Yield Curve Control – the road to infinite QE

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Macro Letter – No 65 – 11-11-2016

Yield Curve Control – the road to infinite QE

  • The BoJ unveiled their latest unconventional monetary policy on 21st September
  • In order to target 10 year yields QE must be capable of being infinite
  • Infinite Japanese government borrowing at zero cost will eventually prove inflationary
  • The financial markets have yet to test the BoJ’s resolve but they will

Zero Yield 10 year

Ever since central banks embarked on quantitative easing (QE) they were effectively taking control of their domestic government yield curves. Of course this was de facto. Now, in Japan, it has finally been declared de jure since the Bank of Japan (BoJ) announced the (not so) new policy of “Yield Curve Control”.  New Framework for Strengthening Monetary Easing: “Quantitative and Qualitative Monetary Easing with Yield Curve Control”, published on 21st September, is a tacit admission that BoJ intervention in the Japanese Government Bond market (JGB) is effectively unlimited.  This is how they described it (the emphasis is mine):-

The Bank will purchase Japanese government bonds (JGBs) so that 10-year JGB yields will remain more or less at the current level (around zero percent). With regard to the amount of JGBs to be purchased, the Bank will conduct purchases more or less in line with the current pace — an annual pace of increase in the amount outstanding of its JGB holdings at about 80 trillion yen — aiming to achieve the target level of a long-term interest rate specified by the guideline. JGBs with a wide range of maturities will continue to be eligible for purchase…

By the end of September 2016 the BoJ owned JPY 340.9trln (39.9%) of outstanding JGB issuance – they cannot claim to conduct purchases “more of less in line with the current pace” and maintain a target 10 year yield. Either they will fail to maintain the 10 year yield target in order to maintain their purchase target of JPY 80trln/annum or they will forsake their purchase target in order to maintain the 10 year yield target. Either they are admitting that the current policy of the BoJ (and other central banks which have embraced quantitative easing) is a limited form of “Yield Curve Control” or they are announcing a sea-change to an environment where the target yield will take precedence. If it is to be the latter, infinite QE is implied even if it is not stated for the record.

Zero Coupon Perpetuals

I believe the 21st September announcement is a sea-change. My concern is how the BoJ can ever hope to unwind the QE. One suggestion coming from commentators but definitely not from the BoJ, which gained credence in April – and again, after Ben Bernanke’s visit to Tokyo in July – is that the Japanese government should issue Zero Coupon Perpetual bonds.  Zero-coupon bonds are not a joke – 28th August – by Edward Chancellor discusses the subject:-

Bernanke’s latest bright idea is that the Bank of Japan, which has bought up close to half the country’s outstanding government debt, should convert its bond holdings into zero-coupon perpetual securities – that is, financial instruments with no intrinsic value.

The difference between a central bank owning zero-coupon perpetual notes and conventional bonds is that the former cannot be sold to withdraw excess liquidity from the banking system. That means the Bank of Japan would lose a key tool in controlling inflation. So as expectations about rising prices blossomed, Japan’s decades-long battle against deflation would finally end. There are further benefits to this proposal. In one fell swoop, Japan’s public-debt overhang would disappear. As the government’s debt-service costs dried up, Tokyo would be able to fund massive public works.

In reality a zero coupon perpetual bond looks suspiciously like good old-fashion fiat cash, except that the bonds will be held in dematerialisied form – you won’t need a wheel-barrow:-

weimar-mutilated-300x236

Source: Washington Post

Issuing zero coupon perpetuals in exchange for conventional JGBs solves the debt problem for the Japanese government but leaves the BoJ with a permanently distended balance sheet and no means of reversing the process.

Why change tack?

Japan has been encumbered with low growth and incipient deflation for much longer than the other developed nations. The BoJ has, therefore, been at the vanguard of unconventional policy initiatives. This is how they describe their latest experiment:-

QQE has brought about improvements in economic activity and prices mainly through the decline in real interest rates, and Japan’s economy is no longer in deflation, which is commonly defined as a sustained decline in prices. With this in mind, “yield curve control,” in which the Bank will seek for the decline in real interest rates by controlling short-term and long-term interest rates, would be placed at the core of the new policy framework.  

The experience so far with the negative interest rate policy shows that a combination of the negative interest rate on current account balances at the Bank and JGB purchases is effective for yield curve control. In addition, the Bank decided to introduce new tools of market operations which will facilitate smooth implementation of yield curve control.

The new tools introduced to augment current policy are:-

  • Fixed-rate purchase operations. Outright purchases of JGBs with yields designated by the Bank in order to prevent the yield curve from deviating substantially from the current levels.
  • Fixed-rate funds-supplying operations for a period of up to 10 years – extending the longest maturity of the operation from 1 year at previously.

The reality is that negative interest rate policy (NIRP) has precipitated an even swifter decline in the velocity of monetary circulation. The stimulative impact of expanding the monetary base is negated by the collapse it its circulation.

An additional problem has been with the mechanism by which monetary stimulus is transmitted to the real economy – the banking sector. Bank lending has been stifled by the steady flattening of the yield curve. The chart below shows the evolution since December 2012:-

jgb-yield-curve

Source: Bloomberg, Daiwa Capital Markets Europe

10yr JGB yields have not exceeded 2% since 1998. At that time the base rate was 0.20% – that equates to 180bp of positive carry. Today 40yr JGBs yield 0.57% whilst maturities of 10 years or less trade at negative yields. Little wonder that monetary velocity is declining.

The tightening of bank reserve requirements in the aftermath of the great financial recession has further impeded the provision of credit. It is hardly optimal for banks to lend their reserves to the BoJ at negative rates but they also have scant incentive to lend to corporates when government bond yields are negative and credit spreads are near to historic lows. Back in 1998 a AA rated 10yr corporate bond traded between 40bp and 50bp above 10yr JGBs, the chart below shows where they have traded since 2003:-

aa_corps_vs_jgb_spread_10yr_2003-2016-2

Source: Quandl

For comparison the BofA Merrill Lynch US Corporate AA Option-Adjusted Spread is currently at 86bp off a post 2008 low of 63bp seen in April and June 2014. In the US, where the velocity of monetary circulation is also in decline, banks can borrow at close to the zero bound and lend for 10 years to an AA name at around 2.80%. Their counterparts in Japan have little incentive when the carry is a miserly 0.20%.

This is how the BoJ describe the effect NIRP has had on lending to corporates. They go on to observe that the shape of the yield curve is an important factor for several reasons:-

The decline in JGB yields has translated into a decline in lending rates as well as interest rates on corporate bonds and CP. Financial institutions’ lending attitudes continue to be proactive. Thus, so far, financial conditions have become more accommodative under the negative interest rate policy. However, because the decline in lending rates has been brought about by reducing financial institutions’ lending margins, the extent to which a further decline in the yield curve will lead to a decline in lending rates depends on financial institutions’ lending stance going forward.

The impact of interest rates on economic activity and prices as well as financial conditions depends on the shape of the yield curve. In this regard, the following three points warrant attention. First, short- and medium-term interest rates have a larger impact on economic activity than longer-term rates. Second, the link between the impact of interest rates and the shape of the yield curve may change as firms explore new ways of raising funds such as issuing super-long-term corporate bonds under the current monetary easing, including the negative interest rate policy. Third, an excessive decline and flattening of the yield curve may have a negative impact on economic activity by leading to a deterioration in people’s sentiment, as it can cause uncertainty about the sustainability of financial functioning in a broader sense.

The BoJ’s hope of stimulating bank lending is based on the assumption that there is genuine demand for loans from corporations’: and that those corporations’ then invest in the real-economy. The chart below highlights the increasing levels of Japanese share buybacks over the last five years:-

nikkei-share-buybacks-may-2016-goldman-sachs

Source: FT, Goldman Sachs

Share buybacks inflate stock prices and, when buybacks are financed with debt, alter the capital structure. None of this zeitech stimulates lasting economic growth.

Conclusion and investment opportunities

If zero 10 year JGB yields are unlikely to encourage banks to lend and demand from corporate borrowers remains negligible, what is the purpose of the BoJ policy shift? I believe they are creating the conditions for the Japanese government to dramatically increase spending, safe in the knowledge that the JGB yield curve will only steepen beyond 10 year maturity.

I do not believe yield curve control will improve the economics of bank lending at all. According to World Bank data the average maturity of Japanese corporate syndicated loans in 2015 was 4.5 years whilst for corporate bonds it was 6.9 years. Corporate bond issuance accounted for only 5% of total bond issuance in Japan last year – in the US it was 24%. Even with unprecedented low interest rates, demand to borrow for 15 years and longer will remain de minimis.

Financial markets will begin to realise that, whilst the BoJ has not quite embraced the nom de guerre of “The bank that launched Helicopter Money”, they have, assuming they don’t lose their nerve, embarked on “The road to infinite QE”. Under these conditions the JPY will decline and the Japanese stock market will rise.

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What are the bond markets telling us about inflation, recession and the path of central bank policy?

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Macro Letter – No 41 – 11-09-2015

What are the bond markets telling us about inflation, recession and the path of central bank policy?

  • Since January US Government bond yields have risen across the yield curve
  • Corporate bond yields have risen more rapidly as stock markets have retreated
  • China, Canada and Mexico have seen their currencies weaken against the US$

For several years some commentators have been concerned that the Federal Reserve is behind the curve and needs to tighten interest rates before inflation returns. To date, inflation – by which I refer narrowly to CPI – has remained subdued. The recent recovery in the US economy and improvement in the condition of the labour market has seen expectations of rate increases grow and bond market yields have risen in response. In this letter I want to examine whether the rise in yields is in expectation of a Fed rate increase, fears about the return of inflation or the potential onset of a recession for which the Federal Reserve and its acolytes around the globe are ill-equipped to manage.

Below is a table showing the change in yields since the beginning of February. Moody Baa rating is the lowest investment grade bond. Whilst the widening of spreads is consistent with the general increase in T-Bond yields, the yield on Baa bonds has risen by 30bp more than Moody BB – High Yield, sub-investment grade. This could be the beginning of an institutional reallocation of risk away from the corporate sector.

Bond       Spread over T-Bonds    
08-Sep 02-Feb Change 08-Sep 02-Feb Change
10yr US T-Bond 2.19 1.65 0.54 N/A N/A N/A
Baa Corporate 5.28 4.29 0.99 3.09 2.64 0.45
BB Corporate 5.55 4.86 0.69 3.36 3.21 0.15

 

Source: Ycharts and Investing.com

The chart below shows the evolution of Baa bond yields over the last two years:-

FRED Baa Corporate bond yield 2013-2015

Source: St Louis Federal Reserve

The increase in the cost of financing for the corporate sector is slight but the trend, especially since May, is clear.

Another measure of the state of the economy is the breakeven expected inflation rate. This metric is derived from the differential between 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities:-

FRED Breakeven Inflation rate 2007-2015

Source: St Louis Federal Reserve

By this measure inflation expectations are near their lowest levels since 2010. It looks as if the bond markets are doing the Federal Reserve’s work for it. Added to which the July minutes of the FOMC stated:-

The risks to the forecast for real GDP and inflation were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks.

This is hardly hiking rhetoric.

The International perspective

The table below looks at the largest importers into the US and their contribution to the US trade deficit as at December 2014:-

Country/Region Imports Deficit
China $467bln $343bln
EU $418bln $142bln
Canada $348bln $35bln
Mexico $294bln $54bln
Japan $134bln $68bln

Source: US Census Bureau

The TWI US$ Index shows a rather different picture to the US$ Index chart I posted last month, it has strengthened against its major trading partners steadily since it lows in July 2011; after a brief correction, during the first half of 2015, the trend has been re-established and shows no signs of abating:-

FRED USD TWI 2008-2015

Source: St Louis Federal Reserve

A closer inspection of the performance of the Loonie (CAD) and Peso (MXN) reveals an additional source of disinflation:-

CAD and MXN vs USD 2yr

Source: Yahoo Finance

Focus Economics – After dismal performance in May, exports and imports increase in June – investigates the bifurcated impact of lower oil prices and a weaker currency on the prospects for the Mexican economy:-

Looking at the headline numbers, exports increased 1.2% year-on-year in June, which pushed overseas sales to USD 33.8 billion. The monthly expansion contrasted the dismal 8.8% contraction registered in May. June’s expansion stemmed mainly from a solid increase in non-oil exports (+6.8% yoy). Conversely, oil exports registered another bleak plunge (-41.0% yoy).

Should the U.S. economy continue to recover and the Mexican peso weaken, growth in Mexico’s overseas sales is likely to continue improving in the coming months.

Mexico’s gains have to some extent been at the expense of Canada as this August 2015 article from the Fraser Institute – Canada faces increased competition in U.S. market – explains:-

There are several possible explanations of the cessation of real export growth to the U.S. One is the slow growth of the U.S. economy over much of the period from 2000-2014, particularly during and following the Great Recession of 2008. Slower real growth of U.S. incomes can be expected to reduce the growth of demand for all types of goods including imports from Canada.

A second possible explanation is the appreciation of the Canadian dollar over much of the time period. For example, the Canadian dollar increased from an all-time low value of US$.6179 on Jan. 21, 2002 to an all-time high value of US$1.1030 on Nov. 7, 2007. It then depreciated modestly to a value of US$.9414 by Jan. 1, 2014.

A third possible explanation is the higher costs to shippers (and ultimately to U.S. importers) associated with tighter border security procedures implemented by U.S. authorities after 9/11.

Perhaps a more troubling and longer-lasting explanation is Canada’s loss of U.S. market share to rival exporters. For example, Canada’s share of total U.S. imports of motor vehicles and parts decreased by almost 12 percentage points from 2000 through 2013, while Mexico’s share increased by eight percentage points. Canada lost market share (particularly to China) in electrical machinery and even in its traditionally strong wood and paper products sectors.

There is fundamentally only one robust way for Canadian exporters to reverse the recent trend of market share loss to rivals. Namely, Canadian manufacturers must improve upon their very disappointing productivity performance over the past few decades—both absolutely and relatively to producers in other countries. Labour productivity in Canada grew by only 1.4 per cent annually over the period 1980-2011. By contrast, it grew at a 2.2 per cent annual rate in the U.S. Even worse, multifactor productivity—basically a measure of technological change in an economy—did not grow at all over that period in Canada.

With an election due on 19th October, the Canadian election campaign is focused on the weakness of the domestic economy and measures to stimulate growth. While energy prices struggle to rise, non-energy exports are likely to be a policy priority. After rate cuts in January and July, the Bank of Canada left rates unchanged this week, but with an election looming this is hardly a surprise.

China, as I mentioned in my last post here, unpegged its currency last month. Official economic forecasts remain robust but, as economic consultants Fathom Consulting pointed out in this July article for Thomson Reuters – Alpha Now – China a tale of two economies – there are many signs of a slowing of economic activity, except in the data:-

With its usual efficiency, China’s National Bureau of Statistics released its 2015 Q2 growth estimate earlier this week. Reportedly, GDP rose by 7.0% in the four quarters to Q2. We remain sceptical about the accuracy of China’s GDP data, and the speed with which they are compiled. Our own measure of economic activity — the China Momentum Indicator — suggests the current pace of growth is nearer 3.0%.

…although policymakers are reluctant to admit that China has slowed dramatically, the recent onslaught of measures aimed at stimulating the economy surely hints at their discomfort. While these measures may temporarily alleviate the downward pressure, they do very little to resolve China’s long standing problems of excess capacity, non-performing loans and perennially weak household consumption.

Accordingly, as China tries out the full range of its policy levers, we believe that eventually it will resort to exchange rate depreciation. Its recent heavy-handed intervention in the domestic stock market has demonstrated afresh its disregard for financial reform.

The chart below is the Fathom Consulting – China Momentum Indicator – note the increasing divergence with official GDP data:-

Fathom_Consulting_China_Momentum_Indicator

Source: Fathom Consulting/Thomson Reuters

A comparison between international government bonds also provides support for those who argue Fed policy should remain on hold:-

Government Bonds 2yr 2yr Change 5yr 5yr Change 10yr 10yr Change 30yr 30yr Change
08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb 08-Sep 02-Feb
US 0.74 0.47 0.27 1.52 1.17 0.35 2.19 1.65 0.54 2.96 2.23 0.73
Canada 0.45 0.39 0.06 0.79 0.61 0.18 1.48 1.25 0.23 2.24 1.83 0.41
Mexico 5.01* 4.13* 0.88 5.29 4.89 0.4 6.15 5.41 0.74 6.81 6.1 0.71
Germany -0.22 -0.19 -0.03 0.05 -0.04 0.09 0.68 0.32 0.36 1.44 0.9 0.54
Japan 0.02 0.04 -0.02 0.07 0.09 -0.02 0.37 0.34 0.03 1.41 1.31 0.1
China 2.59 3.22 -0.63 3.2 3.45 -0.25 3.37 3.53 -0.16 3.88 4.04 -0.16

*Mexico 3yr Bonds

Source: Investing.com

Canada and Mexico have both witnessed rising yields as their currencies declined, whilst Germany (a surrogate for the EU) and Japan have seen a marginal fall in shorter maturities but an increase for maturities of 10 years or more. China, with a still slowing economy and aided by PBoC policy, has lower yields across all maturities. Mexican inflation – the highest of these trading partners – was last recorded at 2.59% whilst core inflation was 2.31%. The 2yr/10yr curve for both Mexico and Canada, at just over 100bps, is flatter than the US at 145bp. The Chinese curve is flatter still.

A final, if somewhat tangential, article which provides evidence of a lack of inflationary pressure comes from this fascinating post by Stephen Duneier of Bija Advisors – Doctoring Deflation – in which he looks at the crisis in healthcare and predicts that computer power will radically reduce costs globally:-

The future of medical diagnosis is about to experience a radical shift. The same pocket sized computer which now holds the power to beat any human being at the game of chess, will soon be used to diagnose medical ailments and prescribe actions to follow, far more cheaply and with a whole lot more accuracy.

Conclusions and investment opportunities

The bond yield curves of America’s main import partners have steepened in train with the US – Canada being an exception – whilst stock markets are unchanged or lower over the same period – February to September. Corporate bond spreads have widened, especially the bottom of the investment grade category. Corporate earnings have exceeded expectations, as they so often do – see this paper by Jim Liew et al of John Hopkins for more on this topic – but by a negligible margin.

The FOMC has already expressed concern about the momentum of GDP growth, commodity prices remain under pressure, China has unpegged and the US$ TWI has reached new highs. This suggests to me, that inflation is not a risk, disinflationary forces are growing – especially driven by the commodity sector. Major central banks are unlikely to tighten but corporate bond yields may rise further.

Currencies

Remain long US$ especially against resource based currencies, but be careful of current account surplus countries which may see flight to quality flows in the event of “risk off” panic.

Stocks

At the risk of stating what any “value” investor should always look for, seek out firms with strong cash-flow, low leverage, earnings growth and comfortable dividend cover. In addition, in the current environment, avoid commodity sensitive stocks, especially in oil, coal, iron and steel.

Bonds

US T-Bonds will benefit from a strengthening US$, if the FOMC delay tightening this will favour shorter maturities. An early FOMC tightening, after initial weakness, will be a catalyst for capital repatriation – US T-Bonds will fare better in this scenario too. Bunds and JGBs are likely to witness similar reactions but, longer term, both their currencies and yields are less attractive.

Rising yields and rising correlation in major bond markets – end of cycle or correction?

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Macro Letter – No 36 – 22-05-2015

Rising yields and rising correlation in major bond markets – end of cycle or correction?

  • European bond yields have risen following the lead of US treasuries
  • Yield curves are steepening despite minimal inflation
  • A return to the natural rate of interest seems unlikely
  • Over-indebtedness will stifle GDP growth and yields will fall

Since the beginning of 2015 the world’s largest bond markets have witnessed increasing yields. In the aftermath of the Great Financial Crisis many economies decoupled and their government bond markets followed suit. Now correlations are rising once more. The table below, which is a snapshot of prices on Tuesday morning 19th May, looks at a broad range of developed bond markets:-

Bond & Maturity Yield Low Date Change CPI Real yield 10yr-2yr
Australia 2Y 2.035
Australia 5Y 2.305
Australia 10Y 2.92 2.236 March 0.684 1.3 1.62 0.885
Canada 2Y 0.646
Canada 5Y 1.006
Canada 10Y 1.711 1.23 February 0.481 1.2 0.511 1.065
Denmark 2Y -0.299
Denmark 5Y 0.088
Denmark 10Y 0.786 0.075 February 0.711 0.5 0.286 1.085
France 2Y -0.162
France 5Y 0.182
France 10Y 0.832 0.332 April 0.5 0.1 0.732 0.994
Germany 2Y -0.21
Germany 5Y 0.026
Germany 10Y 0.563 0.049 April 0.514 0.5 0.063 0.773
Italy 2Y 0.108
Italy 5Y 0.697
Italy 10Y 1.753 1.041 March 0.712 -0.1 1.853 1.645
Japan 2Y -0.002
Japan 5Y 0.103
Japan 10Y 0.388 0.199 January 0.189 2.3 -1.912 0.39
New Zealand 2Y 3.09
New Zealand 5Y 3.25
New Zealand 10Y 3.74 3.085 January 0.655 0.1 3.64 0.65
Norway 2Y 0.857
Norway 5Y 1.035
Norway 10Y 1.676 1.202 February 0.474 2 -0.324 0.819
Sweden 2Y -0.331
Sweden 5Y 0.169
Sweden 10Y 0.691 0.216 April 0.475 -0.2 0.891 1.022
Switzerland 2Y -0.839
Switzerland 5Y -0.48
Switzerland 10Y -0.003 -0.28 January 0.281 -1.1 1.097 0.836
UK 2Y Yield 0.537
UK 5Y Yield 1.39
UK 10Y Yield 1.892 1.337 January 0.555 -0.1 1.992 1.355
US 2Y Yield 0.565
US 5Y Yield 1.506
US 10Y Yield 2.193 1.63 January 0.563 -0.1 2.293 1.628

Source: Investing.com and Trading Economics

I’ve highlighted some of the data. The highest real 10yr yield is to be found in New Zealand (3.64%) but US T-Bonds lie second. The lowest real yield is evident in Japanese Government Bonds (JGBs) however, a quick glance at the shape of the Japanese yield curve suggests that inflation, or perhaps I should say deflation, expectations are firmly anchored at near zero, despite repeated bouts of Abenomic stimulus. Japan has the flattest yield curve. The US curve is second steepest, behind Italy, where the spread between 2yr and 10yr is 164.5bp. Italy has also seen the largest rise in yields since its low back in March, although Danish yields have risen to a similar degree as its non-Euro “safe haven” status has waned.

A number of factors have driven yields higher. In the Eurozone (EZ) concern about a Greek exit initially stimulated a “flight to safety” in government securities – other than Greek government bonds – this spilled over into Swiss Confederation bonds. Switzerland remains the ultimate “safe haven”. As yields in the EZ declined to record lows, capital also flowed into EZ stocks. At the same time economic data began to turn more positive, prompted further flows into equities. The last EZ bond markets to turn lower were France and Germany, last month.

Outside the EZ, the US economy has seen mixed data but GDP growth remains steady. Expectations of Federal Reserve rate increases, whilst still some way off (current consensus January 2016) weigh on the T-Bond market. A rebound in crude oil and weakening of the US$ TWI since its highs in early March have also seen an unwinding of bullish US$ and US Treasury exposures.

Stock markets have so far paid little heed to the bond markets. The S&P500 made new highs this week. Canada, Japan, Germany and the UK all made highs in April whilst the Australian ASX retouched its March highs during the month. Even New Zealand, with the second flattest yield curve and structurally higher real interest rate curve, is less than 4% off its all-time highs.

Inflation expectations and real returns

Earlier this week saw the publication of this first part of a two part article about inflation expectations from the NY Fed – FRBNY DSGE Model Forecast–April 2015:-

The top panel in the chart below presents quarterly forecasts for real output growth and the core PCE inflation rate over the 2014-17 horizon. These forecasts were produced on April 9 using data released through 2014:Q4, augmented for 2015:Q1 with a “nowcast” for GDP growth, core PCE inflation, and growth in total hours, and 2015:Q1 observations for financial variables. The reason for using nowcasts is that the model is estimated on National Income and Product Accounts data, which are only available with a lag. Nowcasts incorporate up-to-date information, and this tends to improve short-run forecasts, as shown here. The black line represents released data, the red line is the forecast, and the shaded areas mark the uncertainty associated with our forecasts at 50, 60, 70, 80, and 90 percent probability intervals. Output growth and inflation are expressed in quarter-to-quarter percentage annualized rates. 

NY Fed PCE GDP forecasts

Source: NY Fed

The FRBNY DSGE forecast for output growth is slightly stronger than it was in our earlier blog post which used data ending in July 2014. This difference is highlighted in the bottom left panel of the chart, which compares current (solid line) and September (dashed line) forecasts. The model projects the economy to grow 1.9 percent in 2015 (Q4/Q4), 2.1 percent in 2016 and 2.2 percent in 2017. The headwinds that slowed down the economy in the aftermath of the financial crisis are finally abating. This is reflected in the model-implied “natural” level of output and the “natural” rate of interest, which are defined as the counterfactual level of output and interest rate that would obtain in an ideal economy where nominal rigidities, markup (or cost-push) shocks, and financial frictions are absent. Estimates of the recent natural level of output show a more rapid growth as the headwinds facing the economy are fading. As we will discuss at length in our next post, the natural rate of interest is finally increasing toward positive ranges, after having been negative for the entire post-Great Recession period.  The recovery has been relatively slow, however, with economic activity remaining below its natural level since the end of 2008 and projected to remain so throughout the forecast horizon. The model thus predicts a very gradual closing of the output gap, measured as the percentage deviation of actual output from natural output (although there is much uncertainty about the gap forecast). This output gap, along with its forecast, is shown in the next chart. 

NY Fed Output Gap

Source: NY Fed

…In conclusion, the FRBNY DSGE model continues to predict a gradual recovery in economic activity with a slow return of inflation toward the FOMC’s long-run target of 2 percent, as the negative effect of the Great Recession dissipates. This forecast remains surrounded by significant uncertainty, with the risks slightly skewed to the downside for output growth because of the constraint on policy imposed by the zero lower bound. 

The Peterson Institute – Quantity Theory of Money Redux? Will Inflation Be the Legacy of Quantitative Easing? Examines the classical monetarist argument that QE will eventually lead to inflation, this is their conclusion:-

On balance, the risk of severe inflation resulting from the buildup of the balance sheet of the Federal Reserve in association with quantitative easing seems low. To begin with, the US economy has not experienced inflation driven by excessive money expansion since at least the mid-1980s. Indeed, the rising demand for money, as the opportunity cost of holding money fell with lower inflation, has meant that over the past three decades there has been a tendency for faster money growth(relative to real GDP) to be associated with lower rather than higher inflation. The supply-focused quantity theory of money broke down. The pattern associating rapid money growth with low inflation since the mid-1980s would require a sharp reversal for money supply to become the proximate cause of inflation. In the meantime, it seems fair to say that in the United States inflation is determined by labor market and product market tightness (in the Phillips curve tradition), and that the opposing proposition that “inflation is always and everywhere a monetary phenomenon” (Friedman’s summary of the quantity theory) does not hold in a narrow sense relating to money supply.

A second important phenomenon is that inflation has remained low despite a large buildup in the Fed’s balance sheet not because the velocity of broad money has collapsed, but because the money multiplier has done so. Because of a large increase in excess bank reserves equal to nearly three-fourths of the increase in the Federal Reserve’s total assets, the usual money multiplier (inverse of the reserve requirement ratio) no longer holds. Broad money was 14 times the money base in 2007; by end-2014 it was only 4 times the money base.

A third observation is that arguably this same phenomenon could pose a risk of inflationary money expansion when and if banks start to draw down excess reserves.

Fourth, the principal implication for policy purposes is that the Federal Reserve will need to be particularly adept in avoiding any inflationary pressures that might develop from the unwinding of large excess bank reserves as more normal monetary conditions return. The Fed has clearly given considerable attention to this task and at present plans to use higher interest rates on excess reserves as needed to control such pressures. Indeed, the authority to pay interest on reserves is what will enable the Fed to raise rates when necessary, because otherwise an incipient rise in the short-term interest rate would quickly be choked off as banks ran down excess reserves to take advantage of the higher interest rates.

Fifth, because quantitative easing constitutes navigating in uncharted waters, there is some non-zero probability that inflation could nevertheless still be the consequence of potential money supply expansion resulting from QE.

The key element in their assessment is the “multiplier effect”, bank reserve requirements have increased globally since 2008, QE has merely offset the tightening of credit conditions, but in the process it has crowded out the private sector – which is where real-GDP growth is generated.

A more deflationary view of the current environment is provided in the quarterly letter from Hoisington Asset Management, here are Lacy Hunt’s six characteristics of highly over-indebted nations:-

1. Transitory upturns in economic growth, inflation and high-grade bond yields cannot be sustained because debt is too much of a constraint on economic activity.

2. Due to inherently weak aggregate demand, economies are subject to structural downturns without the typical cyclical pressures such as rising interest rates, inflation and exhaustion of pent-up demand.

3. Deterioration in productivity is not inflationary but just another symptom of the controlling debt influence.

4. Monetary policy is ineffectual, if not a net negative.

5. Inflation falls dramatically, increasing the risk of deflation.

6. Treasury bond yields fall to extremely low levels.

…Many assume that economies can only contract in response to cyclical pressures like rising interest rates and inflation, fiscal restraint, over-accumulation of inventories, or the stock of consumer and corporate capital goods. This idea is valid when debt levels are normal but becomes problematic when debt is excessively high.

Large parts of Europe contracted last year for the third time in the past four years as interest rates and inflation plummeted. The Japanese economy has turned down numerous times over the past twenty years while interest rates were low. Indeed, this has happened so often that nominal GDP in Japan is currently unchanged for the past twenty-three years. This is confirmation that after a prolonged period of taking on excessive debt additional debt becomes counterproductive.

…Falling productivity does not cause faster inflation. The weaker output per hour is a consequence of the over-indebtedness as much as the other five characteristics mentioned above. Productivity is a complex variable impacted by many cyclical and structural influences. Productivity declines during recessions and declines sharply in deep ones.

…Monetary policy impacts the overall economy in two areas – price effects and quantity effects. Price effects, or changes in short-term interest rates, are no longer available because rates are near the zero bound. This is a result of repeated quantitative easing by central banks. It is an attempt to lift overly indebted economies by encouraging more borrowing via low interest rates, thus causing even greater indebtedness.

Quantity effects also don’t work when debt levels are excessive. In a non-debt constrained economy, central banks have the capacity, with lags, to exercise control over money and velocity. However, when the debt overhang is excessive, they lose control over both money and velocity. Central banks can expand the monetary base, but this has little or no impact on money growth.

…In periods of extreme over-indebtedness Treasury bond yields can fall to exceptionally low levels and remain there for extended periods. This pattern is consistent with the Fisher equation that states the nominal risk-free bond yield equals the real yield plus expected inflation (i=r+E*). Expected inflation may be slow to adjust to reality, but the historical record indicates that the adjustment inevitably occurs.

The Fisher equation can be rearranged algebraically so that the real yield is equal to the nominal yield minus expected inflation (r=i–E*). Understanding this is critical in determining how unleveraged investors fare. Suppose that this process ultimately reduces the bond yield to 1.5% and expected inflation falls to -1%. In this situation the real yield would be 2.5%. The investor would receive the 1.5% coupon but the coupon income would be supplemented since the dollars received will have a greater purchasing power. A 1.5% nominal yield with real income lift might turn out to be an excellent return in a deflationary environment. Contrarily, earnings growth is problematic in deflation. Businesses must cut expenses faster than the prices of goods or services fall.

Hunt goes on to predict that yields may rise but this presents an opportunity to buy rather than signalling the end of the bond bull market.

A slightly contrasting view is expressed by Bill Gross in Janus Capital – Investment Outlook:-

Because of this stunted growth, zero based interest rates, and our difficulty in escaping an ongoing debt crisis, the “sense of an ending” could not be much clearer for asset markets. Where can a negative yielding Euroland bond market go once it reaches (–25) basis points? Minus 50? Perhaps, but then at some point, common sense must acknowledge that savers will no longer be willing to exchange cash Euros for bonds and investment will wither. Funny how bonds were labeled “certificates of confiscation” back in the early 1980’s when yields were 14%. What should we call them now? Likewise, all other financial asset prices are inextricably linked to global yields which discount future cash flows, resulting in an Everest asset price peak which has been successfully scaled, but allows for little additional climbing. Look at it this way: If 3 trillion dollars of negatively yielding Euroland bonds are used as the basis for discounting future earnings streams, then how much higher can Euroland (Japanese, UK, U.S) P/E’s go? Once an investor has discounted all future cash flows at 0% nominal and perhaps (–2%) real, the only way to climb up a yet undiscovered Everest is for earnings growth to accelerate above historical norms. Get down off this peak, that F. Scott Fitzgerald once described as a “Mountain as big as the Ritz.” Maybe not to sea level, but get down. Credit based oxygen is running out.

But what should this rational investor do? Breathe deeply as the noose is tightened at the top of the gallows? Well no, asset prices may be past 70 in “market years”, but savoring the remaining choices in terms of reward / risk remains essential. Yet if yields are too low, credit spreads too tight, and P/E ratios too high, what portfolio or set of ideas can lead to a restful, unconscious evening ‘twixt 9 and 5 AM? That is where an unconstrained portfolio and an unconstrained mindset comes in handy. 35 years of an asset bull market tends to ingrain a certain way of doing things in almost all asset managers. Since capital gains have dominated historical returns, investment managers tend to focus on areas where capital gains seem most probable. They fail to consider that mildly levered income as opposed to capital gains will likely be the favored risk / reward alternative. They forget that Sharpe / information ratios which have long served as the report card for an investor’s alpha generating skills were partially just a function of asset bull markets. Active asset managers as well, conveniently forget that their (my) industry has failed to reduce fees as a percentage of assets which have multiplied by at least a factor of 20 since 1981. They believe therefore, that they and their industry deserve to be 20 times richer because of their skill or better yet, their introduction of confusing and sometimes destructive quantitative technologies and derivatives that led to Lehman and the Great Recession.

Hogwash. This is all ending. The successful portfolio manager for the next 35 years will be one that refocuses on the possibility of periodic negative annual returns and miniscule Sharpe ratios and who employs defensive choices that can be mildly levered to exceed cash returns, if only by 300 to 400 basis points. My recent view of a German Bund short is one such example. At 0%, the cost of carry is just that, and the inevitable return to 1 or 2% yields becomes a high probability, which will lead to a 15% “capital gain” over an uncertain period of time. I wish to still be active in say 2020 to see how this ends. As it is, in 2015, I merely have a sense of an ending, a secular bull market ending with a whimper, not a bang. But if so, like death, only the timing is in doubt. Because of this sense, however, I have unrest, increasingly a great unrest. You should as well.

I believe the world’s major central banks still have the capacity to provide support, should the bond and stock markets collapse, by the effective “quasi-nationalisation” of assets – both equity and fixed income, but I foresee a point where there is a public challenge to the legality of this activity as it crowds out the private sector. I also expect that investors will eventually realise that income generating assets must offer a real-return regardless of potential capital appreciation.

In aggregate, trading is a zero-sum game – except for the broker – investing, by contrast, is about generating long-term income. In a deflationary environment a government bond, should it prove to be risk-free, may offer good value even at next to the zero bound, but, for less fortunate bond holders, default risk needs to be compensated. What is a fair price for lending money to a grateful government? The Minneapolis Fed – Sovereign Default: The Role of Expectations takes a fresh approach to some of these issues. Thomas Piketty – Capital in the 21st Century suggests 5% is the long-term average return on investment, based on his extensive historical research – the link is to a Pdf presentation from 2014, which is easier than reading the 700 page book. Given developed nation governments propensity to run budget deficits, this seems a reasonable return. The only government offering close to 5% is New Zealand at 3.74%. Ironically, their Debt to GDP ratio is only 36% and they have run a small budget surplus for most of the last 40 years.

If risk premia are not permitted to return towards their long-run average, I envisage liquidity disappearing from bond and stock markets as public institutions – namely central banks – acquire the majority of bond issues and the free-float in “strategically important” stocks. Crowdfunding and microfinance may fill some of the gap and capital will flow to growing economies as the world order changes, but liquidity in the world’s largest capital markets may be in short supply. Fortunately, this somewhat apocalyptic view is a while away.

Bond yields may rise, but not significantly above 5%, at which juncture their respective economies will stall due to over-indebtedness – in reality I think it unlikely they will get anywhere near this level until pricing power in product markets returns. The FRBSF – Mortgaging the Future? Investigates the extraordinary expansion in credit since WWII and among their conclusions is the observation that the real estate sector has far greater impact on the economy than in the past. Of course the absolute return to savers is likely to remain pitiful, as this video, from the March conference of the Global Interdependence Centre – Policies for the Post Crisis Era, makes clear; Chris Whalen’s presentation starts around 4 minutes in and lasts for 10 minutes. It’s well worth considering his opinion that, for the world economy to function properly, interest rates need to rise and credit formation to rebound, lest the “wheel of circulation” – as originally described by Adam Smith – grind to an inexorable halt.

For most of the major Central banks, intervention will be undertaken if yield increases are deemed to be detrimental to the mortgage market, and, as bond yields then trend lower, stocks will rise.

At what rate will they intervene? The NY Fed recently commented on “the natural rate of interest” is this article – Why Are Interest Rates So Low?:-

In conclusion, the low level of interest rates experienced since 2008 is largely attributable to a reduction in the natural rate of interest, which reflects cautious behavior on the part of households and firms. Monetary policy has largely accommodated the decline in the natural rate of interest, in order to mitigate the adverse effects of the crisis, but the zero lower bound on interest rates has imposed a constraint on the ability of interest rate policy to stabilize the economy. Looking ahead, we expect these headwinds to continue to abate, and the natural rate of interest to return closer to historical levels.

This is somewhat at odds with thier DSGE forecast. Consensus indicates the natural rate of interest to be around 3% which equates to a nominal rate of 5% assuming an inflation target of 2%. The original concept of the natural rate of interest was introduced in 1898 by Knut Wicksell, it’s a slippery customer:-

…it is not a high or low rate of interest in the absolute sense which must be regarded as influencing the demand for raw materials, labour, and land or other productive resources, and so indirectly as determining the movement of prices. The causality factor is the current rate of interest on loans as compared to [the natural rate].

In the shorter term I do not believe bond investors will suffer too catastrophically. I’m indebted to Garth Friesen – III Capital Management –for the excellent charts below:-

Barclay bond index vs SandP - III Capital Management

Source: III Capital Management

You can read his assessment of the current situation in this article – Silencing the Roar of the Bond Bear. In the past 25 years the largest negative quarterly return from the Barclays bond index was -2.9%, that was back in 1994 when the Fed tightened interest rates abruptly, causing stocks and bonds to collapse in tandem. The next chart highlights the benefits of diversification, generally bonds flip when stocks flop:-

SandP vs Barclays Bond index 25 yr -III Cap Man

Source: III Capital Management

Conclusion and investment opportunities

If inflation is likely to remain subdued due to the excessive debt overhang, then the recent rise in bond prices is simply a correction. How far will this correction go or has it already run its course?

I could analyse each market, apply an array of technical analysis and establish a set of individual forecasts but I believe it is better to view these markets through the lens of the JGB market. Japan has been struggling with bouts of deflation since the 1990’s. Whilst most other nations – Switzerland being a notable exception – have only recently witnessed widespread falling prices, the evolution of inflation expectations are likely to follow a similar course.

japan-inflation-cpi

Source: Trading Economics and Japanese Ministry of Internal Affairs

japan-government-bond-yield

Source: Trading Economics and Japanese Treasury

japan-interest-rate

Source: Trading Economics and Bank of Japan

As the Japanese stock market collapsed after 1989 inflation declined rapidly. JGBs, influenced by the rate tightening of the US Fed, suffered a rise in yields in 1994 but then declined once more – after all, the price index was now negative. Inflation witnessed a brief rebound ahead of the Asian Financial Crisis of 1998. The Bank of Japan (BoJ) left short term interest rates on hold and JGB yields declined again as the Asian Crisis gathered momentum.

Between 2000 and 2005 Japan struggled with mild deflation, despite expansionary monetary and fiscal policies. At the risk of being vilified for wild generalisation, this is the point where the other bond markets are now. The charts below cover the period 2001-2007, after the bursting of the US Technology Bubble and prior to the Sub-Prime collapse:-

japan-government-bond-yield 2001-2007

Source: Trading Economics and Japanese Treasury

japan-stock-market 2001-2007

Source: Trading Economics and Tokyo Stock Exchange

japan-currency 2001-2007

Source: Trading Economics

The table below extrapolates the corrections and counter-corrections of the JGB in the chart above and compares them to the German Bund and the US Treasury 10 year maturities:-

JGB 10yr Rise/Fall Change Bund 10yr Rise/Fall   Change US T-Bond 10yr Rise/Fall   Change
Range in bp BP % Equivalent bp BP % Equivalent bp BP %
55 – 185* 130* 236* 5 – 80* 75* 1500* 138 – 304* 166* 120*
185 – 120* -65* -35* 80 – 52 -28 35 304 – 163* -141* -46*
120 – 195* 75* 63* 52 – 85 33 63 163 – 266 103 63
195 – 160* -35* -18* 85 – 70 -15 -18 266 – 218 -48 -18
160 – 190* 30* 19* 70 – 83 13 19 218 –   259 41 19

*These figures are actual outcomes

Source: Investing.com and Tokyo Stock Exchange

I am taking the US T-Bond low (1.38%) of July 2012 to be the current nadir. It may now be embarking on a third corrective wave, if you believe in Elliott Wave theory, which could see yields rise toward 3% once more. The Bund correction, from 80bp to 55bp by 19th May, was probably too swift, meaning the market may break above 0.80% before yields decline again.

The price cycles in each of these markets are unlikely to tally either in duration or magnitude, but, after a capitulation in Europe, in which 10yr Bund yield almost turned negative, even the most ardent fixed income protagonists have been unable to justify remaining fully invested – we have now entered a corrective period. A 130bp rebound would take Bunds just above the 61.8% retracement of the recent decline (1.35%). This scale of correction would clear out the majority of weak hands.

Without inflation, growth prospects for the EZ will continue to rely on the benevolence of the ECB who announced additional QE measures earlier this week. Benoît Cœuré, Member of the Executive Board of the ECB, gave this speech on Monday – How binding is the zero lower bound?

Since 2007 JGB yields had marched steadily lower until this January; without some form of resolution of the over indebtedness of developed nations, yields will remain well below what used to be regarded as the natural rate of interest. 3% is likely to cap yields on 10yr US T-Bonds, Bunds will struggle to get above 2%. JGBs are more difficult to predict, but attempts at reflation are likely to fail whilst debt remains so high relative to GDP. The Japanese government cannot afford a doubling or tripling of its interest bill.

For the trader there is plenty of opportunity with yields ranges of 200 to 300bp, but beware of the void of liquidity that results from the absence of free-float. Rising bond correlation, rising yields and the lack of a “dealer of last resort” create dangers of their own.