night, but by announcing their decision to keep interest rates unchanged and to start their programme to reduce their balance sheet, markets were taken aback – the USD dollar strengthened and US Treasury yields rose.
The opening statement was bland and changes to the economic projections and the ‘dots’ were minor – which was entirely as expected. However, over the summer, questions regarding the low level of inflation and the technical difficulties of reducing the balance sheet in the face of a lack of progress in raising the debt ceiling (now pushed forward) had been raised. There had been a suspicion that the US Federal Reserve might delay or signal a shallower path of policy tightening and markets had moved accordingly. 5 year US Treasury yields had fallen around 0.15 % between June and September and the US Dollar around 5% on a trade weighted basis.
Last night the surprise was that these suspicions were proved incorrect and a reversal occurred.
What this means for the rest of the world is also of interest. Some recovery in the US Dollar, particularly versus the Euro, may have implications for monetary policy in Europe too. A stronger US Dollar will mean there will be a lower hurdle for ECB tapering.
Government bond markets tend not to register as volatile; media headlines typically focus on shares falling by whatever huge amounts.
But spare a thought for holders of index-linked!
Last week saw the largest weekly fall this year in the long index-linked gilt. The index-linked ‘68s (Gilt 0.125% March 2068) started the week at a price of 260 and ended it at 227 – a fall in value of well over 10%.
Index-linked gilts offer security in providing returns linked to inflation (as measured by the Retail Price index) but they do not offer any certainty over capital values – as last week proved.
One of the main drivers of the high price of index-linked debt over the past couple of years has been the implicit exposure to longer-dated bonds – i.e. duration. And last week saw valuations take a tumble.
As our inflation expert James Lynch remarked on BondTalk on Thursday, we saw a re-run of June’s speech by Andy Haldane; this time the market took fright at Gertjan Vlieghe’s conversion to a base-rate hawk from his previous dovish position. As one of the nine voting members of the Bank of England’s Monetary Policy Committee, his “conversion” matters. And unlike Haldane, who suggested rates should reverse last year’s post-Brexit emergency cut of 0.25%, Vlieghe thinks rates need to move beyond that.
Money markets are now pricing 80% likelihood of a 25bps rate hike for the November meeting; but the trajectory beyond that is far from certain. Unwinding last year’s questionable base rate cut might make sense, but do not confuse that with an ongoing ratcheting of rates higher. Oddly if that were to be the case, index-linked bonds would likely reverse some of last week’s falls.
On the 4th of July this year, the German government issued a bond with a 0% coupon with a maturity date of 7th October 2022.
On its first day of trading this bond closed at a price of €100.78. Sharp-eyed readers will have spotted a potential flaw here. On day one an investor would have to pay €100.78 for a bond that pays no coupon each year between 2017 and 2022 and on the 7th October 2022 will repay you €100. This equates to a yield of -0.15%.
I suppose a 0% coupon makes filling in a tax return easier, but why would anyone do this?
Well in the Alice in Wonderland distortions of the European bond market, sometimes believing six impossible things before breakfast is exactly what you should do.
This bond touched a new high closing price yesterday of €101.86, equating to a yield of -0.36%.
An investor who bought on July 4 will have enjoyed a total return of 1.07% in a two month period. Also for a sterling-based investor, the euro has appreciated by around 5.8% against the pound since July 4. So a sterling investor who bought a negative yielding bond with a 0% coupon would have achieved a near 7% total return since early July.
The Mad Hatter invites everyone to tea.
Yesterday the CEO of the FCA, Andrew Bailey, gave a speech in which he supported ending the publication of LIBOR (London Inter-Bank Offer Rate), the key risk-free reference rate used by the financial system in the UK. In general the comments were nothing new – this has been a project in progress by the Bank of England for many years – so why did the market pay so much attention to the comments? Well, the intent implied in Bailey’s speech was more than the market expected, as well as there being a specific time frame mentioned: 2021.
What is the problem with LIBOR?
There are two main issues with using LIBOR as a reference for risk-free interest rates. Firstly, the most common LIBOR rate used is the 6-month LIBOR (the rate at which banks will lend cash on an unsecured basis in the interbank market for a term of 6 months). The fact that this rate is for a 6-month loan implies that it is not actually a risk-free rate – it carries a 6-month term premium. The second main issue is the way that the LIBOR rate is set, as it relies on banks to submit an estimate of where they think they can lend money. As it is not based on actual traded transactions, it is subject to gaming – as was seen in the well-publicised LIBOR scandal. To solve these issues, the Bank of England working group on sterling risk-free rates proposed in April that SONIA should replace LIBOR and be administered by the Bank of England.
What is SONIA?
The Sterling OverNight Index Average (SONIA) is a reference rate that is based on actual transactions in the overnight unsecured loan and deposit market. Reformed SONIA will actually replace SONIA shortly; reformed SONIA includes other market participants outside the interbank broker market and therefore has a much higher transactional volume than current SONIA.
What would the change mean for the derivatives market?
Currently LIBOR is used as the reference rate for the majority of interest rate derivatives held by end users and used to hedge a variety of liabilities, bonds, loans and other financial instruments. As a result the LIBOR swap market is the most liquid and cost effective hedge, as well as being a match for existing legacy LIBOR derivative positions held by end users. There is also a liquid market in SONIA swaps, however liquidity falls once the maturity of the trade becomes longer than 5 years.
The SONIA swap market has existed for around 10 years, so why have market participants not voluntarily migrated to SONIA? This is a legacy issue. The market agrees that if we were to design the market again from scratch, LIBOR would not be the main reference rate. But with so much of the market already using the fix, it’s not easy to wean off it! The market needs a regulatory push, the FCA and BOE do not see LIBOR as a desirable reference rate, and the comments yesterday are the next step in this process.
Much of the current derivatives trading is facilitated by the large and liquid pool of short sterling futures contracts. For the market to adopt a new reference rate such as SONIA, there needs to be a successful SONIA futures market established, something which is currently being consulted on by the Bank of England working group. Another issue that needs to be resolved is the ability to centrally clear SONIA swaps with maturity longer than 30 years, which is the current maximum – again a focus for the working group.
Clearly the FCA and BOE are intent on moving the market away from LIBOR over the long term. The working group has the (big) job of consulting on this transition and are seeking input from all market participants. There are undoubtedly challenges ahead – but change can be a good thing. This is a global theme with similar projects happening in the US and elsewhere, with the collective ambition of benefiting all market participants.
We have a lovely custom here in the Kames office of buying chocolates for the team after we return from our holidays. Occasionally one of the healthier team members veers into the natural sugar space, but in general the tried-and-tested combination of cocoa and sugar goes down the best. Summer is a good time for treats, many from far-flung parts of the world, but Europe remains our collective clear favourite.
Europe was an uncertain place last summer. The UK had just voted to leave the European Union and the whole of the region suffered a jolt of confidence as an uncertain future beckoned. A year later, the EU has recovered from the shock, weathered the subsequent political storms and the economy is growing stronger quarter by quarter, whilst the UK languishes.
Since the election of French president Emmanuel Macron, business and economic confidence has strengthened across the EU and is now beginning to be reflected in the ‘hard ‘data. This morning, first estimates of GDP growth in the second quarter for 2017 were released for France, Spain, Austria and Sweden, all higher than expected. The French economy grew at 0.5%, the Spanish 0.9%, the Austrian also 0.9% and the Swedish a punchy 1.7%. Their annual growth rates are 1.8%, 3.1%, 2.2% and 4.0% respectively. This augurs well for releases from other countries for the same period and the Eurozone as a whole may have grown close to 2.2% over the last 12 months. By contrast the UK’s growth rate was 0.3% in the second quarter and 1.7% over the last year.
This renewed confidence is being felt across the whole of the continent – even Greece has recorded an increase in GDP in the first quarter of this year. Unemployment across the region is falling while bank lending is growing moderately. The difficulties of the past five years are receding. This is being reflected in the strength of the euro, not only against the pound (some may find their holidays a touch pricier this year) but also against the US dollar and latterly the Swiss franc. The Swiss franc has been widely used as a safe-haven currency over recent years, used to gain European exposure while avoiding the euro. The currency has appreciated substantially over recent years to much protest from the Swiss. This week the President of the Swiss National Bank, Thomas Jordan, reiterated that in their view the currency was overvalued and that they would do all they can to weaken the currency by keeping monetary policy accommodative and by intervening if necessary.
We fully expect the European economic renaissance to continue, and if it does we may all be swapping our post-holiday Belgian bonds, as well as chocolates, for Swiss ones in the months to come.
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).
“Asleep at the wheel” has been the accusation levelled at central bankers such as the Bank of England (BoE) over the financial crisis of 2008. But eager to prove its new found vigilance, the BoE yesterday tightened its controls on bank credit by announcing changes to its counter cyclical buffer (CCB).
The CCB aims to ensure banks are considered in their lending; it requires that banks increase their capital by 0.5% by this time next year and, all other things being equal, to 1% by November 2018. That would equate to £11.4bn extra capital required to back loans in the UK. All very prudent and exactly the sort of pro-active approach that central bankers should implement in boom times.
Yet politics suggest that we are still in a fiscally restrictive environment. Witness yesterday’s British Social Attitudes survey, which has a section entitled “A backlash against austerity”. Think what you like about austerity but it isn’t the stuff of boom times. So what’s the BoE worried about?
A very low savings rate is at the heart, coupled with a material increase in consumer lending through credit cards and car loans. But in an economy growing at below 2% with declining real wages, what are the Bank’s concerns? Most recent public statements over the path of interest rates centre on whether to reverse last summer’s rate cut. But Carney’s raising of the CCB must – even if only at the margin – slow the start and path of rate rises. And 0.25% or 0.5% is the discussion; the UK is not about to replicate the US rate cycle where short rates are up 1% since 2015.
The BoE aims to take a leisurely approach to the CCB increase. Like many of Carney’s initiatives it may be that the message is more effective than the action; he sees some risks but there’s no need to rush; time may mean these risks just disappear anyway. Brexit headwinds remain a challenge for UK policymakers and that is evident in the public tussle over rates with MPC members. It is difficult to view the CCB action in isolation. There is a suspicion that the BoE may just be fighting the last war and not the next. And the orders from the generals are contradictory.
Following the financial crisis our main central banks (to keep it simple let’s stick with ECB, BoE and the Fed) needed to get real interest rates (the difference between the nominal interest rate minus inflation) down. This is the normal playbook that a Central Bank should use and even more so after the global financial crisis. They needed to get money moving again not only to the real economy but also within the financial system which was not only broken but was on the brink of collapse and without too much exaggeration could have brought down capitalism with it.
But the conundrum coming out of the financial crisis was why inflation did not significantly rebound given the spectacular amount of stimulus in place. As inflation has remained low and even went negative again across the developed world in 2015 the Central Banks kept reducing interest rates and buying bonds – the ECB is still negative and is still increasing the balance sheet to keep these real rates as low as they can without causing too many negative side effects.
The reasons why inflation has been lower than you would have expected will probably become a popular dissertation topic amongst Economic students in the coming years. I imagine these papers will cover globalisation, online shopping & tech, demographics and the breakdown of the Philips curve to name but a few. Also I don’t think we should ignore the impact of Shale and the fall in commodity prices over this period.
These are mainly structural changes, but monetary policy is a cyclical tool – and here is the problem. We have policy at what is without doubt emergency levels which has not had the desired effect (apart from one time impacts from falls in the currency) and what it has caused is inflation in asset prices – housing, equities and bonds, not in the real economy and certainly not in wages (which you could argue are structural issues).
Should Central Banks perhaps place more emphasis on growth, employment and wages (which the BoE have explicitly targeted post-Brexit) rather than inflation? Or should that be the job of the Government? Is that the pertinent question – have our governments collectively failed to adapt to this changing world?
All of which leaves monetary policy in a tricky place. There are strong arguments coming to the fore that the emergency levels of accommodation should now be removed, not because inflation is becoming rampant, but because perhaps it was an ineffective tool against the structural challenges we face; or maybe Central Banks just need rates to get high enough so that they can cut them again in preparation for the next down turn (confidence is also a tool). The Fed have raised rates 4 times since December 2015, the ECB will be running out of bonds very soon and there are signs the BoE are becoming twitchy (3 out of 8 voted for a rate hike this week).
For all their failings, at least the Central Banks tried to do something. They were trying to create an environment where ultra-cheap money could foster growth and self-sustained inflation could flourish. Unfortunately if you were not in those assets that have gone up then all it has done is create greater wealth inequality; and while fiscal spending has been absent it is no wonder that we are starting to see political unrest. For example, it seems inevitable in the UK that the current government will have to provide their own stimulus to the population, where nothing is off the table, or the people will vote for a party that will.
Careful what you wish for! Steve Jones our CIO uses this phrase; Theresa May should have heeded these words. Not a natural gambler, May’s snap election has backfired leaving political uncertainty. There is little doubt her political authority is reduced and there will be all kinds of conclusions emerging today, most notably around the style of Brexit and her leadership. As you might imagine this morning’s meeting had the full gamut of opinion and debate.
Senior equity manager Phil Haworth summarises the state of play as “no mandate for anything stupid” – a hard Brexit is less likely and the UK is more likely to reach some economically-sound agreement, such as joining the European Economic Area (EEA). The counter is that May’s reduced political mandate leads to a worse negotiating position, with EU politicians being able to jibe May and ensure a Brexit path with less control of the process and a more material likelihood of crashing out of the EU into WTO rules. The outcome of the next few days of political discussions are crucial. As we write the Conservative Party knows May has failed to deliver her mandate but heresy would be to allow a minority Labour government for all Conservatives. Also, the UK has switched Northern Ireland for Scotland as the “king maker” of Westminster politics. But it is difficult to see the Democratic Unionist Party’s 10 seats in support of pro-Republican Jeremy Corbyn.
The market reaction to increased uncertainty so far has focused on weaker sterling, but even that looks muted as currency markets seem to interpret a hung Parliament as a softer Brexit. Equally so within the gilt market; gilts are a touch higher but there is not panic here. Further sterling weakness could see higher-than-forecast inflation. At this point Mark Carney becomes increasingly important; gilts and global bond markets are at range lows and data continues to make valuations looked stretched. Today’s electoral wobbles do not change that view. The MPC has looked through “transitory“ inflation and worries about consumer demand. With investment at only 15% of GDP and consumption nearer 70%, the consumer remains the barometer for rates policy. Given the central bank’s comments on the squeezed consumer we expect Mr Carney to remain supportive for rates markets, but he is no guarantee to gilts continuing below 1% in 10 years.
As the politics play out, opportunities should emerge; our concern is that fascinating politics may not make for the volatility we would like to see – continuing one of the themes for 2017 so far. This is no 1992 when a surprise election result saw gilts move higher by 5 points!
One of the biggest surprises so far this year has been the strength in the Italian economy. In Q1 2017 Italy posted a 0.4% increase in real GDP, the strongest quarter since the European Sovereign Crisis. Meanwhile composite PMIs are reaching new highs, unemployment is finally falling (now 11.6% down from a peak of 12.6% in 2014) and inflation has picked up to 1.5% from around 0% where it has been for over two years.
True, total government debt to GDP is still high at 132.6%. For this ratio to fall, nominal growth must exceed the budget deficit (2.4% of GDP) and there is a small and rising chance that this can be achieved in 2017.
However, politics as always is getting in the way; political developments is certainly the key negative from the rating agencies’ standpoint right now. The failure to reform the senate last year was a step back in the reform process and the current electoral law reform is progressing slowly.
For Italian government bonds this means volatility over the next few months. The latest day an Autumn election can be called is 3 September, for a 22 October vote. And the precondition is the electoral law being passed in July. Irrespective of when the vote takes place, I think it is extremely unlikely that leaving the EU/Euro as a popular policy would get off the ground (around 67% are in favour of using the euro, 15% are opposed and the rest don’t know) but this won’t stop markets being concerned about it.
Where this differs from our experience in France earlier this year is that the current spread on Italian government bonds (over bunds) is already pricing in some political risk. The Italy/Bund spread is currently 200bps, having been as low as 100bps last year. Our view currently would be to buy on further weakness rather than chase the market. We expect there to be some good opportunities to make money through this election period, keeping in mind the potential for volatility.
The “solids, modestly and little changed” have it. Yesterday’s FOMC minutes as ever run to a dozen pages and steer the market into its thinking. The small bounce of around 25c in 10-year US Treasury prices show the text was received in a “somewhat” dovish tone. Central bank speak is always measured but May’s minutes were more measured than March’s.
Despite this, the trajectory of higher US rates was reiterated, as the FOMC “expects economic conditions to evolve in a manner that will warrant further increases”. More tellingly is that the stock of $4.5trillion odd government and mortgage-backed bonds aren’t for sale any time soon and the key reinvestment of coupon payments are set to be ongoing. What is new is the management of the amount of reinvestment of maturing bonds that will take place.
Enter into the market lexicon reinvestment “caps”. The idea here is that the nominal amount of maturing bonds increases over time and a higher cap means a smaller reinvestment into the market. Set to be discussed at the next meeting, the “caps” could well be introduced by Q4 this year. The FOMC is at pains to add that this should happen in a “gradual and predictable” manner. The market will squabble over the rate and scale of the quarterly increase of the caps, also the balance between Treasuries and ABS along with the tenor of what remains to be reinvested.
So there you have it. Business as usual. Rates are set to trickle higher at some stage – although expectations remain “modest” – and only when the economic conditions demand it; and expect only a slow and gradual unwind of QE.
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.
The most recent unemployment rate in the UK came in at 4.6% – along with the highest ever employment rate achieved, at 74.6%.
Economic theory – namely the Phillips curve model – tells us that as the level of unemployment falls, the economy can expect a corresponding increase in the rate of inflation. But recent inflation increases in the UK have been the result of commodity price increases and a weaker sterling – not inflation generated by a booming labour market. Average earnings and productivity data have been relatively static; this has been attributed to the dampening effect of the gig economy.
‘Gig economy’ is a term used to describe a labour market characterised by flexible, less permanent jobs with more short-term contracts and freelance work. The chart below shows the extent to which the UK has transitioned to this, with a significant increase in self-employed workers and zero-hours contracts as a percentage of the total employed.
Source: ONS as at 31 January 2017
This affects average earnings. Recent data from Barclay’s researchers indicated that self-employed workers earn 20% less than full-time employed workers, while those on zero-hour contracts have little bargaining power and struggle to force wages higher. On top of this, the current tax regime in the UK favours two lower wage earners in one household over one higher wage earner. The same net income can be achieved by two people doing less or doing lower paid work and leaving spare time to work in the cash “black” economy too.
These dynamics directly influence central bank decision-making and so are important to consider when forming a long-term view on rates markets. The structure of employment has changed; this is no rigid 1950’s society and as such we expect the Bank of England to demand some hard data before taking action this time round. Investors calling for a rate hike still have a long wait.
Brexit is a clear risk to any firm view on the outlook for the UK despite the reasonably benign outcome since June last year. With immigration still a key political issue, labour coming from Europe to work in the UK remains a wild card for employment numbers as Brexit negotiations kick off. Nonetheless, Brexit implications are far more likely to see a central bank willing to support the economy, rather than tighten policy.
On Tuesday this week the European Central Bank released their quarterly Bank Lending Survey for the Eurozone. This is a comprehensive document available in the ECB’s website that covers the lending behavior of 140 banks across the Eurozone. Click here to view. The headline message is clear: both credit supply and credit demand are improving. This augurs well for a continuation of the often under-reported recent robust economic performance of the Eurozone, with many commentators preferring to speculate about political change instead.
Another feature that also stands out is that the banking sector as a whole detests the policy of negative deposit rates. 85% of banks surveyed reported in the first quarter that it was having a negative effect on net interest income. This is nothing new as each survey since the negative deposit rate was introduced has provoked a similar reaction. From the ECB’s view, volumes of lending are up as a result of the policy and lending rates are down, so a successful policy to some extent nevertheless. This somewhat controversial policy is benefiting those in the economy that want to borrow money whilst causing a headache for the banking sector.
As the European economy recovers, speculation is now turning to the idea that the ECB is going to start to remove some of the emergency policies that were put in place last year. So what will they do first, raise the deposit rate or stop quantitative easing? Raising the deposit rate will benefit the banks by elevating net interest margins and it may also have the effect of increasing short term interest costs within the economy. Stopping QE first may have the effect of increasing long dated bond yields and increasing long term borrowing costs, maintaining banking sector dissatisfaction.
The debate is on! The ECB meets today to talk about monetary policy. At this meeting there is not expected to be any change, but the Eurozone bond market participants will be listening keenly in the post meeting press conference to see if they can detect a bias to one or other policy. Yield curve and cross Eurozone market opportunities, and also credit sector opportunities will present themselves if a bias is signaled.
Election announcements make good theatre. A rushed press conference, lectern in the middle of Downing Street, searing Prime Ministerial looks and boom – a snap election for June 8.
In years gone by, such uncertainty was a source of material volatility to all markets, especially bond markets, and certainly worthy of more than the 5bps of volatility that we saw in gilts yesterday. But this gives us a clue to what is going on.
The volatility we saw at the end of June and July 2016 was obviously Brexit driven. What calmed markets was the swift resolution to the power vacuum, the UK proved resilient and institutional stability prevailed.
The action was all in the currency market with the c15% fall in sterling against the dollar on a trade-weighted basis. And so it was yesterday too: the action was in currency with a push to $1.28 and a cent on the euro exchange rate. There is no institutional uncertainty in Theresa May’s announcement – quite the opposite. It is a grab for power via a larger majority in Parliament with the desire to deliver the Brexit she sees fit and not one she has to discuss and share with Remainers nor hard Brexit Tory backbenchers. All very calming for the bond market.
There are clearly risks, though. Jeremy Corbyn is elected? Low. UKIP? Now Article 50 is triggered their raison d’etre has been removed. A resurgent Liberal Democratic party retaking Tory seats? More likely but the old Lib-Dem heartlands were in the “Leave” voting South-West. Scotland? Here we have the fourth general election or referendum in four years but despite the SNP’s push for IndyRef2, they are likely to face the Unionist challenge and lose Westminster seats. In short, the gilt market is comforted by the 20 point lead for the Tories in the opinion polls and expect June 9 to be business as usual but emphatically so.
As it stands today, politics are not a driver of material gilt market volatility. The action is in the currency markets and the currency-sensitive FTSE. An increase in gilt market volatility is most likely driven by non-domestic factors.
Theresa May has confirmed that Article 50 will be triggered on the 29th March – will this prove to be a catalyst for showing some UK ‘buyers’ remorse’ following last year’s vote to leave the EU?
In the short term we’ve seen little evidence of such sentiment – business investment has held up surprisingly well and consumer spending has been resilient despite the pinch of imported inflation. The UK has also (so far) avoided signs of institutional instability – there has been no evidence of an overseas buyers’ strike for Gilts.
On a longer-term view we’re still assuming the mood music that we ‘ain’t seen nothing yet’. If this is the case, Bank of England support will become relevant again. Right now the hurdle to more QE is lower in the UK than in anywhere else – although next time we expect a more reactive stance, so we must see some poor economic data first.
With this backdrop we will at some point want to be long UK gilts versus other core markets like US Treasuries. But not yet. We still expect that gilts could underperform in the short term as the Bank of England steps away from the market. To make money we will implement active, tactical trades – to exploit the market’s under or overreaction in the next nine days, and beyond.
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.
The Bank of England re-started its gilt buying operation in August 2016. This action was taken to provide insurance against an anticipated slowdown in the wake of the EU referendum vote. As part of the QE programme the Bank also re-invests the proceeds of the redemptions within the Asset Purchase Facility. The re-investment of the proceeds of the gilt that matured in January 2017 will be completed on March 13.
The impact on the gilt market of the Bank of England’s buying has been significant. The Bank of England buys bonds in three maturity bands, 3yr-7yr, 7yr-15yr, and everything greater than 15yr. However, the Bank has a self-imposed limit that it will not own more than 70% of any one gilt. This restriction means that in the 3-7yr bucket, of the ten bonds available only one is over the 70% limit. In the over 15yr bucket all nineteen bonds are available to purchase. However, in the 7-15yr bucket, of the seven bonds only three have been available for the Bank to buy.
This has the result of distorting the price of bonds with very similar features. For instance, the 2.25% 2024 gilt has been available for the Bank to buy but the 5% 2025 gilt has not. These two bonds have an identical duration, that is, price sensitivity to changes in yield. The 2024 gilt at one point offered 8bps more yield than the 2025. At the moment it offers around 5bps more yield.
An active fund can oppose these distortions created by central bank actions and pick-up the extra yield for no extra risk.
Can your gilt tracker do this?
There has been some chat in the press over the past days suggesting a 50% chance of a hike in March. We think this is a little misleading. A well-used analytical tool on Bloomberg shows a 50% probability, but this number uses the midpoint between the upper and lower bounds of the Fed Fund corridor as the most recent fixing, so this is currently 62.5bps.
However, if we look at the future market where futures trade on the average effective rate (not the midpoint of Fed Funds), this is currently 66bps and has remained very stable over the past few days.
So by our reckoning if you compare the spread between the effective rate from the futures market and the Fed Fund it looks like media observations are overstating the probability of a March rate hike. We think the actual probability is 36% (not a half). We work this out by using the April futures contract expiry price of 75bps, less the effective rate of 66bps which equates to 9bps; so if there is a 25bp rate hike the chances from the more dynamic futures market are 9/25 i.e. 36%.
Here is the effective rate vs the lower bound of 50bp: