13th January 2015 by The Harried House Hunter
#JeSuisCharlie Happy New Year to everyone although it has not been a particularly happy start given the awful events in Paris. I’m sure all my readers will join me in condemning this brutal attack on liberty and in expressing solidarity with and sympathy to the families, friends and colleagues of the victims and to all the people of France.
Wild start to 2015 – In the markets it has been a wild start to the year, with core government bonds falling further, oil prices trading below $50 a barrel and volatility having generally picked up. I would argue that not many people would seriously suggest that the long term outlook for economic growth in the United States is low enough to justify the current level of bond yields. As is typical, when the 10-year treasury yield fell below 2% this week some commentators tried to explain this by arguing that investors in general were now of the view that growth and inflation would be low for a long time and that the Federal Reserve (Fed) would not be able to raise interest rates much above 2.0% at any time over the next 10 years. However, reality check please. The context is that the economy is already growing at close to 4.0% in real terms and inflation is around 1.0-1.5%, so nominal GDP growth is well over 5.0%. Over the last 20 years, 62% of the time, nominal GDP growth has been above 4.0% and above 3.0%, 85% of the time. Nominal GDP growth of 2.0% is only usually seen in either the descent into a recession or the recovery from a recession or the odd quarter where activity is affected by one-off shocks (like the weather). So bonds are at the wrong price in the context of the likely medium term growth outlook. They are probably at the wrong price in terms of what we should expect from monetary policy. While the Fed has been far from bearish, it has generally shifted closer to signalling that interest rates would rise this year given the progress on job growth, capacity utilisation and credit recovery. I personally don’t buy the optical message from the US bond market that the Fed won’t hike this year and the economy will stagnate over the medium term.
Is global growth even that bad? – Of course it is not just treasury yields that have continued to decline. All core government bond yields have remained on the downward trend that was in place for most of 2014. This of course does reflect the general fears about deflation in the developed world, exacerbated recently by the impact that the fall in oil prices will have on measured consumer price inflation in the first half of 2015. It also reflects sub-trend growth in Europe and the general weakness of global demand. However, none of this is new and, if anything, the news on global growth has got marginally better since a year ago. Even in Europe growth does not appear to be getting any weaker. The composite purchasing manage index for the euro area has remained above 50.0. The German labour market is booming with unemployment reaching a record low (although that is still sadly 6.5%). The worst of the fiscal austerity is behind us in Europe and the improved capital position of the European banking sector does provide some scope for a resumption of credit growth this year. However, inflation has weakened over the last year in most economies and the descent into negative territory for European inflation in January was bound to get a lot of headlines. As a result, an announcement of quantitative easing (QE) from the European Central Bank (ECB) looks inevitable now.
Central banks are a massive influence on the price of risk-free assets – There are lots of reasons that could be used to explain why bond yields have continued to decline, but sometimes it just feels like story telling. Growth was weaker in 2013 but bond yields rose. Growth prospects improved during 2014 but bond yields fell. Importantly, bond yields have been on a trend decline since mid-2013 and arguably long before that. I have come to the conclusion that there has been a general under-estimate of the impact of central bank purchases of high quality government bonds in recent years. The Fed, ECB, Bank of England and Bank of Japan together have expanded their balance sheets to represent close to 10% of global GDP and between 15% and 25% of their domestic government bond markets. If you throw in the central bank of China, Russia and the Middle Eastern oil producers you have well over $10 trillion of assets (either domestic or foreign exchange reserves) that are largely in the form of AAA rated government bonds. That’s big. The re-investment of coupons alone creates a huge demand for treasuries, bunds and gilts. Add in the regulatory changes that have driven banks to hold more sovereign bonds on their balance sheets for liquidity and Basel III reasons and it is not a stretch to argue that most of the buying of government bonds has been for non-return maximizing reasons. Then there are other dynamics. If people are of the view that the US economy is strong and that the Fed will raise rates this year, these are reasons why the dollar has risen. Capital flowing into the US has pushed down yields even if the reason for those inflows is an expectation of stronger growth and higher short term interest rates. More recently the Bank of Japan has increased its quantitative and qualitative easing programme, forcing Japanese investors to allocate more to overseas bond markets and everyone now expects the ECB to announce a large programme of sovereign bond purchases which will add even more liquidity to bond and money markets. What kind of world will it be if growth continues to be strong in the US and strengthens elsewhere but because of policy and low inflation, bond yields remain extremely low? Surely this would ultimately lead to asset price bubbles and the related financial instability that could follow.
Up but by how much? – I do believe bond yields will rise from current levels but I am now not convinced that we will see yields rise to levels that are consistent with the longer term economic outlook. That would mean US treasury yields above 4%. For that to happen I think we would need to see an end to QE as a policy (which is unlikely given the Japanese and European position and the unwillingness of the Fed and the Bank of England to shrink their balance sheets just yet). We might also need to see less demand from current account surplus countries for reserve accumulation. This might happen as lower oil prices cut the current account surpluses of Middle Eastern and other oil exporters. They will have less petro-dollars to recycle. It will definitely also need a tightening of monetary policy, starting with the Fed signaling that it intends to raise interest rates to a level where they are at least zero in real terms. At the moment that means around 1% of tightening this year and another 1% in 2016.
Spending the petro-stimulus – Oil has become a central theme in the economic outlook. Lower oil prices are unambiguously positive for global growth. I disagree entirely with the notion that the decline in oil prices is negative and adds to the deflationary outlook. The oil price move is a relative price move and thus shifts incomes from producers to consumers, but it should have no long-lasting impact on expectations about the general price level. Consumers have more disposable income to spend on other goods and services which, all things being equal, should provide upward pressure on prices. Of course, there are disruptions from the oil price decline and it is easier in the short term to identify the losers – oil producers see their revenues decline, oil exporters see their trade balances deteriorate quickly. The knock-on effect on investment in energy is also something not to ignore and we can see from developments in the equity market and the US high yield bond market that investors have quickly revised down their expectations for cash-flow and spending in those areas. However, the benefits of lower oil prices accrue to many over a long period of time. I did a bit of Googling this week to find out that there are around 250,000 people employed in the oil sector in the US but there are 190 million registered drivers. Job growth of 2%, some increase in wages and a massive decline in energy costs point to a potential boom in US consumer spending.
Risky sterling – In the UK, gilt yields have also fallen sharply with the 10-year currently at 1.6%. Yes, you will receive 1.6% a year return for lending your money to a government that still has one of the largest deficits in the OECD world despite four years of spending cuts. Inflation has averaged above 2.0% for most of the time since the Bank of England was made independent in 1997. The upcoming election may result in a hung parliament with negative consequences for decisive action on the economy or it could pave the way for a referendum on the UK’s continued membership of the biggest trading union in the world. Anyone following sterling’s progress in recent weeks will be aware of what markets generally think about the UK. From being one of the top performing sectors in the bond market in 2014, UK gilts look to be one of the riskiest bets for investors.
QE – short Euro and long HY because it’s in the price in bunds and credit – For the rest of Europe it is a case of waiting for Draghi. Look at the performance of the US and Japanese stock markets in 2014 – they both went up and QE was an important driver in both economies for much of the year. In Europe equities were mostly flat, even as bond yields plumbed new depths. Real interest rates are too high in Europe and that is the key factor behind the move towards QE. The ECB needs to stabilise and reverse inflationary expectations in order to drive down real rates. Quite how the ECB will achieve this remains to be seen but to be effective it needs to have a sizeable asset buying programme and that means buying sovereign bonds. I would expect this to send the euro even lower (parity to the dollar is not such a distant target) and to boost equities. The impact on bonds will not be so clear. Yields are already at ludicrously low levels in Germany and other core markets, largely on the expectation of QE. Peripheral bonds spreads could narrow even more on the back of the announcement with Spanish 10-year spreads to Germany potentially going to 80bps from the current 120bp and Italian spreads also moving below 100% from 135bp on Friday last week. High yield should benefit considerably from the portfolio re-balancing effect – otherwise known as the search for yield. Indeed, the high yield market is one of the few places where we see value in bonds given the widening of spreads in recent months, especially in the lower rated parts of the market. Current yields are well above 5.0% in the B and lower rated parts of the European high yield market compared to just 4.0% six months ago. Think about it another way. What parts of the market will get hit the most if the ECB does not announce QE? It will be peripheral government bonds, while high yield has a significant cushion of spread to allow it to outperform in such a scenario.
Vive La France and Long Live Freedom