Global Chief Investment Strategist
September 12, 2016
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Central banks that have ground interest rates down to zero or below have now engendered a global financial market selloff by expressing mere ambivalence over their existing policies.
Common sense would dictate that negative yield bonds and zero yield cash shouldn’t very easily co-exist. Some European corporations marketed new-issue negative-yield bonds in recent weeks. Should industrial and consumer goods companies provide better cash storage services than a safety deposit box, warranting paying them a fee?
There was only scant warning of the bond market selloff of the past two days. However, as discussed in our latest Quadrant, “rate risk” has been building throughout global markets of late (see figure 1).
We are deeply underweight negative yield bonds in our asset allocation (please see our LEVEL 3 portfolio in Quadrant). Unfortunately, the high and rising correlation of nearly all markets across the world leaves the relatively better valued assets at risk of moving down in price along with those overvalued. Consider that German and Brazilian local long-term debt both lost about 1% of their value Friday; Brazil with a 12% nominal yield, Germany at -0.10%. This quick and painful adjustment might continue a while longer. Yet barring a whole new point of view from central banks, we think the selloff will be limited for reasons we will describe.
The rude awakening from the lowest-yielding core developed bond markets began in late July. At the time, the Bank of Japan failed to take interest rates more deeply into negative territory and BOJ Governor Kuroda appeared to dismiss recommendations for the most radical policy steps known to central banks. In practice such might mean immediately financing government spending and simultaneously canceling the liability. This is one possible incarnation of so-called “helicopter money” famously described by U.S. economist Milton Friedman in 1969.
While Japan has yet to fully address the negative impact of sub-zero interest rates on its financial sector and the BOJ’s policy actions have become increasingly unpopular with the public, the Japanese central bank should be seen as not even remotely close to abandoning its large scale asset purchases. With Japanese inflation running at -0.4% and +0.3% excluding food and energy - amid a 2% inflation target - easing efforts that arguably came two decades late won’t be quickly undone. Japanese savers are unlikely to be the long-term winners they have long been.
Late last week, the global bond market selloff resumed after a lull driven by weak U.S. economic data for August, a predictable feature of the past seven years (please see our latest Global Strategy Bulletin: Yellen Advocates Activist Monetary Policy, Leaves Negative Rates Out of Her Toolkit). The vulnerability of risk assets could be seen when global equities and bonds rallied together on the below-consensus employment report for August and subsequent weaker industry data. Of course, the risk-asset rally would be highly misguided if a lasting new economic contraction were beginning. However, monthly proxies for U.S. GDP show more than three months of contraction on average during economic expansion years. Data for August merely showed slower growth. This was the ostensible antidote for immediate Fed tightening after Fed Chair Yellen said the case for further monetary tightening in the U.S. had become stronger in recent months.
However, a range of Federal Reserve officials last week continued to argue that the timing may be at hand for a resumption of U.S. monetary tightening even as U.S. growth indicators have disappointed (see figure 2 CESI USD). Markets are clearly unprepared for such immediate action.
With so much action to intervene in markets over the past decade, policymakers words have power, even by their omission. Thursday, expectations for further easing action out of the European Central Bank were minimal. However, the rolling extension of asset purchases - now with less than seven months officially left in the program - is taken as a given with Eurozone inflation nearly as far behind target as Japan’s.
Thursday, the ECB noted that such asset purchases would continue until inflation goals are met. However, at his press Conference, President Mario Draghi noted that the ECB Governing Council asked its staff to study ways to adjust its asset purchase program given limitations built into the program. These include limits to the shares of key assets the central bank can own and the yield levels at which they can be purchased. The impact on market liquidity and distortions to capital costs driven by widespread bond buying have been rising concerns. Yet the ECB is highly unlikely to change its tactics in our view.
In the case of the Federal Reserve, which has ostensibly come far closer to actually reaching the economic and inflation targets it has aimed for, a “hard stop” of asset purchases seemed a dreadful enough shock that it spent nearly a year “tapering off” the size of such purchases. The Fed deemed markets too ill-prepared for even the start of tapering that it waited six months after the first verbal warning of such by Fed Chairman Bernanke in 2013.
Even under stronger economic conditions and higher inflation rates for the Eurozone than we now expect, we would assume a similar soft “phase out” of asset purchases as the Fed had undertaken. The reality of continued Euro growth challenges - such as those presented by an aging American economic recovery - suggests entirely new easing steps are an equally-likely prospect.
The limitations of monetary policy to address chronic disappointments in both supply and demand in developed market economies is an emerging concern. However, at the Federal Reserve’s Jackson Hole symposium last month, the debate from central bankers and academics was largely over tactics, not choosing whether to retreat from the battle. While higher interest rates could be a welcome sign for the world economy, it must be driven by stronger underlying growth to be sustainable. Hearing calls for higher interest rates and a retreat from market interventions, these central bankers would likely argue that If medicine doesn’t work, don’t try poison.
Central bankers have a long list of hopes. They want easing financial conditions, rising inflation expectations and firming economies to permit them to raise interest rates back into the pre-crisis range. Short of reaching those goals, interest rates for developed market (DM) sovereigns and increasingly other borrowers, will be well short of the old norms.
With most global markets driven to some extent by the remarkable easing of DM central banks, “rate risk” has been building. However, wide valuation differences and fundamentals in certain emerging market and DM assets argue for different investment positions. We believe the two-year collapse in global petroleum-related investment and “overshoot” weakness in related emerging markets currencies has left these assets relatively well positioned for longer-term returns.
In the near-term, we would not be surprised if the highly correlated “global taper tantrum” runs further, with the Federal Reserve’s September 20-21 meeting a key hurdle to get past. Only the most favorable financial market setting and solid growth and inflation indicators for the future would seem adequate for the Fed to take action now. It would take several tightening steps for the Fed to see its policy as merely “neutral” in positioning. Yet the Fed will still likely prefer to tread cautiously.
As noted, we would not expect stability to resume immediately. The third quarter-to-date has been remarkably smooth sailing, free of realized volatility in most equities and bonds. For what is on average the worst performance quarter of the year, sadly, summer has drawn to a close.