As expected, the US Federal Reserve cut interest rates again yesterday. In total, the US Federal Reserve has cut 75bps this year, almost completely reversing the hikes of 2018; the target range for US Fed Funds now stands at 1.5-1.75%. The committee remains split, with two members still dissenting against rate cuts, but the committee’s top dove Bullard did not argue for a bigger rate cut, unlike previous meetings.
As for what is next, the statement and Chairman Powell’s press conference offer few clues. According to the Fed the economy remains sound, but there are concerns over exports and business investment, the depressing effect of trade discussions, and “global developments”. This justifies the cut, but any future cuts are not being signalled – hence the reporting of this current move as a ‘hawkish cut’. In his press conference, Powell emphasised that their stance was “likely to remain appropriate” for some time. As we’ve already seen this year, less forward guidance may well lead to greater volatility as markets struggle to predict the Fed’s next move. A line saying the Fed will “act as appropriate to sustain the expansion”, seen in multiple prior rate announcements, was noticeable by its absence in the statement. A return to rate hikes, though, is not on anyone’s radar: Powell said only a “really significant” rise in inflation would cause a re-evaluation.
In theory we should regard every rate cut as being the last one, otherwise the central bank should have announced a bigger cut. In practice, most economists expect further weakness in the economy and hence further rate reductions into 2020. For financial markets in the near term though, the move is positive. Cutting the risk free rate will encourage investors to move out of cash and into other assets – the S&P 500 closed at a record high on the day of the announcement.
Government bond markets used to be conventional. Macroeconomics departments at prestigious universities all taught the ancient (given the short history of economics) orthodoxy of GDP, inflation, current account balances and unemployment all determining government bond yields. But the old truths have stopped working lately.
Take steadily rising employment across the Eurozone since 2013 – did this spur inflation and drive bond yields upwards? No…
How about a decade of rising US consumer confidence – has this driven 10-year Treasury yields to 5%? Try 1.7%….
Times have changed, and so too have the variables that affect bond yields. The textbooks of 20 years ago simply don’t work in today’s world of quantitative easing, negative interest rates and trade wars. Instead, we can see the new determinants of government yields recently have been market inflation expectations (5y5y inflation swaps), market expectations of central bank rates, forward guidance from the Fed, and the positioning of hedge funds.
So let’s assume that today’s relationships hold – an imperfect assumption I agree, but recent history is a better predictor of the near future than things that drove markets 50 years ago. How should we position a government bond portfolio through to the end of the year?
Inflation expectations have collapsed, rate expectations in the US and Europe – and globally – are for more rate cuts this year and into 2020, and Fed communication on rates has been shifting downwards all year. I think in this environment you own bonds. That’s the medium term trade where inflation is going nowhere and central banks are going to buy assets for a very long time.
In terms of value, bond investors often look at carry – in other words, the return you get from holding the bond and assuming that rates don’t go anywhere. But carry is not a very good indicator of the return from holding a bond over your investment horizon. Italian bonds may be good “carry” at 1.4% over the German equivalent, but you are going be looking at a big hole in your fund performance if you buy them today and they blow out to 3% tomorrow. A much better indicator of the attractiveness of an investment is not the carry, but the carry adjusted for the volatility of the asset. Volatility adjusted carry (VAC) has been proven over certain time periods to be significant in producing an excess return.
Looking at VAC, in my chart below, 5-year Greece is the most attractive government bond asset to own. I like the improving credit story and overarching ECB support. So from here I stay long Greece – maybe I’ll sell when the ECB wants to buy them from me.
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.
My colleague Sandra Holdsworth often comes up with real gems in her observations of the market. This week she said “central bankers should do their market communication in a foreign language”. After mulling this over I think she has a point!
Way back in the 1950s it is fabled that Bank of England policy was made over a cup of tea and the raising of an eyebrow. Fast forward to 2013 and Mark Carney was very keen on providing clear forward guidance. Except that it hasn’t been very clear and arguably hasn’t worked very well. UK rates didn’t rise when unemployment zoomed through 7%. Brexit and the politics of “Project Fear” didn’t help the perception of clarity either. But it’s not just the Bank of England that has struggled to adopt the use of “plain English”.
The US Federal Reserve introduced “dot plots” in the early 2010s. The idea was to give a clear outlook to rates, except that actual Fed funds policy has moved nowhere near what they had been predicting. So when previous Federal reserve chairs Bernanke and Yellen failed to raise rates in line with what had been suggested, the Fed minutes became longer and longer. Policy misses need more explanation, or to put it more simply, if you don’t want to admit you are wrong best hide it through more words. In times past, previous Fed vice chair Alan Blinder referred to central bankers’ language, “Fedspeak”, as a “turgid dialect of English”.
Which returns us to Sandra’s point. Central bankers should be made to communicate not in their native tongue. One’s ability to obfuscate is greatly increased when one employs a carefully constructed rationale to reflect a course that is clearly collegiately predetermined yet which in fact has deviated from the desired outcome. See, no way could I have written that in French. Far easier to hide one’s true meaning in your own language.
Which of course is ironic. Despite having the most difficult job of corralling 19 disparate national central bankers, English is the lingua Franca of the European Central Bank. Doing “whatever it takes” is so much more easily spoken by an Italian in English. You’d never get an Anglo Saxon central banker talk “plain English” like that.
So far 2019 has been unpredictable. We’re yet to see Brexit come to a conclusion, new EU and ECB leaders have been announced and are poised to take on their roles, and Trump (and his Tweeting) remain an enigma. With all this in mind, Adrian Hull, Iain Buckle and Sandra Holdsworth give us their thoughts on what lies ahead for markets in the second half of 2019.
The last two speeches from Mark Carney and Gertjan Vlieghe makes me wonder if the Bank of England (BoE) are preparing us for a change to come at the August Monetary Policy Committee (MPC) meeting.
BoE economists factor-in both government policy and market-based interest rate projections into their models, and then create projections of GDP and inflation. However, this approach raises a number of issues that the Bank is clearly wrestling with.
In his “Sea-Change” speech on the 2nd July, Carney stated “As the perceived probability of a “No-deal” Brexit has picked up, the levels of Bank Rate, Sterling and other UK asset prices in our projections have therefore become increasingly inconsistent with the smooth Brexit assumption in the MPC’s projection”. He then went on to say “The MPC will explore how to best illustrate these sensitivities as we update our projections for the August Inflation Report.”
On the 12th July fellow MPC member Gertjan Vlieghe made a speech on communication improvements. In this speech he said communication is currently:
- Too complex & inefficient – the BoE have to take a market path of interest rates and reverse engineer policy depending on the inflation outlook coming out of the model.
- Too inconsistent – we do not get a coherent message on the outlook.
Importantly, he stated that not only would he like to see the preferred path of interest rates published, but also made it clear that under different scenarios “We might still show an alternative forecast based on some other path, in order to show what difference it would make or to discuss salient alternative scenarios, as this would allow outside observers to better understand the MPC’s policy preferences and views of the transmission mechanism”.
I expect no official change in communication at the August meeting as central banks are inherently cautious, even if there was universal agreement on Vlieghe’s recommendations. However, I think it is entirely feasible that in the Quarterly Inflation Report on the 1st August we get more information on the policy reaction to different Brexit outcomes. We might even get a policy path based on a Brexit deal, No-deal or extension period.
Be prepared for more fan charts!
The Eurozone is very much expecting some further monetary stimulus. Whether it’s July, September or later remains to be seen, but both the timing and the quantum will be key. Whilst a deposit rate cut is firmly on the cards, the size of potential bond purchases is up for debate.
How much should the ECB spend? We believe €6.75trillion should do it! This is a throwaway number – the ECB couldn’t buy that many bonds even if it wanted to, as there aren’t enough bonds available in practice to buy.
However, to illustrate some of the current funk for central bankers, the ECB (like the Bank of England) still has a 2% inflation target. The Governing Council clarified in 2003 that “in the pursuit of price stability it aims to maintain inflation rates below, but close to, 2% over the medium term”. 2003 now seems like ancient history, with the current rate 0.75% below this target at 1.25%.
So how did we arrive at €6.75trillion? Our government bond team spied a very sensible piece of research by Credit Agricole. They used various in-house models that looked at wages, employment, growth, currency and many other factors; they figured that an 18 month bond purchase programme of €50bn would increase core European inflation by 0.1%. So we figure that if the ECB wanted to achieve its 2% inflation target and aimed to do it solely by bond purchases, then to increase the Eurozone rate from its current 1.25, it would need to buy €375bn a month or €6.75trillion over 18 months.
This is, of course, fanciful and will not happen. But what it does illustrate is the stretched situation that monetary policy is in. For Europe, the debate is set to drift. Effective stimulus needs both monetary policy and fiscal policy. Whilst it is still early days for a sea change, the Italian Prime Minister Giuseppe Conte has already asked the EU commission to review finance rules governing the EU. We now have former French finance minister Christine Lagarde taking over from Mario Draghi at the ECB. Current market valuations leave no room for fiscal policy to not be part of the overall solution.
Expectations are building in the bond markets that the US Federal Reserve is about to embark on an easing cycle starting in July, and market pricing suggests that rates will be 0.75% lower by year-end than at current levels.
To date, Chairman Powell has given little away, affirming at every opportunity a neutral stance with the promise of reacting in either direction if necessary. The FOMC meets next week and analysts will scrutinise the statements, the Summary of Economic Projections and the Press Conference for further clues. In our opinion, there is a good chance that the markets will be left speculating for a bit longer about FOMC thinking, and that the neutral stance will be retained.
We come to this conclusion based on the published economic data, which shows that the US economy is still solid and performing better than the US Federal Reserve had expected so far this year. The pace of expansion is admittedly slower in 2019 than was the case last year, but remains around potential and the Economic growth forecasts that will be published are likely to show an upgrade. Inflation on the other hand is likely to be revised down slightly. Both observations would represent an outcome that the FOMC should be delighted with, and would suggest that there is no need for rates to be either higher or lower at present.
The infamous “dot plot” – which shows how the committee members see interest rates evolving over the next few years – will in all likelihood continue to show an upward path in rates into 2020, completely at odds with market pricing. The validity of the dot plot has to be questioned in an easing cycle as the FOMC does not pre-plan rate cuts, and is instead usually reactive to events, crises or recession. The FOMC also forecasts a long run rate, which is currently at 2.75%, which again looks vastly different from bond market pricing. Using the forward curves, rates are expected to be around 2.15% in 10, 20 and 30 years’ time, illustrating how far the bond market has ‘front run’ Federal Reserve policy expectations.
So why would the FOMC start to lean towards easier monetary policy, and what would be implied by a move to an easing stance? Firstly and probably most importantly, by signalling an ease the implication is that we have seen the top of the interest rate cycle. That should surely mean the long term rate must be lowered substantially, closer perhaps to the average rate of the last 10 years which is a mere 0.5%. This would perhaps be a bit extreme (as it does include the immediate post-crisis period), but even over the last 5 years it is still less than 1%. This is more than 100 basis points lower than that implied in the market, and over a whopping 175 basis point difference from the FOMC’s current estimate.
Thus, reverting to an easing stance is hugely significant, and to my mind too big a statement to make at the current juncture when the US economy is performing well, employment is still rising and financial conditions are easing. Should they do so however, yields across the whole of the fixed income universe have a long way to fall. A change in stance like this may well also be positive for riskier assets, as the move is perceived as less of a response to concerns but more a “recalibration” of Fed thinking about what the “neutral” rate for the economy is. On an international comparison, US interest rates are far higher than in Europe and Japan, as President Trump is so fond of pointing out.
The FOMC have surprised us a couple of times this year. We should remain alert to more surprises as they could be even more meaningful than what we have seen already.
“Italy will not be another Greece” said former Italian Prime Minister Matteo Renzi in July 2015. Nearly four years later their sovereign debt markets show that they may be closer than ever before. Italy can borrow for five years at a rate of 1.85% and Greece can now borrow at a slightly lower rate of 1.73%.
So what is behind this, and why are the debt markets pricing equivalent credit risks for the two countries? Back in 2015, Italy could borrow for five years at 1.34% while Greek 5-year debt reached around a 20% yield at one stage. Greece was effectively still shut out of the debt markets.
Coming back to today and taking Greece first, a slow renaissance has occurred. Firstly, there has been recovery in the economy. Secondly, economic reforms have been made and the country has sustained a surplus in public finances. Finally and importantly, Greece returned to international bond issuance. Debt metrics have not really improved yet, but the deterioration has halted and as long as the economy continues to grow, like Ireland and Portugal in recent years, the credit outlook should continue to improve. Credit ratings have already started to reflect this, with all the major ratings agencies upgrading over the last year. Admittedly they remain a long way from investment grade, but things are going in the right direction.
Another factor that supports Greek debt is its scarcity, which may come as some surprise. Although the Greek government debt-to-GDP ratio remains at a very high 181%, a high proportion is funded by various bailout programmes and therefore does not need to be repaid or refinanced in the short term. Current funding needs are thus very low and are usually done to refinance more expensive loans, thus reducing debt servicing costs via issuance.
By contrast Italy, although rated investment grade, is showing some very worrying trends again. The current government is expanding the budget deficit and the ratio of budget deficit to GDP is expected to rise again this year. The ratio of total debt to GDP is rising and currently standing at a record high of over 130% GDP.
All of this debt is financed via the bond market which will have to take the strain if this problem is not tackled via greater issuance. If credit ratings deteriorate, the pool of available buyers will also decline, particularly if a sub-investment grade rating becomes likely. This is why the EU is just about to open an Excessive Deficit Procedure (EDP) for Italy. The EDP is nothing new in the EU, as even Germany has been subject to one in the early years of the Euro, and only Sweden and Estonia have escaped the procedure in recent years. Spain has just exited the procedure having entered it in 2009.
The aim of the EDP is to act as an “early warning system” for fiscal policy. It requires national governments to present plans as to how their nations will return their debt positions to that set by the Maastricht criteria i.e. a budget deficit of less than 3% of GDP and a total debt to GDP ratio of 60% over a period of time. If nation governments fail to comply, ultimately a fine of 0.2% of GDP can be levied. In practice, despite many countries being in the EDP for many years, no fine has been applied.
The current government in Italy shows very little sign of being compliant to the EU, so perhaps this will be tested in the years to come. U-turns, however, are not unprecedented. Returning to Greece, the Prime Minister Alexis Tsipras, who has presided over Greece’s return to debt markets, famously swept into power on anti-austerity rhetoric which was quickly abandoned in the face of the 2015 crises. Four years later the bond market approves, though perhaps not the population – Tsipras has recently lost heavily in the European elections and has just called a General Election.
The inflation-linked bond or “linker” market may seem like the slightly strange little cousin to the main gilt market – everyone knows it exists, but mostly ignore until it does something outrageous. At the moment it is screaming!
Over the next two years, the index-linked market is saying that UK inflation (RPI) will average 3.50%. Current predictions from forecasters are that RPI will be in the 2.2% to 3% region in 2019; to get to the 3.5% average that the index-linked market implies over the next two years, RPI would have to reach the extreme heights of c.4.5% in 2020. Given current levels of inflation, and the outlook for currency markets and oil, it seems very unlikely that we’ll get to these levels north of 4% RPI.
So why is the pricing so extreme? The index-linked market is being used as a political hedge against tail risks, and these risks are becoming more and more like the base case for a lot of investors. It all comes down to expectations of where sterling will move from here.
A no-deal Brexit = £ negative + higher inflation.
A Corbyn Labour government = £ negative + higher inflation.
The Bank of England not hiking rates = £ negative + higher inflation.
So investors are buying inflation-linked bonds on the back of their negative views towards sterling. As they rush to buy “linkers”, they meet little resistance in the market – not many people are willing to take the other side of this argument at the moment.
But at today’s level of £/$ at 1.26 (in the post-referendum trading range of £/$ 1.20 to 1.43), you could argue it has done a lot of the work already. How much further are we able to be shocked by UK political events?
At current pricing we think the inflation market should be done screaming here. It should take a little breather.
May 2019 could go down in the history books as the moment when UK politics really changed – the month where the two dominant political parties lost their way.
Whilst the political risk gauge has certainly increased post-European elections, financial markets have been expecting turmoil for a few weeks now. Sterling has weakened as the probability of a “No deal” Brexit, once thought to be off the table, has started to increase again. Gilt yields have fallen, with the 10-year gilt now yielding less than 1.0%. The yield curve has now started to price in the possibility that the next move in the Bank Rate will be down rather than up, in contrast to the message that the Bank of England have been giving for some time.
At this level of yield, the outlook for fixed income is turning less positive and requires a change in message from the Bank of England to sustain it. The next meeting of the MPC is in June, but they are unlikely to change message at that point unless there is a crisis (economic rather than political) developing. It is more likely that the Bank of England will reassess in August and guide policy at the same time as they release the quarterly inflation report. At that point it appears unlikely that Brexit negotiations or arrangements will be any further forward than they are now. The leadership change within the Conservative party is expected to be completed by mid-July, leaving little time for any further negotiation. The Bank therefore are unlikely to make any changes to their underlying assumption that departure from the EU will be orderly, even if the political developments raise the risk of an alternative scenario.
Another reason why the Bank may change their guidance is if the UK and global economies start to show significant weakness. The UK economy has performed better than expected so far in 2019, but a large part of this performance was to do with economic activity being brought forward ahead of the initial Brexit deadline at the end of March 2019. Some reversal therefore should be expected in the second quarter; with the delay and uncertainty continuing, expectations of the weaker trend in investment are likely to continue from now until the end of the year, and possibly for even longer.
With this in mind, we tend to come down on the side of the Bank of England validating the move lower in gilt yields by changing their message on interest rates to a neutral position from the current hawkish bent. From neutral they then can open up the possibility that if the economic weakness is prolonged, then a cut in bank rate is probable. However, we see this validation to come later in 2019 – most likely in Q4 – thus some consolidation in the gilt market is due in the short term. We expect yields on 10-year gilts to trade in the range of 0.8% to 1.1% over the summer, with the proviso that if it becomes apparent that economic conditions are deteriorating faster than currently expected, then we would expect the Bank of England to act sooner and yields can fall further again.
Financial Markets often become fixated with elections, some more than others. The upcoming European Union elections will choose 751 MEPs to the European Parliament, which along with the European Commission and the Council of the European Union forms the tripartite legislative function of the EU.
Up until very recently the UK was not going to participate in these elections, but now will for obvious reasons. 73 MEPs from the UK may yet take their seats on 1st July 2019. Quite who the UK public will elect and for what reason is difficult to read. A protest vote either from a lack of turnout or by virtue of the representatives that are elected seems the obvious conclusion. Turnout is often low in these elections across Europe, and the current record low was recorded in Slovakia in 2014 where voter turnout was a mere 13% of the electorate.
But will it matter in any way? Do these elections have any impact on economic policy in either the UK or in Europe?
Taking the UK first. Interest rate policy is set by the Bank of England and is in no way influenced by politicians in Brussels. Despite what some UK politicians might say, fiscal policy is set by the UK government. The Brexit process is a far bigger influence on the outlook for the UK economy and that is currently in the hands of the UK members of Parliament. There is likely to be a backlash against the two main parties in the UK which may accelerate the political demise of their leaders, which, although newsworthy, is again not something the Bank of England will react to.
In Europe, the elections again may well be newsworthy. There is predicted to be a rise in representation of the populist parties (Lega in Italy and National Rally in France) but the two largest groupings expected to remain in control are the European Peoples Party (EPP) and the Party of European Socialists (S&D). The European Central Bank again is independent of politicians and will not react to any change in parliament make-up and fiscal policy remains the responsibility of national governments. Oversight from the EU remains, but despite what some politicians are saying, this is unlikely to change.
So interesting, noisy and complicated, but not going to change a lot. Interest rates are low and staying low for a long time to come.
As Emperor Akihito abdicates and Naruhito assumes his father’s role, we thought a review of the Japan and the UK since 1989 might be interesting – the year in which Akihito became Emperor.
First, of course, Akihito’s puny 30 years at the helm rather pales in comparison to Her Majesty’s all-other-UK-monarch-beating 67 years and counting. Back in 1989, too, UK interest rates (using UK base rates as a measure) were a mighty 13% and, like Her Majesty’s efforts, materially more than Japan’s 2.5%. Japan’s bubble burst after the Japanese discount rate was ramped up to 6%. By the end of 1995 Japan had cut rates to 0.5% and, bar an effort in the mid-2000s that saw rates go up to a whopping 75bps, they have remained in “not very much” territory ever since. (Indeed, other policy tools are now used, and the Bank of Japan focusses on the Policy Balance Rate). Thus, Japan has had rates below 1% for almost 25 years and so the phrase “Japanification” was born. Very low inflation, no inflation, or indeed deflation has been the norm and despite reform efforts over the last 5 years the economy has not had sufficient momentum to push rates higher.
This year is the 10th where UK rates have been under 1%. There will some who argue that given the UK’s more open economy and younger population, bar Brexit diversion, UK rates should be substantially higher.
Japan is not the UK, but it is a reminder that even if rates do go up in the UK, the hikes are unlikely to be dramatic.
Housing data is perhaps second only to the US yield curve as a cause for alarm bells to be ringing throughout investment houses over the health of the economy.
Much has already been said of the fortune telling abilities of yield curve inversion. In the US housing sector, data releases toward the end of March showed that growth in new housing starts (and the granting of building permits) has moved into negative territory on a rolling 3 or 6-month average basis. The last time this happened was around the 2007/2008 global financial crisis, where mortgages were key to the collapse.
New Housing Starts & YoY Growth
But the figures themselves do not tell the full story. The fall may well be due to one-off factors undermining data in the past year, or a more general deceleration, rather than a cliff-edge moment. Indeed, activity in the housing sector has been erratic, and therefore a less reliable indicator, for three broad reasons:
- A return towards trend from the unsustainably high readings in 2018 driven by the boost to housing construction post-2017 natural disasters (where hurricane season was the worst since 2005). The recent weather events in the US, though less destructive than in 2017, were still unusual – as also evidenced by construction payroll figures.
- An adjustment to the SALT (“State and Local Tax”) deduction changes in the 2017 tax bill, which impacts higher earners. More price adjustments are likely to come before this fully works through the housing sector.
- The return of mortgage affordability measures to the historical norm (i.e. adjusting to higher interest rates) after being unusually attractive for most of the cycle. The perceived ending of the Fed tightening cycle at a lower interest rate than had been expected should be positive.
There are reasons to believe that building will remain steady rather than fall. The rise in the rate of home ownership to a sustainable level from the post-crisis lows are evidence of a market that has worked off much of the lingering imbalances from the bursting of the housing bubble. This underlying change no doubt helped housing data rise in recent years, until the recent dual pinches of affordability and SALT deductions put the brakes on. Labour market improvements, both in the size of the workforce and their earnings, has also increased the pool of buyers, and mortgage applications are still rising, even if only modestly. Indicators of excess, such as delinquencies, are not sending warning signals either.
The conclusion at present is that the housing market has plateaued because it is adjusting to a combination of factors: the run-up in housing prices for most of this credit cycle; SALT deduction changes which hit states with higher prices and taxes; and some underlying structural/demographic changes.
While the housing sector has lost momentum, there is a way to go before the building cycle has run its course. On the basis of current information, we at Kames would be more inclined to expect a continued growth trend, but with susceptibility to disruption by further price adjustments.
Headlines so far aren’t doing this year’s zodiac much justice; live hog prices have spiked as China battles the repercussions of African swine fever. There is no vaccine for a disease that is highly contagious and fatal to pigs, though thankfully not humans. About 1 million pigs have been culled so far in an effort to try to control the spread.
News regarding the economy has not made for pretty reading either. Figures overnight indicated that year-to-date industrial output marked the slowest start to the year in a decade. Retail sales were similarly moribund compared to recent history, growing at their slowest pace since 2003. Such figures were not wholly unanticipated given China’s well-documented struggles with high debt levels, and increasing concerns over the likely outcome of the protracted US trade negotiations. Other headlines of late have only served to reinforce these concerns; aggregate January and February trade data showed exports and imports fell 5% and 3% respectively, compared to the same period last year. Exports reflect both the impact of US tariff threats and the more general waning of global trade. China’s neighbours are also impacted, with their manufacturing bases sensitive to the appetite of the Chinese consumer.
There is some evidence that the Chinese authorities’ efforts to mitigate the slowdown are having an impact, with bank loans and credit both at record highs in January. Whilst this may renew longer-term fears over the potential for the Chinese authorities to inflate the credit bubble, the rhetoric emanating from the National People’s Congress (which takes place this week in Beijing) continues to be suggestive of a government that remains keen to stimulate, and offset as much as possible, the domestic economic slowdown. The market’s focus will likely continue to be more on the shorter-term growth numbers, rather than what the eventual fall-out will be from a credit bubble bursting down the line.
The health of the Chinese consumer is certainly of greater importance to our core rates markets than in years past. Taking Germany as an example, it is clear that virtually all of the cyclicality of German growth typically comes from exports. In Germany, exports are a c.47% share of GDP, whereas in the US the equivalent figure is c.12%. A healthy Year of the Pig is not just of significance to China, but also to its trading partners.
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.
US Monetary Policy throughout 2018 was a simple tale to tell; rates have increased by 0.25% per quarter, US Monetary Policy has been well signalled and the US Federal Reserve have been clear about the motivation for such a policy.
But as the year draws to an end, speculation has turned to 2019, and things become cloudy. So what factors are causing the uncertainty?
Firstly, the current levels: The fear of the end of the cycle. After each rate increase, by definition the level of rates is getting closer to what is perceived to be the “neutral rate” for the economy. This rate is estimated to be around 2.75% to 3.0%, so the closer official rates get to it, speculations begin about the end of the cycle.
Secondly, the outlook for economic growth: The immediate effects of the tax cuts are fading and 2019 looks a lot less rosy than 2018.
Finally, global economy: To put it politely, the rest of the global economy is less buoyant than it was 12 months ago. Stresses are evident in a number of emerging markets, particularly in China.
As US economic growth dips, this could mean the US Federal Reserve will be less resolute in their stance that global factors will not influence US policy.
So, how much more have interest rates got to rise in the United States? Given all I’ve said already, the maximum looks set to be around four moves of 0.25%. The minimum? Two moves of 0.25% …which follow the Fed’s 0.25% increase yesterday. This would take the upper bound of the Federal Funds Rate to 3.0%, the so called “neutral” rate. We would err on the side of caution (i.e. two rate increases) given that, in this economic cycle, interest rates have never risen as fast as one might expect, mainly because inflation has been so low throughout the recovery. This is the one factor that could take the number of rate increases higher as the US Federal Reserve has a twin mandate of both economic growth and inflation.
And what about rate cuts? Speculation is rising, partly because the US yield curve has now inverted slightly. Rate cuts seem unlikely (although it is obviously always a policy option in the event of a crisis). A more likely candidate for policy easing in 2019 could be China.
So, monetary policy divergence seems likely to be a feature of 2019 with rates in the US tending to rise and interest rates in the other parts of the globe either unchanged or lowered.
Postulating that the gilt market currently trades with a degree of a Brexit risk premium hardly qualifies as searing insight.
The most recent aggressive shift downwards in gilt yields – implying almost zero chance of the Bank of England raising rates in the next 18 months – has largely been a function of the negative political reaction to the “Withdrawal Agreement” that the Prime Minister brought to Parliament last week. The political horse-trading that has begun will continue to envelop the debate over the coming weeks, prior to any “meaningful” vote taking place in Parliament (presumably in the middle of December if the most recent media coverage is to be believed).
As the political debate around the nature of the UK’s exit intensifies, attention will inevitably refocus on the economic prospects that any disorderly Brexit would bring. That economic activity would be severely damaged under a “No-deal” scenario is another statement that hardly qualifies as controversial. Less clear however is the likely gilt market reaction to such an outcome. In “normal” economic circumstances, such an economic shock would precipitate a fall in gilt yields and a dovish Bank of England response.
However, the probability of both domestic and especially international lenders to the UK requiring a higher risk premium in such a scenario is something that should not be dismissed. Given the current febrile political backdrop, a possible new (Labour) government that rips up the fiscal rule-book – and conventional economic wisdom around sustainable debt levels – is unlikely to preside over a compliant gilt market.
“No plan for Italy to leave the Euro”
Claudio Borghi, Head of Lower House Budget Committee
Presumably Signor Borghi said this thinking that it would reassure Italian financial markets. It doesn’t seem to be working as of the time of writing, so maybe the question should be “Will the Euros leave Italy?”
Last week the Italian government released their new three year economic plan, complete with an increase in the budget deficit via increased fiscal spending (i.e. the citizen’s income) and some optimistic estimates for economic growth. On the face of it, it doesn’t look like a very big fiscal expansion, but when you have a total debt level of around 130% of GDP you don’t need a very big fiscal expansion for questions to be asked. Those questions are being asked by the European Union much to the chagrin of Italian leaders.
So what does the EU have to do with it? As part of the strengthening mechanisms put in place after the last Eurozone crises, all Eurozone countries signed up to the monitoring of their fiscal plans, including Italy. There is no desire for further bailouts in the Eurozone and these procedures were put in place to provide an “early warning system”. The EU is reacting exactly as their rules would suggest and Italian bonds and other financial assets are taking the strain as non-domestic and domestic investors withdraw their investments and thus their Euros from Italy.
So what happens next? In terms of the Italian timetable, further detail regarding the budget for 2019 will be released around 10th October. If it is in line with their three year economic plan then the EU will not react favourably. And nor may the ratings agencies which represents the really significant risk – and this is what is driving markets now. Currently Italy is rated Baa2 by Moody’s with a negative outlook. A downgrade to Baa3 is likely and a negative outlook may be maintained – so just one move away from a junk rating. The implications of the world’s third largest bond market moving to junk are enormous. The flight of capital from Italy would be vast.
In time, the knock-on effects will be that policy somewhere will change. It could be that the Italian politicians change fiscal policy, or there is another change of government. What is unlikely though is any action from the European Central Bank (ECB). The ECB cannot start Quantitative Easing again, they cannot cut rates, and their hands are tied unless the banking system comes under stress. There is a mechanism for bailouts and the mythical Outright Monetary Transactions (OMT) policy, but these options are not easy to execute and would only be applied after sufficiently large amounts of Euros from Italy have moved to other parts of the Eurozone. Any of these policies are completely unacceptable to the current Italian government in its present state.
Lastly it is worth mentioning that given the growth and popularity of passive and index tracking funds across the investment management industry, these funds will not be able to reduce their allocation to Italian assets unless they are removed from their benchmarks. These funds are a low fee way of accessing bond markets, but investors must consider whether that is what they really want for their bond market allocation in this more challenging market environment.
Do you want low fees but full exposure to Italian bonds? Consideration of paying up for the optionality of not having that exposure must be worth a thought.
The ECB left rates and the asset purchase target unchanged at their September monetary policy meeting.
The meeting was accompanied by the ECB staff macroeconomic projections, which showed a marginal reduction in the growth forecast versus the projections released in June. Real GDP growth in 2018 was lowered to 2% from 2.1%, in 2019 to 1.8% from 1.9% and in 2020 left unchanged at 1.7%. The risks to this forecast remain “broadly balanced” as communicated in previous policy meetings.
On the inflation front, the headline Harmonised Index of Consumer Prices (HICP) forecast was left unchanged at 1.7% until the end of 2020. Underlying this was weak oil prices being offset by “significantly stronger” core inflation driven by rising wages.
There was no discussion on reinvestment of the asset purchase programme redemptions, with Draghi suggesting that the likely date for this would be October or December.
The worries in Italy, Argentina and Turkey were, in Draghi’s view, reflective of weak fundamentals and as such contagion has been limited, with Italy viewed as an “Italian episode”.
Rates markets rallied however this is more likely reflective of the lower than forecast inflation number out of the US, released at the same time as the press conference.
All in all, no material information and we continue on the ECB glide path.
Monetary policy in Japan has got into a bit of tangle. Back in 2016 the Bank of Japan announced that in addition to managing asset purchases and interest rates on deposits, it would also target yields on long term Japanese government debt. The target was a yield of 0% and since then yields on ten year bonds have been anchored at this level. Arguably this has been a success, but on the other hand a consequence has been the level of asset purchases falling, resulting in the so called “stealth taper” and thus a reduction of monetary stimulus which was unlikely to have been the bank’s intention.
Maybe as a consequence of this slightly contradictory policy, the Bank of Japan at its most recent meeting announced that it would allow a greater volatility in the yield on ten year bonds, with the yield now being allowed to rise as high as 0.2 %. Quite why the bank decided to do this is difficult to read. Maybe bowing to pressure from the banking sector that would like a steeper yield curve; possibly a desire to inject a little more volatility in the bond market; or perhaps a very small signal that monetary policy can be tightened? But does Japan need higher rates? On the face of it – no. Inflation is still low and although the economy is reasonably firm, higher rates are likely to strengthen the Yen which may act as a dampener to activity.
However, there is one bright spot on the horizon. Wages in Japan are now rising faster than at any other time over the last 20 years. Not only that, the rate of increase is rising faster than in other major economies.
||Annual Wage Increase (%) 2018
||Annual Wage Increase (%) 2015
The increase is now notable and could be a precursor to the end of the deflationary era in Japan – something we will be watching very closely.
If this is the case then we can continue to expect much more speculation over Japanese monetary policy and much more volatility in bond markets worldwide.
Last night the Federal Open Market Committee (FOMC), the body responsible for settling interest rates in the United States, met and announced that there would be no change to monetary policy. Its guidance however, is that rates will increase again in September. Also, there was no change made to the rate of reduction in the size of its balance sheet. In the current quarter the rate of reduction per month is $40bn ($24bn from US Treasuries and $16bn from Agency/MBS). This rate is due to increase to $50bn per month in the fourth quarter of the year. Market participants had not been expecting any change but there may have been some expectation that the Fed would signal a reduction in the pace of increase, or at least provide a hint of how accommodative it believes its policy is and therefore how close it is to the peak in interest rates. Little was forthcoming however.
In addition, yesterday the US Treasury announced its plans for US government debt sales over the next quarter and again the sizes of debt auctions have been increased to fund the widening US fiscal deficit. Extra funding is still predominantly focused in the shorter part of the yield curve and via bill issuance. Bill issuance is again expected to increase in the next quarter and this is likely to continue to put pressure on money market rates. In turn this is likely to add to US Dollar strength and funding pressures in the weaker Emerging Markets that have to look for US Dollar funding. The implications of increased US rates coupled with an increase in US Treasury Bills and US Government Bond issuance provides a challenging backdrop to riskier asset classes.
The Bank of England (BoE) have today raised interest rates to 0.75%, the highest level in almost 10 years. It would have been a total shock however, if they did not raise the interest rate given the market had it priced in for a number of weeks without any Monetary Policy Committee (MPC) communication of resistance. So on to the next question – was it going to be a dovish or hawkish hike? Well, the answer was it depends on your view on Brexit.
The bank rate is a blunt tool for the MPC and there are a myriad of factors which enter into the collective judgement as to what level of interest rates the economy needs. The largest of all of the factors is without a doubt Brexit, which appears to be the most inscrutable issue to analyse that a Central Bank could ever face. It is not only a standalone factor, it permeates all of the others such as productivity, fiscal constraints, investment, consumer confidence, the level of currency etc.
The BoE also came up with a new way to tie itself in knots – the introduction of the “equilibrium interest rate” (the level of interest rate that would keep the economy in balance – not too hot and not too cold), which in nominal terms is apparently 2-3%. So the question on this is; “How can the BoE confirm the market pricing of another two rate hikes in three years, moving to a 1.25% bank rate, which is so far below their estimate of a neutral rate? The answer; Brexit.
The Governor was quite clear about how important Brexit is, and his guidance to the market appears to be that you need to make your mind up on what kind of Brexit we will get in order to forecast long term yields.
Italy is back in the news again with the last minute attempt by populist parties “The League” and “The 5 Star Movement” to form a workable government. It had looked as if co-operation was impossible and markets had resigned themselves to the possibility of more elections, or their favoured option of a non-elected technocratic government. Not democratic and inherently unstable, so quite why this was deemed a good option was short-sighted.
Instead, Italian bond and equity markets have suffered some volatility in recent days as the prospect increased of the two populist parties getting together to attempt to govern. There is little in common for the two parties who are united only in their desire to take power themselves and to stop the established parties from governing. Who is appointed Prime Minister and Finance Minister will be very important, as well as the policy agenda. Any signs of policy sense breaking out may be regarded very positively and isn’t entirely out of the question. There have been examples in the past of ‘populist’ governments reversing policy direction once in power on several occasions in Europe. Notably in Greece, where the Alexis Tsipras’s Syriza even held a referendum regarding austerity and then chose to ignore it and follow policies as specified by the EU, the ECB and the IMF. In Portugal, the current government (supported by the Communist party) were elected on an anti-austerity message but again has followed more orthodox fiscal policies once in power.
Developments in Italy will be keenly watched. If the populists prove to be reasonably sensible after all, the outlook could be quite positive and Italy can join the club of countries that enjoy an upgrade in credit ratings. To date it has been left behind whilst structural reform languished.
The mangled syntax, sophistry and “jobbing backwards” evident in the Bank of England’s Inflation Report is a wonder to behold.
As Humpty Dumpty said in Alice through the Looking Glass “When I use a word, it means just what I choose it to mean – neither more nor less”, to which Alice replies “The question is whether you can make words mean so many different things”.
Having raised rates in November 2017 (the first rise since 2007) the Bank soothed fears by stating that any further moves would be “limited and gradual”. In the February Inflation Report the Bank delivered an uppercut to the solar plexus of financial markets by changing the message to “earlier and faster”. This, not unreasonably, led money markets to price a high probability of a rate rise in May. Subsequent weak data and comments from Governor Carney reduced this probability, so that today’s no change decision was generally expected.
If it was expected, what’s the problem?
Well, central bank messaging and consistency is worth real money. The risk premium that attaches to UK assets will be a function (amongst many other things) of confidence in institutions, predictability, and some sense of the framework that the central bank is following. Since September 2017, following Bank of England communication has been analogous to walking behind a fellow shopper whose supermarket trolley wheels are defective.
Where the Bank of England will weave next is increasingly difficult to tell. Our view is that the 0.1% Q1 GDP number likely overstated the weakness of the UK economy and was significantly depressed by bad weather. The path to a Brexit transition deal remains bumpy, but in the central case that such an agreement is reached, the UK economy is likely to grow at or above trend in 2018.
If the economy does rebound and the Bank does not make another swerve from “data dependency”, current market pricing of future interest rate rises would appear to be too low.
Fixed income. Why bother. It’s a dull asset class that simply involves collecting the fixed coupons and managing relatively stable capital prices. And in an environment of better global growth and the increasing threat of inflation, what’s to like? The value erosion from inflation is bad for bonds, right?
Not so fast…
There is another type of fixed income asset that is linked to inflation – in the UK we call these “linkers”. As the level of inflation rises, the income stream generated by inflation-linked bonds increases – they collect more from the coupons to account for higher inflation.
Sounds good. But what about capital prices – surely these are pretty stable?
Not so much…
Since the start of the year a UK government 50-year linker has been down 10%, up 12% and down 12% again. That is not what I would call a stable capital price! As well as offering inflation protection, there is money to be made (and lost!) from inflation-linked bonds.
I see the benefit of linkers when inflation is rising, but can you make money when inflation falls?
If inflation is low and going lower, and let’s say accompanied by a general ‘risk-off’ tone, the long end of fixed income assets can rally (showing an inverse relationship with equities) and within that, bonds linked to inflation can rally too. They are likely to move less than normal bonds, but if they are very long dated (such as that 50-year UK government linker), the duration is so large that the capital upside can be huge.
We can also use derivatives to capture falling inflation – these are called inflation swaps. These instruments are traded “OTC” (over the counter) to make money when inflation falls!
Ok….how does this work?
We enter the swap with a counterparty, agreeing to pay them a floating rate linked to inflation – which we expect to fall. In exchange, they agree to pay us a fixed (constant) rate. On a net basis, if our view about inflation falling is right, we will pay less than we receive over time, and have made a profit from the inflation-linked swap.
To enter the swap contract we also pick the time period we want the swap to last and the country of inflation we want it to be linked to. We can even have positions where we expect inflation to rise in one country and fall in another – a sort of inflation arbitrage trade.
Maybe there’s more to bonds than I thought?
The above demonstrates that some fixed income assets can benefit from rising inflation, are not very stable and not just about clipping a fixed coupon. At Kames as active fixed income managers we understand how to take advantage of the inflation-linked market to the benefit of our clients, a part of the market which is often overlooked by others.
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
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
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
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
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.
You need an interesting title when writing about a topic that tends to have people nodding off after the first sentence. So what is the deal with this LIBOR thingy then?
LIBOR – the London Inter-bank Offered Rate – is going down the drain, thanks to the traders who decided to make up the rate for the next day’s cost of overnight money at dinner one night. We always knew that the Libor fix was a bit dodgy in some of the less transparent overseas markets. That’s why some interest rate swaps trade versus the very liquid USD floating rate and not the domestic floating interest rate (think Russia and Turkey). But for a more established market such as the UK, the scandal was a bit of a shock, though probably a good thing in the long term given that the changes being introduced will make the rate materially more robust and trustworthy.
I have written about the story before, but it’s worth updating a few points.
Firstly, the US Federal Reserve has begun publishing its new overnight reference rate in the US – SOFR, or the Secured Overnight Financing Rate. This is a little different to the UK SONIA rate (Sterling Overnight Index Average rate) as the US SOFR is based on secured transactions as opposed to SONIA’s unsecured rate. (Typically a secured funding rate is lower as the lender receives security against government bonds).
Going forward, the Chicago Mercantile Exchange (CME) is going to launch futures contracts on the new rate, adding to the existing EuroDollar futures market. Later this year, clearing will start for SOFR swaps. So while we are a long way off replacing the LIBOR swap market in the US, it’s the direction of travel.
Over here in the UK, the SONIA fixing is getting a fancy new haircut and shiny new trainers: it’s going to be “reformed”, with more breadth of transactions and a slightly different averaging calculation. So we get a nice trustworthy benchmark, administered by the Bank of England, which we can all transition to from the market’s LIBOR legacy book.
Think about that last line a minute: “that we can all transition to from the market’s LIBOR legacy book”. Who has a legacy book?
Investors using a liability-driven investment strategy (LDI) have a legacy book. Many practitioners in LDI swap their long-dated cash flows (think 30, 40, 50 years) using LIBOR. The market will need to replace LIBOR when it is finally retired (date to be determined). So we have seen a pickup in new hedging being done in SONIA as opposed to LIBOR. This can be seen in the spread between the LIBOR and SONIA rates, which has moved noticeably as shown in Chart 1 below.
Chart 1: 30-year LIBOR – SONIA swap spread
How does this affect a pension mandate then?
Most schemes using swaps are ‘in the money’, as those that have ‘received fixed’ from an older, higher interest rate environment now have a paper profit.
In all of these in-the-money swaps, there is a risk of the current discount curve (SONIA) moving differently to the forward curve (Libor) – so the market needs to pay close attention to SONIA moves relative to LIBOR. Guess what? That’s happening now!
How far this relationship goes and the implications for numerous pension schemes is unclear, but what is certain is that it’s a regime change, so expect a bit of a ride.
Something has been happening to interest rates in the United States this year and it may be one of the myriad of reasons that markets are a bit unsettled. Interest rate policy from the US Federal Reserve has been well flagged and entirely consistent with what has been signposted. But it isn’t US Fed policy that has been the main problem.
The US Federal Reserve announced in October of last year that it is starting the long-awaited reduction in its balance sheet, thus reducing the amount of excess reserves within the financial system. The best way to think about this is that on average the US Federal Reserve is selling bonds back into the banking system that are then bought by banks thus reducing the amount of liquidity/reserve that the banks hold or need to place in money market instruments.
At the same time the supply of these instruments has increased dramatically. As a result of the 2018 shenanigans with the US budget and debt ceiling, the US Treasury has ramped up bill issuance massively in February and March. Newly passed tax reform has also made it more advantageous for US companies to raise funds from issuing Commercial paper in the US market, rather than raid cash from their foreign subsidiaries.
What this has meant is that for the first time since the financial crisis, the Fed funds rate is no longer a good guide to financial conditions in the US. For example, in the table below we look at how the different measures of short-term interest rates have changed this year:
||1 January 2018
||27 March 2018
|US Federal Funds upper bound
|3-month Treasury bills
|3-month $ Libor
|3-month Top Tier Commercial paper
So although official rates have been rising quite slowly, actual borrowing rates have been rising twice as fast in 2018. It is little wonder that markets are a bit nervous; the last time this occurred was during the financial crisis. The difference this time being that this is not a credit or solvency issue. It’s a supply and demand issue and the effect should begin to fade as the supply demand imbalance reduces.
‘Pair trades’ work by going long one bond and short another. In our absolute return bond funds we use pair trades extensively in rates markets to add performance. There’s plenty of fish in the bond market sea; the breadth and depth of global rates markets allows us to find the perfect match.
The beauty of pair trades is that we can make money without taking exposure to the direction of interest rates – a source of performance that is particularly desirable as yields move higher. We do this by sizing the long and short side of each pair in equal duration, as well as finding well-matched assets.
For example, last month we paired together Australia and the US. Australian bonds in our view offered relative value versus the US as the Australian market had prematurely priced in a rate hike in late 2018. We went ‘long’ Australia versus a ‘short’ in the US so that we were exposed to the outperformance of Australian bonds, without being exposed to a generic move higher in yields.
But not all pairs would work out like this, so we have to manage our matchmaking carefully. If we had positioned long Italy versus the US for example (with Italy a ‘riskier’ market than ‘safe-haven’ US Treasuries), the pair would be likely to perform badly in a generic ‘risk-off’ environment and perform well in a ‘risk-on’ market – not a risk-neutral position, or a well-matched pair!
So we would caution, on Valentine’s Day, that blind dates may not be the path to domestic bliss! We would never walk blindly into a pair-trade relationship, rather make sure to understand the correlation between markets and how they change over time. We would also argue that there’s no harm in a bit of caution (expressed as our strict review discipline): always have an exit strategy in mind and remember, not everyone mates for life.
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!
In its last monetary policy meeting of the year, the European Central Bank (ECB) kept monetary policy unchanged.
There were no surprises regarding policy or signalling from the Governing Council which was very much as expected given it was only in the last meeting that the ‘recalibration’ of policy was announced.
The staff forecasts announced were a welcome Christmas present for the ECB and the Eurozone as a whole. Economic growth was revised up well above market consensus levels: in 2017 to 2.4%, 2.3% in 2018, 1.9% in 2019 and 1.7% for 2020. This is a very impressive outlook given trend growth is estimated to be around 1.5% each year.
Inflation forecasts though remain low and heavily dependent on prospective oil prices. In 2017 it is estimated to be 1.5%, 1.4% in 2018, 1.5% in 2019 and 1.7% in 2020.
The market reaction was muted. Bond markets have become less sensitive to the growth outlook, focussing on inflation and the level of cash deposit interest rates (still negative in the Eurozone)…a situation that we believe is likely to pertain for some time to come.
Swiss National Bank
The Swiss National Bank (SNB) kept interest rates and monetary policy unchanged today.
Despite recent modest currency depreciation, the National Bank continued to reiterate that the currency remains ‘highly valued’ and thus it remains committed to maintaining its policy of negative interest rates and willingness to intervene in foreign exchange markets as necessary.
Forecasts regarding the economy were also updated. Inflation rates were revised up in 2018 and 2019 to 0.7% and 1.1% respectively. GDP is forecast to increase by 2% in 2018, compared with 1% in 2017.
We expect the SNB to maintain this policy for the foreseeable future, yet at present money market curves are priced to suggest that it will increase interest rates ahead of the European Central Bank. In our opinion this is an extremely unlikely scenario unless the Swiss franc depreciates materially.
This is something we are looking to exploit in our absolute return funds via relative value trades.
One of my favourite publications of the month comes from JP Morgan and has the catchy title of “Negative Yield Index Monitor” – I know, I should get out more.
This publication provides a snapshot of the weird and wonderful world of global bonds and the prevalence of negative yielding bonds. The current outstanding market value of negative yielding government debt stands at $10.1trn – that is even more than a pocketful of Bitcoins, but watch this space.
This will be the highest year-end total of negative yielding bonds on record, compared to $9trn at the end of 2016 and $6trn at end 2015. So in a year when global central banks have reduced the degree of support they provide, the Federal Reserve and Bank of England have raised interest rates and the European Central Bank and Bank of Japan have reduced the scale of their easing, the amount of negative yielding bonds has actually risen.
This is a key reason why we believe active management of fixed income portfolios is key at this point in the cycle. A passive allocation could leave you a prisoner to the growing drag of negative yielding bonds.
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
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.
Over the years some of us fixed income fund managers have had to endure much leg pulling from our colleagues that manage assets in other more ‘exciting asset classes’. Boring, dull are adjectives I‘ve heard whispered in corridors or by the coffee machine, perhaps they weren’t talking about the asset class but I prefer not to think about that. The financial crisis quietened many down for a bit as industry professionals fell over themselves in the stampede to learn about duration, convexity, the forward forward curve and other bond jargon.
I have defended the asset class many times over my career. I have found it an extraordinarily interesting and varied part of the financial market to work in. Where else could I combine my interest in mathematics, economics, statistics, current affairs, human behaviour, debate and discussion, all with the ambition to add value to our customers’ hard earned cash?
But …and there is a but….2017 has turned out to be somewhat boring in government bonds and this is a surprise. 2017 was supposed to be full of risks; there was Trump, there is Brexit, we have had a number of elections, some haven’t even resulted in a government yet! There was the independence vote in Catalonia and the first known flight to Brussels for refuge by Senor Puigdemont. What next? The US Federal Reserve has raised interest rates and is reducing its balance sheet. The European Central Bank has tapered and the Bank of England has raised interest rates. There has been a lot to consider.
German government bonds however have sailed serenely through these events, 10-year bonds are yielding 0.36% at the time of writing, this is also the average yield over the last 12 months, the median is 0.37% and for around 75% of the year, the yield has deviated only 0.1% from this level. Not hugely exciting although quite extraordinary when you consider it.
Very exciting when compared with Japanese bonds. In Japan the central bank operates a policy of Yield Curve Control where it targets a yield of 0% for 10-year government bonds. To do this it buys an awful lot of bonds if the yield rises too much and stops buying if it falls. And now, the market has the message and 10-year yields have traded in a mere 12 basis point (0.12%) trading range all year. The yield today is 0.03%. Again quite extraordinary.
In the US the MOVE index which measures the volatility of the US bond market is at the lowest levels in the history of the index. Only UK gilts have tried their best to cause some angst but even so, 10-year UK debt was yielding 1.33% on the first trading day of the year. At the time of writing, 10-year gilts yield 1.30%.
UK rates move up by 0.25%. This was widely anticipated – but more interestingly – what next?
Carney and the MPC would like to be have some flexibility but as the short press statement reminds us – they are as much in the dark about the economy up to, and after, Brexit as the market is. Six of the eight paragraphs in the statement refer to the impact of Brexit on their decision, which was voted 7-2.
They have not said anything as emphatic as ‘rates aren’t going up again soon’, but the following sentence does hint at that outcome : “All members agree that any future increases in the Bank Rate would be expected to be at a gradual pace and to a limited extent.” Rates are set to stay low, uncertainty prevails and gilts shooting higher in price after the midday announcement gives an insight into the markets thinking. This rate cycle is set be a long and protracted affair.
Being reasonably experienced in European bonds I can just about recall the time when, just over 25 years ago, Standard & Poor’s awarded Italy its first Foreign Currency Long-Term Debt rating. Back then, Italian debt was denominated in Lira and withholding tax was payable on the coupons by investors. The gross yield on a 10-year bond was nearer 12.5%. Interestingly the post-tax differential between Italian domestic debt and German domestic debt was around 300 basis points, much higher than the 150 basis points of today. The spread however is not strictly comparable with current markets as it was in the pre-Euro period and therefore incorporated an element of currency risk.
The credit rating awarded was AA+. Over the last 25 years, Standard & Poor’s has downgraded Italy eight times, culminating in a rating of BBB- in 2014. Yields have been volatile but currently are close to 25-year lows at around 1.75%, despite this trend of continual downgrades; the interest rate and inflation environment have had a greater influence than the credit rating.
Last Friday, the trend changed and for the first time ever, Standard & Poor’s upgraded its rating for Italian debt. Only one notch to BBB with a stable outlook. But an upgrade nonetheless.
Reasons cited were the improved economic outlook, an improvement in government finances and the resolution of some of the problems in the banking sector. Further upgrades could occur if progress is maintained, which we think is reasonably likely.
A word of caution however; we may have to wait another 25 years before a rating of AA+ is to occur.
On Thursday (26th October), Mario Draghi outlined the ongoing monetary easing that the European Central Bank (ECB) will provide to the European economy. He announced that the ECB will buy assets at a rate of €30bn per month in the first nine months of 2018 (at least) which is a reduction from the current pace of €60bn per month.
Another, and perhaps not so tendentiously related, event also occurred yesterday. A Rolex watch that had been owned by the actor Paul Newman made the highest price ever achieved for any watch at auction. You were too polite to ask, but the watch was sold for $17,752,500. No guarantee is made to its time-keeping.
Mario Draghi, as far as we are aware, did not buy the watch. However, he and other global central bankers are involved in the process which has resulted in the present elevated level of asset prices.
The size of global central bank balance sheets is around $20trn, an increase of $15trn over the past 10 years.
In the first instance, central banks bought government bonds, then they bought corporate bonds and mortgage backed bonds, and the Bank of Japan has also bought equities.
For the sellers of those assets the money has to go somewhere. Cash isn’t an option as low or negative interest rates are the norm. The move into riskier assets and out of monetary assets into real assets has driven many markets to all-time-high levels.
So how does Leonardo relate to all this? A re-discovered Leonardo painting will be offered at Christies New York on November 15. The painting had a hard life and suffered from unsympathetic restoration over the years. As such it was not considered an original. It sold at auction in 1958 for £45 and then re-surfaced in the US where it was sold as a Leonardo copy in 2005 for $10,000. The estimate in the upcoming sale is around $100mn.
Sounds like a lot? It is a lot. However, at that price it would not make it into the top 10 prices paid for a work of art in the past ten years.
QE – the money finishes up somewhere.
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.
The inflation surge as evidenced by the TIPS market (US Government Treasury Inflation Protected Securities) that started around September ’16 has taken a bit of pause and has actually has started to reverse.
Undoubtedly there were some Trump effects to the inflation rally in the US, which in turn lifted markets globally, but the path to higher inflation prints and decent economic conditions was already in place before the November Presidential election. The election just removed some of the downside tail risks.
However, since inauguration day on 20th January 2017, the level of inflation break-evens in the US are now lower. Some of the enthusiasm based on expectations of a relatively quick implementation of tax reform and infrastructure spending, perhaps financed by either Border Taxes or increased borrowing, has fallen away. Healthcare reform has highlighted how difficult it will be for President Trump to implement changes. Another issue for the inflation market is that we may already have reached the high in the US inflation print for this year, 2.7% CPI recorded in February, which does have a psychological impact.
So where does the market go from here? Expectations are now low for reforms and the medium to long term picture has not changed. The “America First” policy is still alive but it is proving not to be progressing as fast as the market would like. The fundamentals are solid, core inflation in the US is 2.2% (excluding energy and food) and 5 year inflation is priced at 1.85% according the market, so valuations are compelling. However, the pause in the market seems correct as we look for the next catalyst.
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: