Investors need to seriously think about what will happen with monetary policy over the next couple of years.
The final level of interest rates may not be that high compared to the past but at least one economic model suggests that they should be considerably higher than they are today. Because quantitative easing (QE) was used as a substitute for negative interest rates, unwinding QE will be a key part of the normalisation of rates policy. The significant increase in government bond yields over the last week suggests that markets are starting to price this in. My guess is that it will have quite a bit further to go.
Computer says hike
The reason central banks introduced QE was because they felt they could not meaningfully reduce interest rates below the zero bound at a time when major economies faced large downside deflationary risks. One of the most famous and often referred to models of monetary policy is the Taylor Rule which estimates what the key policy interest rate should be at any point in time. The estimate is based on an assumption about the long-run neutral rate and the cyclical position of inflation and unemployment relative to desired or target levels. Like all economic models the results are only as good as the model estimation and the data inputs but, generally, the Taylor Rule has proved to be a useful guide to the appropriateness of policy. Bloomberg very helpfully calculate a baseline Taylor Rule for all the major economies and a cursory look at what these models say does lead to the conclusion that we are in a world where monetary policy is out of line with economic fundamentals. As I wrote last week, we could be on the cusp of a change in the global monetary policy regime. A macro strategist said to me this week that we are past the point of “peak QE” and if the overall stance of monetary policy is to move back towards that suggested by the Taylor Rule, then the bond market is in for further sell-offs. The Federal Reserve’s (Fed) balance sheet should start to be reduced later this year, the growth of the Bank of Japan’s balance sheet is slowing and most expect the European Central Bank (ECB) to begin tapering its purchases of bonds in 2018. Global central bank balance sheet growth will slow and that means a net reduction in official purchases of bonds.
Reducing the balance sheet
At the worst of the post-crisis downturn in the United States, the Taylor Rule suggested that the Fed Funds rate should have been set at ‘minus 2%’. The Fed was reluctant to introduce negative rates so instead focused on bringing down the overall cost of credit in the economy through QE. It was only when the Taylor Rule estimate moved decisively into positive territory in 2013 that the Fed felt confident enough to start winding down its purchases but even then it took its time because of the sharp rise in yields (taper tantrum) that accompanied Ben Bernanke’s first attempt at slowing purchases of Treasuries and mortgage-backed securities. Now the naive estimate is that the Fed Funds rate should be at 3.8% - more than 250 basis points (bps) above where the actual rate is. Many people will argue that this is too high and that the new neutral rate is much lower than the 2.0% it was presumed to be in the past. However, the Fed is apparently committed to further rate increases and removing some of the “stock” of its QE purchases in order to bring the overall stance of monetary policy back to more in line with the fundamentals, as suggested by a Taylor Rule type analysis.
Guidance is tricky
It’s a similar story for the euro area with a Taylor Rule estimate suggesting that policy rates should be close to 2.0%. Take that with a pinch of salt but the message is clear that policy is too loose and the ECB needs to start winding down its own QE programme. The Bloomberg data don’t appear to fit as well with the UK, but the divergence in what the Taylor Rule says and where the Bank of England’s (BoE) base rate is has widened a lot because of the increase in inflation and the decline in the unemployment rates in the UK. The economic models point to higher rates and less QE and that is the path that central bankers are trying to guide market participants towards. The obvious problem is that adjusting to higher rates is going to generate capital losses in fixed income and other parts of the financial markets. Higher rates and wealth losses can have negative feedback on the real economy, so this is why adjustment is happening slowly and central banks are cautious, to the point of being contradictory at times.
Risk is ongoing rate volatility
I do get the feeling that people don’t want to think too much about the monetary unwind. The consensus is that it will happen slowly because central bankers are fearful of doing anything that opens up new downside risks to global growth. However the last week has suggested that investors may need to be prepared for higher volatility and rates. This would only not be the case if there were signs that deflation was coming back and the global economy was materially slowing down. The current data does not suggest that. This week’s slew of purchasing manager surveys from the US and Europe point to healthy levels of activity with little to suggest that employment growth is topping out. I think we can rule out Mario Draghi saying that rates will stay low forever and QE will just keep on going, or Janet Yellen saying there is no inflation risk even if the unemployment rate goes to 3%. Even though rates have sold off over the last week, the risk return is still skewed against being overly exposed to low yielding, long duration assets like government bonds and very high quality credit.
High yield could hold in
It’s early days but the sell-off in rates has started to hit credit spreads a little. Spreads on US and European high yield credit default swap (CDS) indices are wider as are emerging market credit spreads, even if the moves have not been dramatic so far. It is important for investors in high yield assets to have a view on what happens when government bond yields move higher. Our analysis of historical returns in the US market shows a negative correlation between US Treasury total returns and the excess returns earned in the high yield market (i.e. the return component linked to the credit risk premium). Even in very weak periods for government bonds, the correlation is still negative. Of course, in periods of market dislocation and higher volatility it is likely that high yield investors will see some hit to performance, particularly at times like this when the credit risk premium is quite low. But the longer term record is that high yield should outperform in a rising Treasury yield environment and it would be only when the economy starts to show a fundamental deterioration that high yield spreads would start to widen. The analysis holds true at the extreme as well, with very long duration Treasury returns being negatively correlated with the lowest rated parts of the high yield market. The converse situation of falling Treasury yields in an economic downturn is associated with negative excess returns from high yield. The same holds true for emerging market debt with the spread on the hard currency index being negatively correlated over time with Treasury yields. The point is that investors that have loaded up on higher yielding spread product in fixed income in the years of QE might be concerned if the current volatility in government bond markets persists. However, the outperformance of riskier parts of the bond market should continue until the cycle turns weaker.
The move in government bonds has been impressive this last two weeks. Benchmark 10-year yields are between 25bps and 35bps higher which represents a huge percentage increase in yields and a significant hit to capital because of the duration. The three themes of monetary regime change, continued reduction in spare capacity and the desire for more populist fiscal policies are longer term negatives for yields that won’t go away anytime soon. This doesn’t mean rates will go up in a straight line and there will be buyers of government bonds at these higher yield levels – certainly Japanese investors will see increased value in European and US bonds after the last two weeks. But if the Taylor Rule tells us anything it is that there is still some way to go before the level of interest rates and bond yields is back in line with what, after all, are significantly better global growth fundamentals than at any other time since the recession of 2009.
While developments in the major economies might be bond bearish on balance, it is worth watching what is going on here in the ‘capital of chaos’. The UK economy does seem to be softening against a very uncertain and toxic political backdrop. The purchasing manager surveys for June saw a little softening and data out at the end of the week showed weakness in house prices. There is a strong view amongst economists that the UK will slow, led by weakness in consumption as higher inflation undermines real incomes and the credit binge comes to an end. The data might not fully reflect that bearishness so far but it is hard to find many people outside of the Bank of England who think there is an immediate need to raise interest rates. Next week’s employment data will be important in helping understand what the majority of participants in the Monetary Policy Committee may be thinking. Of course, the UK is in a peculiar position with household and business confidence at risk from politics and Brexit. Still, there is no shortage of money in English football. Arsenal have splashed the cash this week and it looks as though Man United will pay out a large sum for a new striker. Maybe what we need is a stamp duty on football transfers – think of the money that could bring in to Treasury coffers.
Chris Iggo - CIO Fixed Income - AXA Investment Managers
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