The problematic nature of current bond yields

One of the features of the credit crunch era has been the falls in first world interest-rates and bond yields. The first phase saw the slashing of official short-term interest-rates and once that was seen to be inadequate, central banks directly purchased bonds to reduce yields further. It is seldom put like this but there was already an implied failure as according to the models back then the interest-rate cuts should have done the trick. Back then I was already looking ahead to when there would have to be ch-ch-changes and posted the view that central banks would delay what has become called policy normalisation.

For example back on the 24th of February 2011 I pointed out this about a speech from David Miles of the Bank of England.

 My problem with this is that when you act as they have and you have in effect used what weapons the Bank of England has virtually to the maximum by cutting interest-rates by 4.75%% and spending some £200 billion on asset purchases then you have been extraordinarily interventionist. Accordingly it is then hard for you to blame events because some of them are the consequence of your own actions……

What that illustrates is that already the truth was being manipulated and also I am glad I wrote “virtually to the maximum” as of course the amount of asset purchases has more than doubled. In addition we have seen credit easing in the UK via such policies as the Term Funding Scheme and the start of full-scale QE from the European Central Bank as well as negative interest-rates.

But the point about delaying proved to be very accurate as the Euro area is still actively pursuing QE and in net terms the UK has managed to raise interest-rates by a measly 0.25%. The opportunity in 2014/15 was meant with promises via Forward Guidance but no action.

The US

This is the one country which has taken clear action on the path to normalisation. Here is the current state of play.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 2 to 2-1/4 percent.

That is currently working out be be around 2.2% and more rises are promised. Also there is some reversing of the QE or Qualitative Tightening.

The Committee directs the Desk to continue
rolling over at auction the amount of principal
payments from the Federal Reserve’s holdings
of Treasury securities maturing during each
calendar month that exceeds $30 billion, and to
continue reinvesting in agency mortgage-backed
securities the amount of principal
payments from the Federal Reserve’s holdings
of agency debt and agency mortgage-backed
securities received during each calendar month
that exceeds $20 billion.

That combined with forecasts of another interest-rate rise in a fortnight and at least a couple next year seemed to put pressure on bond markets. However this sentence in a speech from Federal Reserve Chair Jerome Powell shook things up on the 28th of last month and the emphasis is mine.

We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth.

You may note we seem to have travelled from “policy normalisation” to neutral. But what the neutral interest-rate represents is an attempt to figure out what interest-rate would neither stimulate or contract the economy. Or a sort of measure of what we might aim for as a new normal. When they are trying to put a pseudo scientific gloss on things economist and central bankers call it r-squared.

However the “just below” dropped the expected path for US interest-rates by 0.5%.

Bond Markets

Let me take you to the Wall Street Journal on Tuesday.

This quarter, yields on longer-dated bonds have dropped and those on two-year Treasurys are flat. The gap between two and 10-year Treasury yields is now around 0.11 percentage point, compared with around 0.55 percentage point at the beginning of the year.

This is attracting a lot of attention in the financial media but the change of 0.44% is pretty much my 0.5% suggestion above. Now let us look at the US ten-year yield which is 2.9% as I type this and we see that in basic terms it is predicting a couple more 0.25% interest-rate rises. This will come in the next year or so if true so it is not very different to the two-year yield of 2.76%.

If we look beyond Federal Reserve policy we have seen a fall in the price of oil over the past month or two. If we look at it in Brent Crude terms then just above US $86 of early October has been replaced by below US $59 this morning as oil follows equity markets lower. The exact amount of the change varies but the path for inflation now seems set to be lower as it has been rare in 2018 for the oil price to be below where it was this time last year. That is another reason for lower bond yields.

Is this a signal of a recession? Here is the St.Louis Fed from last week.

Does the recent flattening of the yield curve portend recession? Not necessarily. The flattening of the real yield curve may simply reflect the fact that real consumption growth is not expected to accelerate or decelerate from the present growth rate of about 1 percent year over year. On the other hand, a 1 percent growth rate is substantially lower than the U.S. historical average of 2 percent. Because of this, the risk that a negative shock (of comparable magnitude to past shocks) sends the economy into technical recession is increased.

That is a fascinating way of looking at it and in my experience precisely zero bond market participants will look at it like that. It is also revealing that we seem to just assume growth will now be lower. Didn’t they save us?

Comment

I wanted to look at this subject today because of the clear changes which are happening. Now it looks much less likely that US interest-rates will pass 3% and if they do not by much. So “normalisation” will be at best about two-thirds of what it might have been considered to be pre credit crunch ( 4.5%). Some of you have suggested that we can no longer afford interest-rates and yields above 3% so well done at least if we stay where we are! If Italy folds you may get a second tick in that box.

But as we look wider we see even more extraordinary developments. Let me take a look at my own country the UK which is in political disarray yet the ten-year Gilt yield is below 1.3%. So those predicting a surge in Gilt yields are slipping back into the bushes whilst I note the extraordinary absolute level and the persistence of negative real yields which bust past metrics. Germany has a ten-year yield of 0.26% and a five-year one of -0.3% as we note again more metrics which are busted.

So my view is that we cannot rely on old recession metrics because another cause of all of this is that QE4 from the US Fed has got closer. I have worried all along that interest-rate rises might run into more QE and if they do we will be singing along to Coldplay.

Oh no I see
A spider web and it’s me in the middle
So I twist and turn
Here am I in my little bubble

 

 

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22 thoughts on “The problematic nature of current bond yields

  1. I believe the concern about interest rates is misplaced. This is simple economics 101. Interest is the price of money and the low interest rate reflects the fact that mature economies are saving too much. Post industrial development no longer needs the huge quantity of savings that past industrial development required. This is exacerbated by government subsidies to savers (pension pots, ISA’s etc.) . The appropriate government action is to remove subsidies on savings and to tax savers, ie the rich. Neither s going to happen so get used to low interest rates. QE is a red herring; this is merely an informal introduction of the Chicago Plan. See the Bank of England’s own paper on this. Regards Charles

    • (sighs)

      sorry rates are low to save the banks and HMG . they are killing the Pensions industry too ( which I note we are all “encouraged” to join ) .

      They have caused the greatest mis-allocation of resources since god know when to stop an asset crash like the 1930’s

      today it’s easier to sell off your land to build more poorly built housing ( see BBC ) than to invest in any industry or service company.

      The rich are doing very well out of this situation too , any direct tax on savings ( there is a de facto tax now – low interest rate as opposed to RPI ( don’t get me started on CPI !) ) will cause a Bank run …… perhaps this is why Carney likes the idea of banning cash .

      no doubt others will chime in here too……

      Forbin

    • I am curious to know why you think a tax on savings is a good idea? generally people who have saved are largely self sufficient in old age and cost the state much less than those who are more profligate. Simply taxing the rich will make very little difference to the economy unless you define the rich as anyone who doesn’t exist on handouts.A couple of years ago I did a calculation to see what effect taxing the top few percent of the income curve at 100% would be. It actually makes very little difference; which is why income tax is broad based. It does however satisfy the Green Eyed Monster of envy!

      • It is only possible to save by creating a claim on the future. The actual physical output of an economy obviously cannot be “saved”. It is impossible to create sufficient claims on the future to meet the entire retirement income of future retirees. For example a savings fund to finance the old age pension would require a “pot” larger than the entire value of every asset in the UK. Fundamentally this is why state pensions are not funded. If individuals wish to acquire claims on the future to fund a more comfortable old age than ordinary pensioners I do not see why tax payers, which includes everyone who has any kind of income., should subsidise those individuals. Roughly half the households in the country have a negative nett weath (hard to believe isn’t it?). The rich then are the top half of the population; probably like most of the readers of this blog! Taxing the rich (the top half), by removing tax subsidies on savings is fairer to the poor who cannot afford these tax dodges. There are also aggregate effects on the economy, ie keynsian effects, which are manifested by low interest rates, etc. Regards Charles

    • Interesting, but I can’t see the bankers buying the Chicago Plan (2012 version); 97% of money created is created by the banks and I think they still think that if they over egg it they’ll get bailed out. The Chicago Plan seems quite sensible to me but just can’t see it being implemented.

      • I think you are quite correct. But the very low level of interest rates means that the banks are not earning much on their “free” deposits. Also the banks are struggling to find anyone who wants to borrow the money (at profitable rates!). The BOE’s QE has simply moved £400 billion from the balance sheets of the banks to the balance sheet of the BOE. That is what I meant by an “informal” introduction of the Chicago Plan. This process has been facilitated by the extraordinary excess of savings. Unless the government rectifies this by reducing saving and increasing consumption then this process will continue and I could well imagine the full introduction of something like the Chicago Plan. Not necessarily a bad thing.

  2. I am no expert, but it does seem to me that the USA has acted more quickly and decisively than the ECB ever since the 2008 crash. It looks as though the banks were sorted out earlier in the USA and that left room for ending QE earlier than the ECB. This then led to starting QT (not even on the table in Europe as far as I can tell) and pushing up interest rates (again, not really on the cards in Europe).
    Looking at the share prices of Deutsche Bank and half a dozen banks in Italy, my guess is that the ECB is terrified of a systemic banking crisis if it raised rates. I would also guess that there is a lot of pressure from indebted countries such as Italy not to raise the cost of government borrowing.
    So, if there is a recession, it would then seem to me that the USA might be in a better position to use traditional interest rate reductions to stimulate the economy. If recession hits Europe, I have no idea what the ECB will do (except increase QE) and, unless the deficit rules are relaxed, there is not much fiscal stimulus permitted either.
    Whatever one’s views on QE, it does seem that no-one really thought about how to reverse it and we are left with the real possibility of a downturn with very little ammunition to deal with it.

    • Good summary.

      It seems to me that the Fed can tighten partly because the ECB has been/is loosening. When the ECB starts tightening (if it ever plucks up enough courage) then the total hard currency available in the World will start to fall. And that will quickly tighten the screws on emerging markets who have borrowed in foreign currency and over-stretched companies and economies. However, while the two major central bank’s cash flows partly balance each other the market continues along the tightrope.

      • DD,
        The crisis is already happening, emerging markets borrowed in $, not euros and so their debt has mushroomed as the dollar has strengthened, as if to make matters worse, interest rates have been regularly increased by the Fed.

        I think this time around the next crisis will be triggered by the corporate bond market, as companies have borrowed unbelievable amounts of money to buy their own shares back to boost directors option schemes and boost the stockmarket, but already 15% of SP500 companies cannot even service the debt on their balance sheets from current operations , let alone pay the capital back, this whole process is going to go into reverse, with the bond collapse causing the shares to drop, and the Fed will then have a new set of problems to face, this is where I expect the Fed to step into the market and buy corporate bonds and then as the crisis worsens, eventually shares, just as the BOJ has.

        It isn’t as if they didn’t see this coming, they knew exactly what they were doing, so they delibeartely blew an asset bubble in virtually everything and now they are pretending they are going to keep raising interest rates, they are fooling noone, how can Powell go from interest rates being “nowhere near neutral” six weeks ago to now saying “they are just below neutral”?

        Here is Powell back in 2012 admitting the minute they start to raise rates they will crash the market, he starts at page 192.
        https://www.federalreserve.gov/monetarypolicy/files/FOMC20121024meeting.pdf

        • To reply to myself, I think the market in the US is catching up to the Feds lies and deceptions, check out financial and particularly banks stocks, they are are getting destroyed(higher rates would have meant higher margins and hence bigger profits), who wudda thunk it ?- a central bank governor lying and deceiving?Just never EVER believe anything a central banker says, always assume they are lying and assume they are ALWAYS going to inflate debt away by keeping rates too low for too long, they NEVER allow asset prices to fall naturally even after a bubble that they have created.

  3. Also sighs, another zombie that needs killing is loanable funds theory along with quantity of money. There is no connection anymore between saving rates and investment rates, just to be clear, none,zip, nada, zero, sweet fanny adams. As a point of fact no government needs to issue bonds at as long as it is monetarily sovereign. I stab with my steely knife but I just can’t kill the beast….

  4. Great blog, Shaun, as usual. You write that the US “is the one country which has taken clear action on the path to normalisation”, but the Bank of Canada’s overnight rate has been following (strong emphasis on the last word) the US federal funds rate, so Canada is on the same path. As Governor Poloz said in Toronto this morning: “the Bank has raised the key policy interest rate five times over the past year and a half, by a total of 125 basis points.” The unprecedented Chapter 33 of USMCA, which sets up a Macroeconomic Committee for the NAFTA countries,seems to institutionalize the pressure that Ottawa was facing from Washington to follow a similar monetary policy. Poloz may not go on matching Powell hike for hike, since our economy isn’t growing nearly as rapidly as theirs, but it seems very unlikely that Poloz will ever again feel free to lower interest rates while the Fed is hiking them. Today’s speech was to justify leaving the overnight rate at 1¾% yesterday. Poloz noted that there was a decline in business investment in 2018Q3, and that “the economy has less momentum going into the fourth quarter than we believed it would”. This is Centralbankerspeak for: “there was a 0.07% decline in real GDP in September and real GDP growth in August was so feeble that real GDP per capita peaked in July 2018 based on current data, which is unlikely to change with the October update.” Nevertheless, Poloz, little given to forward guidance, was still ready to say that the Bank of Canada was on a path to a neutral policy interest rate, somewhere between 2½% and 3½%. Even the lower bound of the range would imply three more hikes are coming, if he keeps each hike to 25 basis points. Poloz also noted that Canada would typically import 60% to 70% of any rise in global bond yields. So mortgage rates will likely rise in early 2019 if Powell hikes interest rates, even if Poloz, breaking ranks, refuses to follow.

    • Hi Andrew and thank you

      You are right that I was implicitly saying that Canada is linked to US interest-rates which is both usually true in practice and unfair. The Bank of Canada does make its own decisions and so yes it has moved towards normal, so apologies. As to its unchanged decision yesterday well it might now be considered ahead of the game.

      “Fed officials are considering whether to signal in December a new wait-and-see approach that could slow the pace of rate increases next year” ( WSJ)

      Of course we have seen plenty of flawed Forward Guidance before so let’s see….

  5. Shaun, Its a very valid observation of yours. It is like the whole market evolution has become compressed. The trump boom and upward trajectory has quickly turned as a wide range of economic indicators suggest a turn down across the board and as the long forecasted downturn for 2020 jumps forward into 2019. Jay has had to eat his schedule as he acts to recover toppling assets. As someone here suggests, turning Japanese seems to be the only pre-existing model we have to follow. I work for NTT so I am well placed to benefit from their successful approach.

    Expect voracious schools of whales floundering across all the markets as CB’s seek to prop it all up. We will even get our own UK Brexit Blue Whale, finally Carney’s economic forecasting calls it right (by accident).

    Maybe you can do a blog on how to do whale spotting, what signals they give, how to spot them under the water/market…. 😉

    • Hi Paul C

      Well with another burst of QE we could see a Bank of England Blue Whale as there aren’t that many “free” Gilts around these days especially as we are issuing less. Also it may already be a Blue Whale in the corporate bond market. But a few more days like today in the FTSE and perhaps Carney will become an equity market market albeit one who only buys….

      • We are in the twilight zone as far as economic theory. I think that’s one of the reasons behind the poor productivity (people are waking up to the fact that no matter how hard they work they will never have enough for the good life, so why bother)

        I can see this more and more with the millennials, more and more of them are switching off and not playing the game anymore and tbh I don’t blame them

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