Dysfunctional long-term rate markets: next stop for 10-yr US is 1.25%, not 3.75%
Sometimes, the first glimpse of a bad reality is followed by a period of remission, in which many believe they had just experienced a bad dream or even nightmare.
Late last year, many in the market-place took fright at what they saw – especially, a serious global economic slowdown. Now in Spring 2019, that fright is widely dismissed as imaginary. The Chinese and the US presidents are soon to announce a deal. Green shoots, which should indicate an economic re-bound by late this year, have been sighted. The US equity indices are back to their peak levels (almost).
Beware: look at that celebrated March 1939 Punch cartoon which captured, so famously, the delusions of nightmare recognition, just because the still present (and growing) menace has not immediately shown up in new action. In that cartoon, John Bull, wakes up and rubs his eyes, now convinced that all those war fears of late 1938 were just a bad dream. The day of publication was the day that Czechoslovakia (already diminished by the Munich accord) collapsed under German might.
The possible peril, for those now embracing the risk-on revival in global markets, is that the underlying economic reality has continued to worsen.
The vanguard, of the “risk-on” trades, believe that (like in 2015/16) our central bankers (led by the Fed) are on the case, and they can be trusted to deliver another growth cycle upturn, most probably by the end of the year.
The counter-argument may yet prove correct. According to this, the global economic slowdown is this time stronger and more enduring than the mini-growth cycle downturn of 15/16, and cannot be turned round simply by an extended pause in Fed plans, to raise short-term interest rates (together with increased negativity, in German and Japanese rates plus Chinese official lending boom). The fall in medium and long-term US rates, through the first quarter, is plausibly consistent with a forthcoming economic re-bound. Yes, in principle, optimism should mean higher long-term rates. But markets for these are now dominated by the rate manipulators, at the central banks, most of all in the Fed and ECB. There has also been some decline in perceived inflation risks.
bond markets gain from fading inflation
Key fact for bonds: measured inflation, in goods and services markets, is trending lower, whether in the US, Europe or Japan. For example, in the US, the year-on-year increase in the private consumption deflator in February was down to 1.4% year-on-year. The deceleration in the core measure was just perceptible – to 1.8%, compared to 2% late last year. This trend lower is, most likely, going along with some easing of overall monetary inflation; but in today’s anchor-less monetary environment, there is no way of cross-checking reliably price data with monetary data. In turn, the downdrift of goods and services price inflation (present oil market speculation, notwithstanding) also goes along with business cycles, internationally having moved into a slowdown phase.
Core inflation, in the US, could well move down to 1.5% or below, by this Winter. Furthermore, in a general climate of economic cooling, further decline looms. Whenever the next recession emerges, it is surely not fantasy to imagine US core inflation nearer to zero than 2 per cent.
These prospective declines in US inflation and inflation expectations are positive for the dollar, and could more than offset negative impulse from a shrinking nominal yield spread, in favour of US Treasuries (compared to say German government bonds).
Yes, there are serious grounds for fearing high inflation scenarios, into the next business cycle – given the broken monetary control systems, the collapse of sound money critique in the US Congress, and the essential instabilities of the 2 per cent inflation standard regime – all against the background of a massive US budget deficit (which could well reach 10% of GDP or more in the next recession).
Contemporary markets, in US Treasuries and other top government bonds (around the world), do not typically reflect such log-run concerns. They are dominated by the central banks and the short run data, especially PMI indices. The algorithms and quants would wipe out any resistance, based on thinking about the next cycle.
False optimism on economic rebound
Why are the many (and indeed dominant) optimists, favouring a global economic re-bound, likely to be wrong?
Here are some reasons.
The emerging market credit boom, which led the global cyclical expansion (both in 2010-13, and 2016-17), has faltered, even though in the corporate bond markets, high yield and BBB yield spreads have sharply contracted alongside the equity market re-bound this year.
Distrust is widespread about the banks – whether in Europe, Japan (concern focussed on giant dollar funding exposure) or in emerging market economies.
US banks, for now, are viewed as safer than those in Europe and Japan. That view could change, when asset deflation starts in earnest. Who knows the ultimate exposure of US banks to private equity, real estate, foreign banks and so on?
The speculative narrative, of endless emerging market boom and outperformance (of the advanced economies), is broken.
Indeed, there is a growing view that the artificial intelligence revolution will kill the prospect of emerging market economies pulling themselves up, predicated by cheap labour costs.
In Europe, whatever the next version of the Brexit drama, confidence in the EU and European projects has dissipated. Negative interest rates, for ever in Germany and Japan, are a wake-up call to savers, planning for long retirements.
Real estate market booms continue in some areas (especially Japan, Germany), but in general, there are growing patches of weakness or worse.
Yes, earnings yields in the US equity market may look superficially attractive, relative to diminished 10-year yields (especially as quoted in the inflation indexed Treasury bond market).
But who believes these earnings picture fully (as Alex J Pollock tells us, in his new book “Finance and Philosophy”) – especially under present accounting conventions, earnings are what they are, in the eye of the beholder, like beauty of the tree. How low could profits fall in the next cyclical downturn?
What horrors would then be revealed about the true underlying leverage ratios, in much of the corporate sector?
Venezuela, gold and Russia
Geo-politics (which is not heard so much about at present, in financial market chat shows), is no less menacing in consequence. It could be bearing down on business and consumer confidence, in ways not detectable by simple metrics.
A looming US-Russia showdown, over the Venezuela end-game (however implausible this is to analysts convinced that President Trump cannot cross President Putin), is an evident danger scenario with broad consequences (including Europe). Ultimately, the fall of the Russia-Cuba-Iran supported regime, in Caracas, would be good news of course, for liberty and economic prosperity. A failure of Washington to achieve its stated goals, in Venezuela, would be a serious setback for the Trump administration policies on the global stage.
The gold market does not seem to be impressed presently by the danger here, but there are offsets. Reports that the Venezuela dictator has disposed of gold (via the Middle East with Russian logistic support), together with the dollar’s strength against European currencies, have weighed on the yellow metal – further amplified by the perception of declining inflation risks. The dollar’s strength, against the Europeans, could get new impetus from political chaos ahead – Brexit, European elections, Italy government crisis, and the fall of the Merkel regime. On the other hand, low US bond yields and the reinforcement of negative rates in Europe and Japan are gold positives.
Transcending all this, is the obsession of global bond markets with the Federal Reserve and ECB, with their each and every policy statement (whether collectively or by leading officials) – It wasn’t always like this!
Long rates were not always manipulated
In a monetary regime, where interest rates (both short and long), were wholly market determined – there would be no focus on the central bankers at all (if they existed). Indeed, such was the case in the heyday of the gold standard.
Short-term rates, in money markets, were determined chiefly by the present availability of gold money, as against demand for this. Typically, these rates were highly volatile, and only exceptionally fell below 1-2% p.a. – and then, only transitorily – even during periods of extended price weakness in goods and services markets.
No-one cared about the volatility. Long-term rates had their own existence, determined mainly by the micro-decisions of businesses and savers in the market for capital. Under that regime, the long-term rate had real information of its own, an indicator of business strength or weakness – no algorithmic programs to tie the long-term rate to the ISM index, under this regime!
The long-term rate would tend to be a coincident indicator of the business cycle. Its level and path would not be determined by macro-bets or central bank manipulation. Instead the long-term rate would fully reflect information in the market-place, from hugely decentralized decision making – far surpassing what big data can provide to the econometricians.
Fast forward to monetary regimes, where the central bank pegs the short-term rate, and influences tremendously expectations of its path, over coming quarters and even years. Then the long-term rate becomes glued to the pegging tactics and direction.
The glue consists in part of irrational material – what the behavioural finance theorists call “anchoring fallacies”. If no one knows where the price should be, some trivial market (apparently relevant), becomes the starting point for market iteration – in this case, the central bank policy rate.
Beyond such irrationality, markets may have justification, for awe of central bank power over long-term rates. Under some sets of economic circumstances, these institutions can control short-term rates over an extended period. Moreover, by huge purchase operations (QE), they might be able to influence, seriously, term premiums (bringing these down sometimes to negative levels).
Economics 101 wrong? Fixing long-term rates and hyperinflation
This power of central banks to fix long-term rates may seem to run counter to economics 101. There we learn that a central bank cannot (for long) hold rates below neutral, without triggering ever higher inflation. Interest rate manipulation, at worst, could end up with hyperinflation, as the central bank prints more and more base money, towards stabilizing long-term bond prices.
Why has there been no sight of such problems, through the now many years of QE and long-term rate manipulation?
The apologists for the central banks tell us that there has been no problem, because the neutral rate level (r* in Fed-speak) has been historically low. In itself that is a bold assertion.
No one can measure this reliably, and the concept has diverse meaning.
Some economists (especially those joined to the central bankers’ club) define neutral as that level, consistent with 2 per cent inflation.
Others (in the sound money school) would put the emphasis on no overall inflation (spanning goods and asset markets).
There are grounds for doubting that the neutral level is exceptionally low. Why would there be so much asset inflation, if this were so?
In any case, monetary inflation in goods and services markets cannot be assessed by looking simply at official price indices. Instead we have to consider how strongly prices might have been falling under the benign influences of globalization and digitalization – quite consistent with sound money and no monetary inflation overall. A symptom of monetary inflation in goods markets is prices edging up slowly (as at present in the US) when in fact the natural rhythm under sound money would have been downwards.
Central bank rate fixing power is ephemeral
The apparent power of central banks, to influence long-term rates under these circumstances, has impressed many in the market-place. They now think that the power is ever-lasting. So yes, if you are considering where the 10-year US bond yield might go, the central bank’s plan for short-term rates over the next years becomes pivotal, and will play a crucial role.
These circumstances will not remain unchanged.
We should well imagine that in the future, the powerful downward rhythm of prices in goods and services markets will falter. Alternatively, confidence in the central banks and their administration of the so-called 2 per cent inflation standard can suddenly evaporate, both on the way down and the way up. For example, in a recessionary environment, when recorded inflation is languishing around zero or below, who would have confidence in the central banks armed with their econometric models (including Philipps curve!) and related tools pushing inflation back up again?
Last and by no means least, markets can suddenly realize that purchase operations of the central bank, in the long-term markets, might lose effectiveness. After all, in most cases there are large stocks of such paper outside the central banks, and these stocks can be amplified by large short-selling operations.
What could be the biggest change to roll-back central bank manipulation of long-term rates, over say the next year or two?
This could plausibly be an assault of Washington on the currency manipulators, in Berlin and Tokyo. They use negative interest rate regimes largely, with the unspoken purpose of depreciating their currencies and deceiving (with varying degrees of success) taxpayers about a hidden tax (which their governments are raising on ordinary citizens’ savings). Desperation of European and Japanese savers to flee, from negative returns, explains the particular sensitivity of long-term US rates to perceived rate-fixing strategies, by both the Bank of Japan and ECB.
Why would the Trump Administration seek to ban negative rates in Japan and Europe?
The underlying objective would be to halt currency manipulation and the promotion of dangerous bubbles in global asset markets.
What would be the forum for such diplomacy?
It could be the negotiation over free trade agreements now under way between: the US and Japan and the US and the EU. Or it could be the G-20.
Pity: there is absolutely no likelihood of this occurring under the Mnuchin Treasury, especially where a top political priority of the White House is sustaining asset inflation in the stock market. We could view this effort as futile – personified by the apocryphal image of King Canute desperately trying to turn back the tide. But futile or not, that is present strategy, with the next elections barely 18 months ahead.
If asset inflation turns to asset deflation before then, it is implausible that Washington would call for monetary tightening in Europe and Japan. Rather, the White House would work with the Fed, to draw up radical easing plans. Who knows, Governor Moore might be the key liaison.
In global risk-on markets, many participants now regard the jitters of late last year, as a bad dream, which did not reflect actual or future reality. The optimists now point to the looming US-China deal, Fed “easing”, and perhaps an “orderly” Brexit. Furthermore, data points this week in China and Europe have been “supportive” of the “green shoots” view. All of this is unconvincing. A China-US deal is not the magic wand to restoring Chinese and European growth. There have been winners as well as losers, from tariffs. We just do not know, whether the pause in rate rises by the Fed amounts to monetary easing. The stance of policy should not be measured by rate moves. It is premature to cheer any Brexit deal.