Where next for interest-rates and bond yields?

2021 has opened by reminding us that the world has become increasingly bi-polar.Perhaps I should refine that to the human world. Prospects for interest-rates are doing that as well and let me give you an example of one trend.

Government bond #yield keeping higher: 10 year German #Bund yield at -0.48%, 10 year UK Treasury #Gilt yield at 0.32% and 10 year US #Treasury yield at 1.15%. (@CIMBank_News)

The player here is the United States. I noted yesterday the impact of higher US bond yields on the price of Gold and in the meantime the ten-year has nudged higher to 1.15%. Part of this has been caused by the way that the prospects for Yield Curve Control ( essentially more QE bond buying) have collided with this.

WASHINGTON (Reuters) – The Federal Reserve could begin to trim its monthly asset purchases this year if distribution of coronavirus vaccines boosts the economy as expected, Atlanta Fed President Raphael Bostic said on Monday in what amounted to a bullish outlook for the coming months.

As you can see they have been talking bond yields higher just as they were expected to be heading in the opposite direction. So much for Forward Guidance! This is more like a car crash as we wait for the handbrake turn. Just to add to the land of confusion there was also this.

In separate comments, Chicago Fed President Charles Evans also said policymakers were poised to push bond-buying in either direction – adding more if the economy seems to need it but also open to cutting back if the recovery and vaccines gain traction. ( Reuters)

On a technical level this just reminds us how useless Forward Guidance is. We have seen central bankers and their acolytes push it as a policy tool but right now they are pulling in every direction. How can anyone take guidance from this.

Mr and Mrs Market have decided to push bond yields higher and see if they break.Those who remember what was called the Taoer Tantrum and the climb down of the US Federal Reserve in the face of pressure from President Trump will no doubt be thinking when they climb down. Such thoughts are no doubt behind the rise in bond yields because so far QE has been an example of the genius of the song Hotel California.

“Relax”, said the night man
“We are programmed to receive
You can check out any time you like
But you can never leave”

Negative Interest-Rates

On the other side of the coin is the negative interest-rate enthusiast of the Bank of England Silvana Tenreyro. Yesterday she gave a speech setting out her views on them.

Financial-market channels appear to be unimpeded under negative rates, and some may even be
stronger than usual.
 While pass-through to household deposit rates can be constrained near zero, pass-through appears
to be less constrained for corporate deposit rates, which may stimulate spending by firms.
 There is strong evidence of transmission into looser bank lending conditions, even if this is
somewhat constrained relative to ‘normal’.
 There is no clear evidence that negative rates have reduced bank profits overall, and a number of
studies find positive impacts, once you take into account the boost to the economy.
 Taking these points together, the evidence suggests that negative rates can provide significant
stimulus.

Let us examine these in detail. Her view on the financial market channel is really rather extraordinary, so let us take a look in more detail. The emphasis is mine.

For example, estimates from the Bank’s suite of models suggest that financial market channels – operating via the exchange rate, firms’ cost of capital and households’
financial wealth – account for a third to two thirds of the total medium-term impact on output from Bank Rate
changes, and a half to three quarters of the impact on inflation.

Yes we are back to wealth effects again with no addressing of the issuing for younger people of how they will have to buy more expensive assets is inflation for them.We look at this usually in terms of housing. Also if firms cost of capital responded to Bank Rate in the manner hinted at we would not have had the Funding for Lending and Term Funding Schemes. 

Next is the issue of corporate deposit rates which “may” stimulate corporate spending. Well after the years of evidence now about the impact of negative interest-rates in the Euro area then if you can only say “may” it means the answer is no. Although Silvana keeps plugging away at this.

This suggests one aspect of the banking channel of negative rates which could be more powerful than usual.

How bank lending can be both “looser” and “somewhat constrained” speaks for itself so I will leave that there.

Next comes the issue of the banks. The issue her is one of profitability or rather lack of. Her Silvana finds herself trapped between her theories and real world examples where people are backing their views with their money.

Interestingly, a number of studies48 – though not all49 – find that bank equities tend to fall after policy rate
cuts below zero are announced. That seems at odds with the more sanguine results on bank profitability.

Revealingly she decides that she is right and they are wrong.

One interpretation is that financial markets initially focussed on net interest income, but did not initially
account for the indirect boost to profits from negative rates arising from improvements in other sources of
income.

Indeed they have been wrong for quite some time according to her. It would be too cruel to look at the Italian banking sector so let us go to the benchmark for the Euro area banking sector which is Deutsche Bank. Back in 2015 there were two occasions when its share price approached 29 Euros whereas now it is 9.57 Euros. If we take out the Covid-19 pandemic then we see it does not change much as in February last year it was 10.2 Euros. So the share price has plunged over the era of negative interest-rates and bond yields because markets have failed for over five years to spot the “improvements in other sources of income.” Come to think of it the accountants and auditors have missed it as well!

We seem to be entering something of an alternative universe here.

And I have previously highlighted that in the UK interest rates affect inflation more quickly than in the past.

The ECB in fact published some work a few years back suggesting the reverse. I can only think that Silvana has misunderstood what happened in the summer of 2016.

Also we already have negative UK bond yields in the UK at the shorter maturities mostly due to all the QE bond buying she does not think is that important.Meanwhile that influences the increasing number of fixed-rate mortgages. On that road Bank Rate is ever less important which she seems to miss.

Comment

There are several contexts here so let me set out my view. There is a clear asymmetry between how central bankers regard interest-rate rises and cuts. The former are a vague wish and the latter are a clear desire often implemented via panic. Indeed interest-rate rises are often reversed ( the UK is an example of this ) and the new scenario is lower. For example the Bank of England told us the “lower bound” for UK interest-rates was 0.5% whereas Bank Rate is presently 0.1%. In a sane world we would be projecting interest-rate increases but in the insane one we inhabit any further economic weakness will see more cuts.

Next comes the issue of negative interest-rates which so far have been singing along with Muse.

Super massive black hole
Super massive black hole
Super massive black hole
(Super massive black hole)

The main place that has implemented them which is the Euro area is still there. In fact last year it cut again, although contrary to the Tenreyro rhetoric it only cut by 0.1% showing it sees risks. If negative rates had the impact claimed surely things would have got better and interest-rates could have been raised or at least returned to zero? The Riksbank in Sweden has raised back to 0% but that only illustrates the issue. It cut into negative territory in a boom and ended up so unsure about it all that it raised interest-rates in a bust. If they worked surely Sweden would have them now?

 

The operation of QE by central banks is getting ever more confused

One of the problems of an era that involves markets mostly front-running central banks is when there are rumours of a change, as markets are then left wondering what to do? This happened yesterday when Bloomberg in particular started to push a suggestion that the ECB ( European Central Bank) was going to reduce or taper its sovereign bond buying.

The European Central Bank will probably gradually wind down bond purchases before the conclusion of quantitative easing, and may do so in steps of 10 billion euros ($11.2 billion) a month, according to euro-zone central-bank officials.

Accordingly there was a lot of focus on a move from the current 80 billion Euros a month to 70 billion Euros a month. This was quite a change as at the last ECB press conference Mario Draghi had given a clear impression that the central bank was in fact looking at ways of addressing this.

The Governing Council has tasked its committees with considering adjustments to QE, such as loosening self-imposed rules that make some bonds ineligible.

For those who have not followed this issue so many bond yields in Germany in particular are yielding below the -0.4% Deposit Rate that is used as the threshold. Accordingly there is a shortage of German bunds to buy meaning that it may not be able to buy much more than the 255 billion Euros worth it has purchased at the end of September. As you can see the formation of committees to look at this was seen as an example of this below.

They didn’t exclude that QE could still be extended past the current end-date of March 2017 at the full pace of 80 billion euros ($90 billion) a month.

So there you have it which is that ECB will either be tapered or extended. They have of course forgotten that it might stay the same! Just to add to the land of confusion we also discovered this.

“The Governing Council has not discussed these topics, as President Mario Draghi said at the last press conference and during his recent testimony at the European Parliament,” the ECB said in an e-mailed statement.

Italy issues a 50 year bond

Perhaps the most nervous group yesterday were those who heard news of the possible ECB Taper after just buying some of the new Italian 50 year bond. Here are the details from the Wall Street Journal.

Italy sold €5 billion ($5.6 billion) of debt in its debut 50-year-bond issue in a further sign of how much economic stress investors will overlook amid the global hunt for yield.

There were more than €18.5 billion of orders Tuesday for the bonds that mature in 2067 and that were priced at a yield of 2.85%, according to people familiar with the deal. The strong demand allowed the Italian treasury to raise more than the roughly €3 billion to €4 billion that analysts had expected.

Those investing were no doubt hoping for a continuation of the bond market rally which has seen investors in long-dated bonds around Europe do very well in 2016. But as the WSJ points out there are particular issues for Italy.

But the case for investing in long-dated Italian debt isn’t as clear-cut as for some of the country’s eurozone neighbors. Italian lenders are at the center of concerns over bad loans in the European banking system. Investors also cited a referendum scheduled for December as a vote of confidence in Italian Prime Minister Matteo Renzi that could rattle markets. Meanwhile, economic growth in Italy has stagnated.

Actually as I have pointed out before economic growth in Italy has (sadly) pretty much carried on as it has throughout the Euro era. As to why investors might be piling into long-dated Italian debt well here is the rationale.

“The search for yield is one key reason,” said Axel Botte, a fixed-income strategist at Nataxis Asset Management.

The yield on Italy’s 50-year bond looks high in relative terms, Mr. Botte said, and there is demand for long-dated securities from institutional investors such as pension funds that need to match their liabilities.

This is to some extent back stopped by the ECB purchases of Italian government bonds which at the end of September totalled some 176 billion Euros and might have been expected to accelerate by some as the supply of German bonds faded. A bit different to a Taper for those hoping for something like this.

Spain’s 2066 bonds, which were sold with a yield of 3.493% in May, yield 2.55%. Yields fall as prices rise.

In other words those who bought the Spanish bonds cleaned up.Of course extrapolating from a past profit is very dangerous and will not be helped by this from the Italian statistics office this morning.

The composite leading indicator , updated to take into account the latest information, provided negative indications on the development of economic activity, having experienced in the last month the eighth consecutive decrease.

So slowing from not very much in the first place.

A Space Oddity

It was strange to see rumours of a change in ECB policy on the same day as this was announced by the International Monetary Fund (IMF).

To support growth in the near term, the central banks in advanced economies should maintain easy monetary policies, the IMF said.

Moving to the Euro area we got this.

Growth in the euro area declined to 1.2 percent at a seasonally adjusted annualized rate in the second quarter, after mild weather and consequent strong construction activity helped boost growth in the first quarter to 2.1 percent.

The background though was that growth of 2% was achieved in 2015 which would be followed by 1.7% this year and 1.5% next or in other words a slowing. Hardly a recipe for a less easy policy stance from an organisation which believes this sort of thing works.

Problems, Problems

An illustration of the problems caused by all these easy monetary policies and QE especially has come from the UK this morning. From the Financial Times.

Tesco’s  pension deficit has ballooned £3.2bn to £5.9bn as a result of lower bond yields. The increase is one of the most dramatic we have seen since the start of quantitative easing.

This shows how longer term business models are affected by what is happening and of course so far the UK has in the vast majority avoided any negative yields which destroy such business models. However allowing for costs one can be caught out as I discovered when getting a pension fund statement recently which showed I could expect it to be worth less than now when I retire. Only £56 but every little helps or rather not……

This principle applies in Europe and in places with negative yields even more so accordingly please take this below as something of a generic as the FT looks at Tesco.

The danger for Tesco and other mature businesses with defined benefit pension schemes is that sluggish economic growth, monetary stimulus and slim yields really are the new normal. If that problem was compounded by an equities rout, many companies would have to pay a lot more into their pension schemes.

Comment

The central planners are hitting trouble. Not only are events not working out to plan but they have in fact recently tightened their grip. For example the Bank of Japan is now targeting specific sections of the Japanese Government Bond yield curve. Yet we see confused examples of Open Mouth Operations from central bankers all over the shop and the ECB demonstrated that yesterday. No doubt one day it will adopt some sort of Taper but for now it is probably a confused attempt to stop bond yields falling further which is quite an irony as of course that is supposed to be the plan.

There are difficulties with the capital key or how it divides up its purchases between nations and no doubt some ECB members ( Weidmann of Germany) are unhappy. But as the central banks try to tighten their grip more is slipping through their fingers.