From Bill Evans of Westpac today comes a big picture piece:
My Weekly piece is, as expected, usually focussed on short term market and policy issues. In the piece below I set out some longer term musings that will have some near term significance but are more appropriate for putting longer term issues in perspective.
Global yields are at record lows. The excess of savings over investment continues to widen so returns to savers continue to be squeezed. Central banks, regulators and governments have to take some of the responsibility.
Central banks figured that embracing quantitative easing would drive down interest rates and release bank liquidity which would incentivise investment and narrow the savings investment gap.
That highlighted a key misunderstanding of the reasons why investment remains weak around the world. Businesses are concerned about disruption through technology which might quickly render long term investments obsolete; some businesses believe that shareholders will react poorly if they take on new investment which cannot justify something like a 15% return despite the US risk free rate (say 10 year bond rate) holding at 1.5%Governments are not encouraging business with policies to support future growth. Further, the capacity overhang in emerging markets which resulted from the excessive fiscal boost in the immediate post GFC period also threatens investment in the developed economies.
There is a global reticence by governments to embrace reform. This may be because of the short election cycle in countries like Australia; challenging political structures (White House/Congress impasse in US; House of Representatives/Senate impasse in Australia) or concerns around the impact of sudden reform on social harmony in, say, China.
Increasing liquidity from quantitative easing has also been partially offset by regulators whose policies may be restricting credit supply through heavy demands on the balance sheet structures of banks with sharply increased capital and liquidity requirements.
By aggressively expanding their balance sheets central banks are effectively further widening the savings/investment imbalance with the end result that bond yields have fallen into negative territory in Japan; Europe and, now, the UK.
These negative bond yields are weighing directly on US bond rates. International bond investors are attracted to selling their bond holdings of German; Japanese and UK securities and reinvesting in US bonds, dragging down US yields. Exchange rate considerations are not key to long term investors whose views are probably in favour of an appreciating USD in any case.
Chair Yellen likes to characterise bond rates as reflecting the FED policy outlook and the term premium. However the term premium seems to be dominating. For example, in December last year when the market, in the aftermath of the FED rate hike and the “dots” (average expectations of FOMC members) pointing to four more hikes in 2016, US 10 year yields held at 2.20% and 10 year bunds were trading at 0.55%. Market expectations were for 65 bp’s of hikes by the FED over the next 12 months. Today US yields stand at around 1.55% and Bund yields at around –0.05% – a margin of 1.60% – yet expectations for the FED have fallen to 25 bp’s of hikes over the next 12 months. If FED expectations were the key driver of US yields we would have seen a marked narrowing in the FED/Bunds margin.
It is reasonable to conclude that US 10 year rates are being dominated by Bund rates (to a lesser extent JGB’s and STG bonds would also be a factor) which in turn are largely determined by the QE policy of the ECB (and BOJ/BE). If, as we expect, the FED raises its FFR in December it is unlikely that there will be a marked repricing of US 10 year bonds although shorter bonds will react. The relationship between, say, three year rates with Bunds and US Treasuries is not as stable as we see in the long end. Fluctuations in the outlook for FED policy clearly impact the short end of the Treasury curve.
So, if an ill-conceived QE policy in Europe, Japan and now UK is largely responsible for US rates being so low the US 10 year rate cannot really be viewed as a reliable indicator of the global risk free rate.
During the period 1992 – 2002 the correlation in the US between nominal GDP and the 10 year bond rate was 0. 55. That could be assessed as a time when savings and investment were broadly in balance with, if anything, a possible excess of investment over saving in the US. The link between nominal GDP and bond rates has some foundations in theory as the bond rate is seen to be the sum of the short term real rate; expected inflation; and the term premium. In equilibrium the real short rate plus the term premium can be equated with real growth and inflation with expected inflation.
But in recent times including the five years before the GFC when the huge lift in China’s savings swamped global bond markets (exacerbating the savings/investment balance)the relationship between bond rates and nominal GDP broke down with bond rates falling well below nominal GDP growth.
What could restore the savings/investment balance ?
There are many options.
Firstly, central banks should withdraw from QE thus lowering pressure on excess savings; secondly, governments could embrace infrastructure spending, boosting their own investment. Ideally these policies would need to be protected from political distortion with projects assessed on an arms-length cost/ benefit basis.
Governments should also separately pursue economic reform encouraging the private sector to raise investment as sensible reform policies would boost expectations of higher growth. If firms moved to competing on the basis of productivity enhancing growth policies perhaps the current grounds for competition – cost cutting and wage restraint – might be downplayed.
Finally, the recent strengthening of household balance sheets, 19 August 2016 2 Bulletin Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts. particularly in the US, may encourage renewed leverage in the household sector; governments should also consider reform measures to boost consumption. The lift in global growth resulting from the previously discussed policies will embolden households to raise spending as labour markets heal while a move away from cost cutting at the firm level would encourage consumers.
However, that transition would be painful for markets.
Consider the potential impact on bond markets should ECB and BOJ taper QE in recognition of the damage to economies; banking systems and distortive market signals from negative interest rates. We have already seen a confronting example of the potential instability of markets. From mid-April last year to early June German 10 year bund rates jumped unexpectedly from around 0.1% to 0.9% causing a chain reaction in other bond markets. US 10 year Treasury yields jumped from 1.8% to 2.4% and Australian 10 year rates lifted from 2.3% to 3.0%. At the time the adjustment was broadly rationalised by the reasonable assessment that buying 10 year bonds at near zero rates made no economic sense.
However such reasonable thinking did not factor in the ECB.
The Bank had introduced its purchasing program (EUR 60 billion per month) in March, 2015, and Bund yields were gradually driven back to zero and beyond over the course of the next year. In fact, in March 2016 the ECB raised its purchasing target from EUR 60 billion per month to EUR 80 billion. As discussed, with Bund rates falling, US Treasuries and Australian Commonwealth bonds adjusted accordingly.
Over the course of the next year Bund rates fell around 100 bp’s to around –0.05% while US Treasuries fell by around the same 100 bp’s to 1.5% with Australian Commonwealth rates falling by around 110 bp’s.
If there was no distortive buying at negative rates by the ECB and markets were left to assess true fair value for Bunds I have little doubt that rates would be much higher globally and represent a much fairer assessment of the risk free rate. My conclusions are the following:
1. Record low interest rates have not been effective in stimulating investment to close the savings/investment imbalance. A change in policy from governments on infrastructure and structural reform is urgently required.
2. Central banks are exacerbating the imbalance with QE policies. With these policies now generating negative yields and pressuring the banking system while sending confusing signals on risk free rates there is an urgent need for these policies to be reviewed and abandoned. Global “tapering” needs to be the national catch cry. These policies are also creating headwinds for the US FED which would have been further into its normalisation process had QE not been adopted in Europe and Japan.
3. While these central banks persist with these distortive policies the actions by the FED will have only minor significance for long term yields and therefore risk free rates.
4. When these QE policies are finally abandoned, as they surely must be, there will be a huge repricing of risk free assets with rates heading in the direction of nominal GDP growth, although the pace of this adjustment will still depend on the other progress which governments have made in closing the savings/ investment imbalance.
5. In those circumstances other asset markets, including equity markets, will have to reprice given a higher risk free rate.
All very reasonable but also offering an insight into why H&H has now beaten Australia’s number one interest rate forecaster two years running. Bill is treating the global malaise as more of a cyclical than a structural problem (not entirely of course). But the issues are all structural:
- failing demographics in the major economies;
- peak debt in developed markets and soon emerging markets as well;
- and an exhausted monetary system that has produced massive oversupply worldwide by borrowing from the future.
The solutions too all of these problems can come by raising the risk free rate but only at the cost of worldwide depression as the debt is delevered and excess capacity shaken out.
There is not a government nor central bank on earth that wants to take that on, nor should they.
Thus the only way out is not, as Bill suggests, by withdrawing from current policies. It is, in fact, to dive deeper in. The next evolution in our global slow motion depression will not be less QE but more, only this time for the people; a QE for productive purposes (at least in theory!). Helicopter money, as it were, that is printed and spent on infrastructure (and probably just given away in some quarters) that supports growth while enabling the crippling debt stock to be worked off in the public and private sectors.
Accompanying that evolution will be a rise of government and possibly even the end of the licence for banks to print money.
It won’t come before the next crisis but then it will.
For Australia, it could be worse. Once the economy is reset in the next shock, commodities will be needed in the following global building cycle, and a low Australian dollar will help.
There’s plenty of pain ahead but hope too.
