What and indeed where next for bond markets?

The credit crunch era has brought bond markets towards the centre stage of economics and finance. Before then there were rare expressions of interest in either a crisis or if the media wanted to film a response to an economic data release. You see equities trade rarely but bonds a lot so they filmed us instead and claimed we were equities trades so sorry for my part in any deception! Where things changed was when central banks released that lowering short-term interest-rates ( Bank Rate in the UK) was not the only game in town and that it was not having the effect that they hoped and planned. Also the Ivory Towers style assumption that short-term interest-rates move long-term ones went the way of so many of their assumptions straight to the recycling bin.

QE

It is easy to forget now what a big deal this was as the Federal Reserve and the Bank of England joined the Bank of Japan in buying government bonds or Quantitative Easing ( QE). There is a familiar factor in that what was supposed to be a temporary measure has now become a permanent feature of the economic landscape. As for example the holdings of the Bank of England stretch to 2068 with no current plan to reverse any of it and instead keeping the total at £435 billion by reinvesting maturities. Indeed on Friday it released this on social media.

Should quantitative easing become part of the conventional monetary policy toolkit?

The Author Richard Harrison may be in line for promotion after this.

Though the model does not support the idea that central banks should maintain permanently large balance sheets, it does suggest that we may see more quantitative easing in the future.

So here is a change for bond markets which is that QE will be permanent as so far there has been little or no interest in unwinding it. Even the US Federal Reserve which to be fair is doing some unwinding is doing so with baby steps or the complete opposite of the way it charged in to increase QE.

Along the way other central banks joined in most noticeably the European Central Bank. It had previously indulged in some QE via its purchases of Southern European bonds and covered ( bank mortgage) bonds but of course it then went into the major game. In spite of the fact that the Euro area economy is having a rather good 2017 it is still at it to the order of 60 billion Euros a month albeit that halves next year. So we are a long way away from it stopping let alone reversing. If we look at one of the countries dragged along by the Euro into the QE adventure we see that even annual economic growth of 3.1% does not seem to be enough for a change of course. From Reuters.

Riksbank’s Ohlsson: Too Early To Make MonPol Less Expansionary

If 3.1% economic growth is “too early” then the clear and present danger is that Sweden goes into the next downturn with QE ongoing ( and maybe negative interest-rates too). One consequence that seems likely is that they will run out of bonds to buy as not everyone wants to sell to the central bank.

Whilst we may think that QE is in modern parlance “like so over” in fact on a net basis it is still growing and only last month a new player came with its glass to the punch bowl.

In addition, the Magyar Nemzeti Bank will launch a targeted programme aimed at purchasing mortgage bonds with maturities of three years or more. Both programmes will also contribute to an increase in the share of loans with long periods of interest rate fixation.

Okay so Hungary is in the club albeit via mortgage bond purchases which can be a sort of win double for central banks as it boosts “the precious” ( banks) and via yield substitution implicitly boosts the government bond market too. But we learn something by looking at the economic situation according to the MNB.

The Hungarian economy grew by 3.6 percent in the third quarter of 2017…….The Monetary Council expects annual economic growth of 3.6 percent in 2017 and stable growth of between 3-4 percent over the coming years. The Bank’s and the Government’s stimulating measures contribute substantially to economic growth.

We are now seeing procyclical policy where economies are stimulated by monetary policy in a boom. In particular central banks continue with very large balance sheets full of government and other bonds and in net terms they are still buyers.

The bond vigilantes

They have been beaten back and as we observe the situation above we see why. Many of the scenarios where they are in play and bond yields rise substantially have been taken away for now at least by the central banks. There can be rises in bond yields in individual countries as we see for example in the Turkish crisis or Venezuela but the scale of the crisis needs to be larger and these days countries are picked off individually rather than collectively.

At the moment there are grounds for the bond yield rises to be in play in the Euro area with growth solid but of course the ECB is in play and in fact yesterday brought news of exactly the reverse.

 

A flat yield curve?

The consequence of central banks continuing with what the Bank of Japan calls “yield curve control” has led to comments like this. From the Financial Times yesterday.

Selling of shorter-dated Treasuries pushed the US yield curve to its flattest level since 2007 on Tuesday. The difference between the yields on two-year Treasury notes and 10-year Treasury bonds dropped below 55 basis points in afternoon trading in New York. While the 10-year Treasury was little changed, prices of two-year notes fell for the second consecutive day. The two-year Treasury yield, which moves inversely to the note’s price, has climbed 64 basis points this year to 1.83 per cent.

If we look long the yield curve the numbers are getting more and more similar ironically taking us back to the “one interest-rate” idea the central banks and Ivory Towers came into the credit crunch with. With the US 2 year yield at 1.8% and the 30 year at 2.71% there is not much of a gap.

Why does something which may seem arcane matter? Well the FT explains and the emphasis is mine.

It marks a pronounced “flattening” of the yield curve, with investors receiving decreasing returns for holding longer-dated bonds compared to shorter-dated notes — typically a harbinger of economic recession.

Comment

We have seen phases of falls in bond prices and rises in yield. For example the election of President Trump was one. But once they pass we are left wondering if the around thirty year trend for lower bond yields is still in play and we are heading for 0% ( ZIRP) or the icy cold waters of negativity ( NIRP)? On that road the idea that the current yield curve shape points to a recession gets kicked into touch as Goodhart’s Law or if you prefer the Lucas Critique comes into play. But things are now so mixed up that a recession might actually be on its way after all we are due one.

For yields to rise again on any meaningful scale there will have to be some form of calamity for the central banks. This is because QE is like a drug for so many areas. One clear one is the automotive sector I looked at yesterday but governments are addicted to paying low yields as are those with mortgages. On that road they cannot let go until they are forced to. Thus the low bond yields we see right now are a short-term success which central banks can claim but set us on the road to a type of junkie culture long-term failure. Or in my country this being proclaimed as success.

“Since 1995 the value of land has increased more than fivefold, making it our most valuable asset. At £5 trillion, it accounts for just over half of the total net worth of the UK at end-2016. At over £800 billion, the rise in the nation’s total net worth is the largest annual increase on record.”

Of course this is merely triumphalism for higher house prices in another form. As ever those without are excluded from the party.

 

 

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What is austerity and how much of it have we seen?

The subject of austerity is something which has accompanied the lifespan of this blog so 7 years now. The cause of its rise to prominence was of course the onset of the credit crunch which led to higher fiscal deficits and then national debts via two routes. The first was the economic recession ( for example in the UK GDP fell by approximately 6% as an initial response) leading to a fall in tax revenue and a rise in social security payments. The next factor was the banking bailouts which added to national debts of which the extreme case was Ireland where the national debt to GDP ratio rose from as low as 24% in 2006 to 120% in 2012.  It was a rarely challenged feature of the time that the banks had to be bailed out as they were treated like “the precious” in the Lord of the Rings and there was no Frodo to throw them into the fires of Mount Doom.

It was considered that there had to be a change in economic policy in response to the weaker economic situation and higher public-sector deficits and debts. This was supported on the theoretical side by this summarised by the LSE.

The Reinhart-Rogoff research is best known for its result that, across a broad range of countries and historical periods, economic growth declines dramatically when a country’s level of public debt exceeds 90% of gross domestic product……… they report that average (i.e. the mean figure in formal statistical terms) annual GDP growth ranges between about 3% and 4% when the ratio of public debt to GDP is below 90%. But they claimed that average growth collapses to -0.1% when the ratio rises above a 90% threshold.

The work of Reinhart and Rogoff was later pulled apart due to mistakes in it but by then it was too late to initial policy. It was also apparently too late to reverse the perception amongst some that Kenneth Rogoff who these days spend much of his time trying to get cash money banned is a genius. That moniker seems to have arrived via telling the establishment what it wants to hear.

The current situation

The UK Shadow Chancellor John McDonnell wrote an op-ed in the Financial Times ahead of Wednesday’s UK Budget stating this.

The chancellor should use this moment to lift his sights, address the immediate crisis in Britain’s public services that his party created, and change course from the past seven disastrous years of austerity.

If we ignore the politics the issue of austerity is in the headlines again but what it is has changed over time. Before I move on it seems that both our Chancellor who seemed to think there were no unemployed at one point over the weekend and the Shadow Chancellor was seems to be unaware the UK economy has been growing for around 5 years seem equally out of touch.

Original Austerity

This involved cutting back government expenditure and raising taxation to reduce the fiscal deficits which has risen for the reasons explained earlier. Furthermore it was claimed that such policies would stop rises in the national debt and in some extreme examples reduce it. The extreme hardcore example of this was the Euro area austerity imposed on Greece as summarised in May 2010 by the IMF.

First, the government’s finances must be sustainable. That requires reducing the fiscal deficit and placing the debt-to-GDP ratio on a downward trajectory……With the budget deficit at 13.6 percent of GDP and public debt at 115 percent in 2009, adjustment is a matter of extreme urgency to avoid the debt spiraling further out of control.

A savage version of austerity was begun which frankly looked more like a punishment beating than an economic policy.

The authorities have already begun fiscal consolidation equivalent to 5 percent of GDP.

But the Managing Director of the IMF Dominique Strauss-Khan was apparently confident that austerity in this form would lead to economic growth.

we are confident that the economy will emerge more dynamic and robust from this crisis—and able to deliver the growth, jobs and prosperity that the country needs for the future.

Maybe one day it will but so far there has been very little recovery from the economic depression inflicted on Greece by the policy prescription. This has meant that the national debt to GDP ratio has risen to 175% in spite of the fact that there was the “PSI” partial default in 2012. It is hard to think of a clearer case of an economic policy disaster than this form of disaster as for example my suggestion that you needed  a currency devaluation to kick-start growth in such a situation was ignored.

A gentler variation

This came from the UK where the coalition government announced this in the summer of 2010.

a policy decision to reduce total spending by an additional £32 billion a year by 2014-15, including debt interest savings;

In addition there were tax rises of which the headline was the rise in the expenditure tax VAT from 17.5% to 20%. These were supposed to lead to this.

Public sector net borrowing falls from 11.0 per cent of GDP in 2009-10 to 1.1 per cent in 2015-16. Public sector net debt is forecast to rise to a peak of 70.3 per cent of GDP in 2013-14, before falling to 67.4 per cent in 2015-16.

As Fleetwood Mac would put it “Oh Well”. In fact the deficit was 3.8% of GDP in the year in question and the national debt continued to rise to 83.8% of GDP. So we have a mixed scorecard where the idea of a surplus was a mirage but the deficit did fall but not fast enough to prevent the national debt from rising. Much of the positive news though comes from the fact that the UK economy began a period of sustained economic growth in 2012.

Economic growth

We have already seen the impact of economic growth via having some (  UK) and seeing none and indeed continued contractions ( Greece). But the classic case of the impact of it on the public finances is Ireland where the national debt to GDP ratio os now reported as being 72.8%.

Sadly the Irish figures rely on you believing that nominal GDP rose by 68 billion Euros or 36.8% in 2015 which frankly brings the numbers into disrepute.

Comment

The textbook definitions of austerity used to involved bringing public sector deficits into surplus and cutting the national debt. These days this has been watered down and may for example involve reducing expenditure as a percentage of the economy which may mean it still grows as long as the economy grows faster! The FT defines it thus.

Austerity measures refer to official actions taken by the government, during a period of adverse economic conditions, to reduce its budget deficit using a combination of spending cuts or tax rises.

So are we always in “adverse economic conditions” in the UK now? After all we still have austerity after 5 years of official economic growth.

What we have discovered is that expenditure cuts are hard to achieve and in fact have often been transfers. For example benefits have been squeezed but the basic state pension has benefited from the triple lock. Also if last years shambles over National Insurance is any guide we are finding it increasingly hard to raise taxes. Not impossible as Stamp Duty receipts have surged for example but they may well be eroded on Wednesday.

Also something unexpected, indeed for governments “something wonderful” happened which was the general reduction in the cost of debt via lower bond yields. Some of that was a result of long-term planning as the rise of “independent” central banks allowed them to indulge in bond buying on an extraordinary scale and some as Prince would say is a Sign O’The Times. As we stand the new lower bond yield environment has shifted the goal posts to some extent in my opinion. The only issue is whether we will take advantage of it or blow it? Also if we had the bond yields we might have expected with the current situation would public finances have improved much?

Meanwhile let me wonder if a subsection of austerity was always a bad idea? This is from DW in August.

Germany’s federal budget  surplus hit a record 18.3 billion euros ($21.6 billion) for the first half of 2017.

With its role in the Euro area should a country with its trade surpluses be aiming at a fiscal surplus too or should it be more expansionary to help reduce both and thus help others?

 

 

Why have the bond markets lost their bark and their vigilantes?

The credit crunch era took us on quite a journey in terms of interest-rates. At first central banks reduced official short-term interest-rates in the hope that they would fix the problem. Then they embarked on Quantitative Easing policies which were designed to reduce long-term interest-rates or bond yields. This was because quite a few important interest-rates are not especially dependent on official interest-rates and may from time to time even move in the opposite direction. An example is fixed-rate mortgages. However if they are a “cure” then one day all the downwards manipulation of interest-rates and yields needs to stop. Of course the fact that it is still going on all these years later poses its own issues.

The United States looked as though it was heading on that road last year on two counts. Firstly the Federal Reserve was in a program to raise interest-rates and secondly both Presidential candidates indicated plans for a fiscal stimulus. When Donald Trump was elected as President he reinforced this by telling us this as I reported back on November 9th.

We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We’re going to rebuild our infrastructure, which will become, by the way, second to none, and we will put millions of our people to work as we rebuild it.

This was somewhat reminiscent of the “New Deal” of President F.D. Roosevelt although I counselled caution at the time and of course any fiscal expansion would be added to by the plan for tax cuts. The two impacted on bond markets as shown below.

There has been a clear market adjustment to this which is that the 30 year ( long bond) yield has risen by 0.12% to 2.75%.

In the US this tends to have a direct impact on fixed mortgage-rates as many places quote a 30 year one.

What happened next?

US bond yields did rise and in mid March the 10 year Treasury Note yield rose to 2.63% meaning that it was approaching the long bond yield quoted above. Meanwhile the long bond yield rose to 3.21%. However as we look back now those were twin peaks and have been replaced by 2.07% and 2.69% respectively.

Why might this be?

Whilst there does seem to be some sort of concrete plan for tax cuts there is little sign of much concrete around any infrastructure spending. So that has drifted away and there has been an element of this with official interest-rate rises. The US Federal Reserve has raised them to a range between 1% and 1.25% but seems to be in no hurry to raise them further. It does plan to reduce its balance sheet but the plan is very small compared to its size.

The Recovery

The US economy has continued to grow in 2017 as shown below.

Real gross domestic product (GDP) increased at an annual rate of 3.0 percent in the second quarter of 2017 (table 1), according to the “second” estimate released by the Bureau of Economic Analysis. In the first quarter, real GDP increased 1.2 percent. ( These are annualised figures )

This has not been enough to unsettle bond markets especially if we add in that so far in 2017 inflation has if anything faded. Here are the latest numbers from NASDAQ.

Excluding food prices and fuel, core PCE measure – the Fed’s preferred measure of inflation – increased 1.4% in July year over year compared with 1.5% in June. However, it edged up 0.1% in July on a monthly basis. Therefore, it is still far from the Fed’s target of 2%.

For once it does not matter if you use a core inflation measure as it comes to the same answer as the headline! Although the annual rate has only fallen by 0.2% for the core measure since March as opposed to 0.4% for the headline. But we are left with okay growth and fading inflation which gives us a reason why bond markets have rallied and yields fallen.

What about wages?

The various output gap style theories that falling and indeed low unemployment rates would push wage and in particular real wage growth higher have not come to fruition. From the Bureau of Labor Statistics.

From July 2016 to July 2017, real average hourly earnings increased 0.8 percent, seasonally adjusted. The increase in real average hourly earnings combined with no change in the average workweek resulted in a 0.7-percent increase in real average weekly earnings over this period.

Japan

If we stay with the subject of wages here is today’s data from Japan. From the Financial Times.

 

Unadjusted labour cash earnings fell 0.3 per cent year on year in July, down from a 0.4 per cent increase a month earlier, according to a preliminary estimate by the Ministry of Health, Labour and Welfare…….Special cash earnings, which includes bonuses, were down 2.2 per cent on the same month a year ago.

If we widen our discussion geographically and look at the US where there is some wage growth we see that in other places there is not as real wages in Japan fell by 0.8%. If we stay with Japan for a moment then we see that in spite of the media proclamations over the past 4 years that wages are about to turn upwards we are still waiting. Bonuses were supposed to surge this summer. So the “output gap” continues to fail and there is little pressure on bond yields from wage growth in Japan.

QE

This of course continues in quite a few places. In terms of the headline players we have the 60 billion Euros a month of the European Central Bank and the yield curve control of the Bank of Japan which it expects to be around 80 trillion Yen a year. I raise these points as a bond yield rally in these areas would require these to be substantially reduced or stopped. We expect little substantive change from the ECB until the election season is over but some were expecting a reduction from it as the Euro area economy improved. As time passes it will have to make some changes as its rules suggest it will run out of German bonds to buy next spring and the more it shuffles to avoid that the more likely it will run out of bonds to buy in France, Spain and even Italy.

Added to this are the sovereign wealth funds as for example Norway which seems to be rebalancing in favour of US Euro and UK bonds. There are also the investment plans of the Swiss National Bank.

Comment

So we see a dog that has little bark and has not bitten. Some of this is really good news as unlike the central banker cartel I am pleased that so far inflation has for them disappointed. Although as we look ahead there may be issues from some commodity prices. From Mining.com

December copper futures trading on the Comex market in New York made fresh highs on Tuesday after the world’s number one producer of the metal reported a sharp drop in production.
Copper touched $3.1785 a pound ($7,007 per tonne) in morning trade, the highest since September 2014. Copper is now up by more than 50% compared to this time last year.

So Dr,Copper may be giving us a hint although I also note that hedge funds are getting involved so this may be a “financialisation” move as opposed to a real one.

Another factor which would change things would be some real wage growth. Perhaps along the lines of this released by the German statistics office last week.

The collectively agreed earnings, as measured by the index of agreed monthly earnings including extra payments, increased by an average 3.8% in the second quarter of 2017 compared with the same quarter of the previous year. This is the highest rise since the beginning of the time series in 2011. The Federal Statistical Office (Destatis) also reports that, excluding extra payments, the year-on-year increase in the second quarter of 2017 was 3.4%.

If we move to my home country then it remains hard to believe with our penchant for inflation we have a ten-year Gilt yield of 1.01% as I type this. Even worse a five-year Gilt yield of 0.43% as you will lose the total yield in inflation this year alone. I can see how a “punter” might buy at times front-running events or the Bank of England but how can it be an investment unless you expect quite an economic depression?

 

 

 

Will rising bond yields mean ECB QE is To Infinity! And Beyond!?

Yesterday the ECB ( European Central Bank ) President Mario Draghi spoke at the European Parliament and in his speech were some curious and intriguing phrases.

Our current monetary policy stance foresees that, if the inflation outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, the Governing Council is prepared to increase the asset purchase programme in terms of size and/or duration.

I say that bit was curious because it contrasted with the other rhetoric in the speech as we were told how well things are going.

Over the last two years GDP per capita has increased by 3% in the euro area, which compares well with other major advanced economies. Economic sentiment is at its highest level in five years. Unemployment has fallen to 9.6%, its lowest level since May 2009. And the ratio of public debt to GDP is declining for the second consecutive year.

The talk of what I would call “More,More,More” is also a contrast to the December policy decision which went down the road of less or more specifically slower.

We will continue to purchase assets at a monthly pace of €80 billion until March. Starting from April, our net asset purchases will run at a monthly pace of €60 billion, and we will reinvest the securities purchased earlier under our programme, as they mature. This will add to our monthly net purchases.

There was another swerve from Mario Draghi who had written to a couple of MEPs telling them that a country leaving the Euro would have to settle their Target 2 balances ( I analysed this on the  23rd of January ) whereas now we were told this.

L’euro e’ irrevocabile, the euro is irrevocable

Of course Italian is his natural language bur perhaps also there was a message to his home country which has seen the rise of political parties who are against Euro membership.

Such words do have impacts on bond markets and yields but I was particularly interested in this bit. From @macrocredit.

DRAGHI SAYS ECB POLICY DOESN’T TARGET BOND SPREADS

A rather curious observation from someone who is effectively doing just that and of course for an establishment which trumpeted the convergence of bond yield spreads back before the Euro area crisis. Just to be clear which is meant here is the gap between the bond yield of Germany and other nations such as Spain or Italy. These days Mario Draghi seems to be displaying all the consistency of Arsene Wenger.

Oh and rather like the Bank of England he seems to be preparing himself for a rise in inflation.

As I have argued before, our monetary policy strategy prescribes that we should not react to individual data points and short-lived increases in inflation.

Spanish energy consumers may not be so sanguine!

Growing divergence in bond yields

The reality has been that recently we have seen a growing divergence in Euro area bond yields. This has happened in spite of the fact that the ECB QE ( Quantitative Easing) bond buying program has continued. As of the latest update it has purchased some 1.34 trillion Euros of sovereign bonds as well as of course other types of bonds. Perhaps markets are already adjusting to the reduction in the rate of purchases planned to begin on April 1st.

France

Ch-ch-changes here are right at the core of the Euro project which is the Franco-German axis. If we look back to last autumn we see a ten-year yield which fell below 0.1% and now we see one of 1.12%. This has left it some 0.76% higher than its German equivalent.

Care is needed as these are still low levels but politicians get used to an annual windfall from ,lower bond yields and so any rise will be unwelcome. It is still true that up to the five-year maturity France can borrow at negative bond yields but it is also true that a chill wind of change seems to be blowing at the moment. The next funding auction will be much more painful than its predecessor and the number below suggests we may not have to wait too long for it.

The government borrowing requirement for 2017 is therefore forecast to reach €185.4bn.

Italy

Here in Mario’s home country the situation is more material as the ten-year yield has risen to 2.36% or 2% over that of Germany. This will be expensive for politicians in the same manner as for France except of course the yield is more expensive and as the Italian Treasury confirms below the larger national debt poses its own demands.

The redemptions over the coming year are just under 216 billion euros (excluding BOTs), or some 30 billion euros more than in 2016, including approximately 3.3 billion euros in relation to the international programme. At the same time, the redemptions of currently outstanding BOTs amount to just over 107 billion euros, which is below the comparable amount in 2016 (115 billion euros) as a result of the policy initiated some years ago to reduce the borrowing in this segment.

The Italian Treasury has also noted the trends we are discussing today.

As a result of these developments, the yield differentials between Italian government securities and similar securities from other core European countries (in particular, Germany) started to increase in September 2016……. the final two months of 2016 have been marked by a significant increase in interest rates in the bond market in the United States,

Although we are also told this

In Europe, the picture is very different.

Anyway those who have followed the many debacles in this particular area which have mostly involved Mario Draghi’s past employer Goldman Sachs will note this next bit with concern.

Again in 2017, the transactions in derivatives instruments will support active portfolio management, and they will be aimed at improving the portfolio performance in the current market environment.

Should problems emerge then let me place a marker down which is that the average maturity of 6.76 years is not the longest.

Portugal

Here the numbers are more severe as Portugal has a ten-year yield of 4.24% and of course it has a similar national debt to economic output ratio to Italy so it is an outlier on two fronts. It need to raise this in 2017.

The Republic has a gross issuance target of EUR 14 billion to EUR 16 billion through both auctions and syndications.

To be fair it started last month but do you see the catch?

The size was set at EUR 3 billion and the new OT 10-year benchmark was finally priced at 16:15 CET with a coupon of 4.125% and a re-offer yield of 4.227%.

That is expensive in these times of a bond market super boom. Portugal has now paid off some 44% of its borrowings from the IMF but it is coming with an increasingly expensive kicker. Maybe that is why the European establishment wanted the IMF involved in its next review of Portugal’s circumstances.

Also at just over five years the average maturity is relatively short which would mean any return of the bond vigilantes would soon have Portugal looking for outside help again.

As of December 31, 2016 the Portuguese State direct debt amounted to EUR 236,283 million, decreasing 0.5% vis-à-vis the end of the previous month ( 133.4% of GDP).

Comment

Bond markets will of course ebb and flow but recently we have seen an overall trend and this does pose questions for several countries in the Euro area in particular. The clear examples are Italy and Portugal but there are also concerns elsewhere such as in France. These forces take time but a brake will be applied to national budgets as debt costs rise after several years when politicians will have been quietly cheering ECB policies which have driven falls. Of course higher inflation will raise debt costs for nations such as Italy which have index-linked stocks as well.

If we step back we see how difficult it will be for the ECB to end its QE sovereign bond buying program and even harder to ever reverse the stock or portfolio of bonds it has bought so far. This returns me to the issues I raised on January 19th.

If we look at the overall picture we see that 2017 poses quite a few issues for central banks as they approach the stage which the brightest always feared. If you come off it will the economy go “cold turkey” or merely have some withdrawal systems? What if the future they have borrowed from emerges and is worse than otherwise?

Meanwhile with the ECB being under fire for currency manipulation ( in favour of Germany in particular) it is not clear to me that this from Benoit Coeure will help.

The ECB has no specific exchange rate target, but the single currency has adjusted as a consequence. Since its last peak in 2011, the euro has depreciated by almost 30% against the dollar. The euro is now at a level that is appropriate for the economic situation in Europe.

Rising bond yields are feeding into the real economy

Once upon a time most people saw central banks as organisations which raised interest-rates to slow inflation and/or an economy and cut them to have the reverse effect. Such simple times! Well for those who were not actually working in bond markets anyway. The credit crunch changed things in various ways firstly because we saw so many interest-rate cuts ( approximately 700 I believe now) but also because central bankers ran out of road. What I mean by that is the advent of ZIRP or near 0% interest-rates was not enough for some who plunged into the icy cold waters of negative interest-rates. This has posed all sorts of problems of which one is credibility as for example Bank of England Governor Mark Carney told us the “lower bound” for UK Bank Rate was 0.5% then later cut to 0.25%!

If all that had worked we would not be where we are and we would not have seen central banks singing along with Huey Lewis and the News.

I want a new drug
One that won’t make me sick
One that won’t make me crash my car
Or make me feel three feet thick

This of course was QE (Quantitative Easing) style policies which became increasingly the policy option of choice for central banks because of a change. This is because the official interest-rate is a short-term one usually for overnight interest-rates so 24 hours if you like. As central banks mostly now meet 8 times a year you can consider it lasts for a month and a bit but in the interest-rate environment that changes little as you see there are a whole world of interest-rates unaffected by that. Pre credit crunch they mostly but not always moved with the official rate afterwards the effect faded. So central banks moved to affect them more directly as lowering longer-term interest-rates reduces the price of fixed-rate mortgages and business loans or at least it should. Also much less badged by central bankers buying sovereign bonds to do so makes government borrowing cheaper and therefore makes the “independent” central bank rather popular with politicians.

That was then and this is now

Whilst there is still a lot of QE going on we are seeing ch-ch-changes even in official policy as for example from the US Federal Reserve which has raised interest-rates twice and this morning this from China.

Chinese press reports that the PBoC have raised interest rate on one-year MLF loans by 10bps to 3.1% ( @SigmaSqwauk)

The Chinese bond market future fell a point to below 96 on the news which raised a wry smile at a bond market future below 100 ( which used to be very common) but indicated higher bond yields. These are becoming more common albeit with ebbs and flows and are on that road because of the return of inflation. So many countries got a reminder of this in December as we have noted as there were pick-ups in the level of annual inflation and projecting that forwards leaves current yields looking a bit less than thin. Or to put it another way all the central bank bond-buying has created a false market for sovereign and in other cases corporate bonds.

The UK

Back on the 14th of June last year I expressed my fears for the UK Gilt market.

There is much to consider as we note that inflation expectations and bond yields are two trains running in opposite directions on the same track.

In the meantime we have had the EU leave vote and an extra £60 billion of Bank of England QE of which we will see some £1 billion this afternoon. This drove the ten-year Gilt yield to near 0.5%. Hooray for the “Sledgehammer” of Andy Haldane and Mark Carney? Er no because in chart terms they have left UK taxpayers on an island that now looks far away as markets have concentrated more on thoughts like this one from the 14th of October last year.

Now if we add to this the extra 1.5% of annual inflation I expect as the impact of the lower UK Pound £ then even the new higher yields look rather crackpot.

In spite of the “Sledgehammer” which was designed by Bank of England lifer Andy Haldane the UK ten-year Gilt yield is at 1.44% so higher than it was before the EU leave vote whilst his ammunition locker is nearly empty. So he has driven the UK Gilt market like the Duke of York used to drill his men. I do hope he will be pressed on the economic effects of this and in the real world please not on his Ivory Tower spreadsheet.

The Grand old Duke of York he had ten thousand men
He marched them up to the top of the hill
And he marched them down again.
When they were up, they were up
And when they were down, they were down
And when they were only halfway up
They were neither up nor down.

If you look at inflation trends the Gilt yield remains too low. Oh and do not forget the £20 billion added to the National Debt  by the Term Funding Scheme of the Bank of England.

Euro area

In spite of all the efforts of Mario Draghi and his bond-buyers we have seen rising yields here too and falling prices. Even the perceived safe-haven of German bonds is feeling the winds of change.

in danger of taking out Dec spike highs in yield of 0.456% (10yr cash) ( @MontyLaw)

We of course gain some perspective but noting that even after price falls the yield feared is only 0.456%! However it is higher and as we look elsewhere in the Euro area we do start to see yield levels which are becoming material. Maybe not yet in Italy where the ten-year yield has risen to 2.06% but the 4% of Portugal will be a continuous itch for a country with such a high national debt to GDP (Gross Domestic Product) ratio. It has been around 4% for a while now which is an issue as these things take time to impact and I note this which is odd for a country that the IMF is supposed to have left.

WILL PARTICIPATE IN EUROGROUP DISCUSSION ON – BBG ( h/t @C_Barraud)

 

The US

The election of President Trump had an immediate effect on the US bond market as I pointed out at the time.

There has been a clear market adjustment to this which is that the 30 year ( long bond) yield has risen by 0.12% to 2.75%.

 

As I type this we get a clear idea of the trend this has been in play overall by noting that the long bond yield is now 3.06%.  We can now shift to an economic effect of this by noting that the US 30 year mortgage-rate is now 4.06% and has been rising since late September when in dipped into the low 3.3s%. So there will be a contractionary economic effect via higher mortgage and remortgage costs. There will be others too but this is the clearest cause and effect link and will be seen in other places around the world.

Japan

Here we have a slightly different situation as the Bank of Japan has promised to keep the ten-year yield around 0% so you can take today’s 0.07% as either success or failure. In general bond yields have nudged higher but the truth is that the Bank of Japan so dominates this market it is hard to say what it tells us apart from what The Tokyo Whale wants it too. Also the inflation situation is different as Japan remains at around 0%.

Comment

We find ourselves observing a changing landscape. Whilst not quite a return of the bond vigilantes the band does strike up an occasional tune. When it plays it is mostly humming along to the return of consumer inflation which of course has mostly be driven by the end of the fall in the crude oil price and indeed its rebound. What that has done is made inflation adjusted or real yields look very negative indeed. Whilst Ivory Tower spreadsheets may smile the problem is finding investors willing to buy this as we see markets at the wrong price and yield. Unless central banks are willing to buy bond markets in their entirety then yields will ebb and flow but the trend seems set to be higher and in some cases much higher. For example German bunds have “safe-haven” status but how does a yield of 0.44% for a ten-year bond go with a central bank expecting inflation to go above 2% as the Bundesbank informed us earlier this week?

The economic effects of this will be felt in mortgage,business and other borrowing rates. This will include governments many of whom have got used to cheap and indeed ultra-cheap credit.

 

 

 

Is this the revenge of the bond vigilantes?

The latter part of 2016 has seen quite a change in the state of play in bond markets. If we look at my own country the UK we only have to look back to the middle of August to see a situation where the UK Gilt market surged to an all-time high. This was driven by what was called a “Sledgehammer” of monetary easing according to the Bank of England Chief Economist Andy Haldane.  This comprised not only £60 billion of Gilt purchases and £10 billion of corporate bond purchases but also promises of “more,more,more” later in the year. Not only was this a time of bond market highs it was also a time of what so far at least has been “peak QE” as central planners like our Andy flexed both their muscles (funded of course by a combination of the ability to create money and taxpayer backing) and their rhetoric.

However those who pushed the UK Gilt market to new highs following the Bank of England now face large losses as you see it has fallen heavily since. The ten-year Gilt yield which fell to 0.5% is now 1.5% as the Bank of England’s Forward Guidance looks ever more like General Custer at Little Big Horn with bond vigilantes replacing the Red Indians. Let me switch into price terms which will give you a clearer idea of the scale of what has taken place. There are always issues with any such measure but the UK Gilt which matures in 2030 can be considered as an average. Fresh with his central planning mandate Mark Carney paid 152.7 for it back in mid-August but last week he got a relative bargain at 138 and if today’s prices hold will be paying much less later this week.

This of course means that the Bank of England has made fairly solid losses on this round of QE as we wonder if that is the “Sledgehammer” referred to. So will anyone else who bought with them and I raise this as some may have been forced to buy in a type of “stop-loss” situation as we wait to see if the pain became too much for some pension funds and insurance companies. Such a situation would be a complete failure as we recall central banks are supposed to supervise and maintain free and fair markets which awkwardly involves stopping the very price and yield manipulation that QE relies on.

As we stand the overall Bank of England QE operation will be in profit but of course that has been partly driven by the new round of it! Anyway here is a picture of the Sledgehammer as it currently stands.

What has driven this?

The UK may well have been at least partially a driving force on the world scene in mid-summer but of course the recent player has been the Trump Truck on its journey to the White House. I recall pointing out on here on November 9th that this part of his acceptance speech meant that a new fiscal policy seemed on its way.

We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals.

It had an immediate impact.

There has been a clear market adjustment to this which is that the 30 year ( long bond) yield has risen by 0.12% to 2.75%.

We have of course more perspective now and this morning that yield has nudged 3.2%. Of course there is ebb and flow but also we have seen a clear trend.

Crude Oil

This has also been a player via its impact on expectations for inflation. This morning the announced deal between OPEC and non-OPEC countries saw the price of a barrel of Brent Crude Oil rising 5% to around US $57 per barrel. This compares to the recent nadir of around US $42 in early August. There are of course differences in taxation and so on but roughly I would expect this to raise annual consumer inflation by around 0.5%. This time around the effect seems set to be larger as we have so far replaced the price falls of the latter part of 2015 with rises in 2016. Of course the oil price will change between now and the end of 2016 but this gives an idea of the impact as we stand.

There has also been a general shift higher in commodities prices or to be more specific a surge in metals prices which has only partially been offset by the others. The CRB (Commodity Research Bureau) Index opened 2016 in the low 370s and is now 427.

US Federal Reserve

This has had an influence as well. It contributed to the bond market rally by the way its promises of “3-5” interest-rate rises were replaced by a reality of none so far. Now we face the prospect of this Wednesday’s  meeting thinking that they probably have to do one now to retain any credibility at all. Back on November 9th I wondered if they would and there are still grounds for that as we look at Trump inspired uncertainty and higher bond yields and US Dollar strength. However on the other side of the idea I note that @NicTrades suggesting they could perhaps do 0.5% this week. Far too logical I think!

But as we look back at nearly all of 2016 how much worse could the Forward Guidance of the US Federal Reserve have been?

The Ultras

No not the Italian football hooligans as I am thinking here of the trend that involved countries issuing ever longer dated debt. If we stay with Italy though Mark Jasayoko had some thoughts yesterday on Twitter.

Italy‘s 50year bond issued on Oct 5 is down 11.33% since. = 4yrs of coupons Dear bond bulls, enjoy holding on for the next half century.

Oh Well as Fleetwood Mac would say. There was also Austria with its 70 year bond which pretty much immediately fell and I note that this morning reports of a yield rise approaching 0.1%.  Those who gambled on the ECB coming to the rescue are left with the reality that such long-dated bonds are currently excluded from its QE. As for the 100 year bond issued by Ireland in March the price may well have halved since then.

Perhaps the outer limit of this can be found in Mexico which issued a 100 year Euro denominated bond in March 2015. Of course not even Donald Trump can put a wall around a bond but it puts a chill up your spine none the less.

As we look at the whole environment we see that taxpayers have done well here or more likely governments who will spend the “gains” and investors will have lost. Should the wild swings lead to casualties and bailouts the taxpayer picture will get more complex.

Comment

So we have seen a sort of revenge of the bond vigilantes although care is needed as a few months hardly replaces a bear market which in trend terms has lasted for around 3 decades. However there is a real economy effect here and let me highlight it from the United States.

Interest rates on U.S. fixed-rate mortgages rose to their highest levels in more than two years……..The Washington-based industry group said 30-year fixed-rate conforming mortgages averaged 4.27 percent, the highest level since October 2014……..The spike in 30-year mortgage rates, which have risen about 0.50 percentage point since the Nov. 8 election, has reduced refinancing activity.

That effect will be seen in many other countries and we will also see the cost of business loans rise. Also over time governments which have of course got used to ever cheaper borrowing seem set to find that the tie which was forever being loosened is now being tightened. How is the fiscal expansionism recommended by establishment bodies such as the IMF looking now?

 

 

The ECB drives Euro area short-dated yields even more negative

The recent trend for world bond yields has been for them to rise. This has been particularly evident at the longer maturities. The clearest example of this comes from the US Long Bond or thirty-year yield which spent late summer around 2.3% and is now 3%. There was a rise before the advent of President-Elect Trump which accelerated quickly afterwards. We will never know now what effect a President- Elect Clinton would have had but I suspect it would have been similar. As to the pre-Trump rise in US bond yields this was mostly driven by hints and promises or what is called Forward Guidance from the US Federal Reserve about a second interest-rate rise. Although of course it has been hinting that for all of 2016 so far without delivering it yet.

The international context

This new trend has had effects in places like Portugal where the ten-year yield is 3.6% and Italy where it is 2.1%. This is of course nothing like the levels seen at the peak of the Euro area crisis but there are two points to note. Firstly government’s tend to spend the gains from lower bond yields ( as the gains are not widely understood politicians can take the credit for their largesse) meaning any reversal can create fiscal issues. Secondly the ECB is of course buying considerable numbers of these bonds as it purchases around a billion Euros of Portuguese government bonds and 13 billion Euros of Italian government bonds each month. So we see a rise in spite of all this buying.

A similar situation has arisen in the UK where the “sledgehammer” QE bond buying of Chief Economist Andy Haldane has been swept aside in yield terms by the recent moves. So far an extra £38 billion of Gilts purchases have been made but whilst the ten-year yield is now at 1.37% below the level at which this started it is not be much and this particular phase is underwater overall. Some of the purchases are well underwater in price terms. Perhaps this is why Bank of England Governor seems to be finding the time to do this according to the Financial Times.

Mark Carney has urged the government to seek transitional arrangements with the 27 remaining members of the EU as it negotiates Brexit in an attempt to smooth the path of leaving the EU for companies and for financial stability.

I guess anything is better than discussing why he eased monetary policy into a currency decline and economic growth which one of his colleagues ( Kristin Forbes) admitted is faster than last year’s! I guess some will also be mulling how Mark Carney rejects politicians interfering in his work yet seems happy to interfere in theirs. I wonder how he would define independence. Still if monetary policy gets any worse I guess we can expect more speeches on climate change.

This higher yield trend has also seen some bond yields depart the negative zone. For example the ten-year bund yield of Germany has risen to the not so giddy heights of 0.22% pulling other Euro area yields out of negative territory as well. Even Japan has seen its ten-year yield nudge above zero albeit marginally and ended at 0.016% today. This is a bit awkward for the Bank of Japan as yields have risen in spite of its rhetoric about “unlimited purchases” as I discussed only last Monday.

A problem for the ECB

This arises at the shorter maturities and is especially evident in Germany. As you review the chart below please remind yourselves that under its rules the ECB QE bond buying cannot buy at yields below its own deposit rate which is currently -0.4%.

This is what are called Schatz bonds in Germany and they have pulled prices on other Euro area bonds higher and yields lower as well. For example the two-years in both Belgium and France yield -0.68%. Perhaps the Italian two-year is a clearer example because in spite of the risks around the upcoming referendum the yield is a mere 0.22%. There was a time yields shot higher in response to such risks!

A Technical Issue

The essential problem here comes from something I have pointed out before which is that central bank bond buying tends to freeze up bond markets. Of course it also destroys the price discovery mechanism but volumes and liquidity dry up. This was quite noticeable in the early days of the Greek crisis where buying by the Securities Markets Programme saw volumes drop to a tenth of what they were. That remains an issue which has recurred in Japan but the current phase is being driven by the repo market. Reuters looked at this last Wednesday.

The European Central Bank is looking for ways to lend out more of its huge pile of government debt to avert a freeze in the 5.5 trillion-euro short-term funding market that underpins the financial system, central bank sources told Reuters.

Why should it care about this?

it has taken away the key ingredient for repurchase agreements, or repos, whereby financial firms lend to each other against collateral, typically high-rated government bonds such as Germany’s.

So it has inadvertently damaged the “precious” which is the banking system. Also it has shot itself in the foot as regards its own objectives.

Repo is used by investment funds to finance trading and is regarded by the ECB as a key avenue to transmit its own monetary stimulus to the economy.

A freeze in repo activity risks undoing some of the ECB’s stimulus by hampering lending between financial companies and leaving bond markets vulnerable to sharp sell offs.

The situation was so bad we even got an official denial that anything was wrong!

“The ECB’s securities lending is proving valuable for smooth market functioning, and it is being reviewed on an ongoing basis,” an ECB spokesman said.

The situation is driven by the way that derivative portfolios now need more collateral to be held against them whilst there is less top-notch collateral to be had.

With the ECB now owning more than a quarter of all outstanding German bonds, funds pay up to 1.5 percent to borrow a 10-year Bund, up from some 0.40 percent a year ago, according to Icap data.

Another problem on the list for pension funds and hence in time pensioners.

Comment

As you can see the side-effects from the ever-growing amounts of central bank QE are growing. This was met with an official denial which sat oddly with the recent changes made by both the Bundesbank and the ECB to try to ameliorate things. It sat even more oddly with the market reversal on the 23rd in response to hopes/hints of a change of policy as shown in the chart about . Since then those hopes have been extinguished, until the next set of rumours anyway. So we get a bond market where the battle between central banks ( price highs) and inflation trends leading to price falls continues.

Meanwhile thank you to @sallycopper C for highlighting an issue which I think may lead to problems for the game of paper, scissors,stone. From Bloomberg.

Paper made from rock tempts Japan’s biggest printer to invest.

Meanwhile I pointed out earlier to the Financial Times that for an article telling us this “the cost of Christmas dinners is almost unchanged from a year ago ” the headline on Twitter from its commodities editor gave a rather different impression.

Christmas pudding pricier after Brexit hits pound

As a Christmas pudding fan I in fact have already bought two rather nice ones for £3 but  one has already gone, after all I had to find out how good it was!