Via the excellent Damien Boey at Credit Suisse:
- Fed minutes reveal preference for yield curve control. Minutes from the Fed’s late April meeting reveal that officials were concerned about slow recovery, permanent scars on the economy from the crisis, and a potential second wave of the outbreak. There was no mention of negative interest rates in the minutes, but officials did suggest that stronger forward guidance on rates, backed by the Fed’s balance sheet to control the yield curve, could be helpful. Some officials also felt it could be helpful for the Fed to explicitly spell out the growth and inflation milestones it would need to see before considering raising rates.
- The Fed wants shadow rate cuts, as well as suppression of rates and rates volatility. We find it interesting that Fed officials are so pre-occupied with stopping bond yields from rising, having seen yields spike at the height of market turbulence in March, We also note staunch resistance among officials to negative rates in recent rhetoric, partly because of the significance of money market funds to the plumbing of the system, but partly also because of the mixed international experience with negative rates. It seems that the Fed is eager to explore further easing options to support financial markets and the real economy, without having to go below the zero bound on rates. Officials want to achieve the same theoretical outcome as further cuts to the policy rate through the suppression of longer-term yields – that is “shadow rate” cuts. Officials also know that the future path of growth and inflation could potentially be quite a wild ride with very wide uncertainty bands. Therefore, they want to limit the scope for uncertainty about the future to permeat into today’s pricing of interest rates and rates volatility. Otherwise, the consequences for passive and risk parity investors could be quite disastrous, and the real economy would bear the consequences of financial market dislocation. If these investors are wrong footed in their risk assumptions again, just like they were earlier in the year, they could be forced into large scale de-risking and de-leveraging activities again across all the asset classes they invest in, exerting negative wealth, credit and confidence effects on the economy.
- Position for the environment shaping the Fed’s choices – not the choices themselves. We are less interested in whether or not the Fed goes into negative rates territory, and more interested in the circumstances driving the discussion. As far as we are concerned, the intentional suppression of rates and rates volatility is a sufficient building block for portfolio construction. We think that in the near term, the Fed could well get its desire for a weaker USD and slightly lower rates structure, despite all of the prevailing uncertainties. But all of this would occur at the cost of gold and commodity price inflation. And should actual CPI inflation start to pick up, the Fed would encounter a credibility problem. Suddenly, it would be forced to choose between competing objectives, rather than be in a position to limitlessly expand its balance sheet and boost asset prices. Inflation, as always, is the limiting factor of the current policy mix and growth model. And this time around,policy makers have a greater chance of stoking inflation through large scale fiscal stimulus and unconventional balance sheet expansion, amid supply chain disruptions and destruction of productive capacity via permanent business closures. In the parlance, central bankers have a massive “time inconsistency” and credibility problems to deal with, perhaps explaining the extensive back room discussions about forward guidance. And if they fail to navigate these challenging times well, they could easily undermine investor confidence today.
- Almost the same difference for banks? Negative rates are “evil” for banks because they represent an unavoidable tax on the system awash with excess reserves. Inevitably, the tax cannot be avoided by banks collectively, and it gets passed on to savers through lower, or even negative deposit rates. And the evidence is mixed as to whether negative rates really do boost asset prices or spending in the economy via financial repression. But returning to the equation for banks, it is a moot point as to whether or not yield curve control is any better or worse for them than negative rates. After all, bank lending creates deposits – long duration assets (loans) and short duration liabilities (deposits). Therefore, the steeper the yield curve – the more long-term interest rates exceed short-term rates – the more profitable lending activity should theoretically be. Conversely, the flatter the curve, the less profitable bank lending becomes. With all of this in mind, yield curve control is not a first best outcome – but rather, potentially the lesser of two evils. Both negative rates and flatter yield curves weigh on bank earnings. But, if the Fed can get away with a moderately upward sloping yield curve despite its controls, potentially this could be the best achievable outcome, balancing market and financial stability with growth prospects. Indeed, the most recent Senior Loan Officers’ Survey suggests that mortgage demand is very strong, despite the path of the economy and markets in early 2020, and so perhaps suppression of long-term bond yields is a viable strategy. On a more sour note though, the real, rather than nominal yield curve – that is, the yield curve after stripping out short- and long-term inflation expectations, is deeply inverted. This is not only the case in the US – but in almost every developed economy, including Australia, where incidentally, yield curve control is already underway. Therefore, it is questionable whether central banks can really support bank profitability, in a yield curve control environment, especially when we consider the bad debt cycle. And if the Fed cannot achieve a meaningful steepening of the real yield curve, investors will increasingly think that banks are becoming “handmaidens” of society, rather than profit making institutions. Just nationalize them already!
- USD on a secular depreciation path if “eurodollar” funding markets remain orderly. Our joint parity framework for assessing medium-term equilibria in foreign exchange (FX) markets suggests that the USD is turning the corner. Whereas for the better part of the past decade, real interest rate differential and relative terms of trade factors were supporting a stronger USD, in early 2020, they now signal that the USD needs to weaken. Of course, the USD is not a normal currency, as it is used extensively in offshore “eurodollar” markets. But if the Fed can get a grip on the plumbing of the eurodollar system, as it seems to have already done via FX swap lines, special repo facilities and creative use of its balance sheet, it can devalue the USD to support global growth. In this respect, yield curve control, and arguably even negative rates, are interesting and credible easing options (although many will argue that negative rates could be counterproductive in disrupting key funding markets, undoing the Fed’s progress so far).
- Gold investors cognisant of the cost of suppressing rates and rates volatility. In recent articles, we have demonstrated that intentional suppression of the market price of interest rate volatility relative to fundamentals results in USD devaluation against gold. And the case fo gold and commodities gets even stronger when we consider the state of “excess liquidity” in the world. The process of rates volatility suppression can go on for quite a long time, supporting gold and the commodities complex …. until actual CPI inflation becomes a problem. And even when CPI inflation genuinely becomes a problem, investors will be looking for inflation hedges like gold and commodities for a little while, at least until the Fed gets serious about its choice set. Suffice to say, we are not at this point yet. And gold is breaking out the upside of recent technical trading ranges, with other commodities starting to follow.
- Limited upside for bonds. We understand that central bank quantitative easing (QE) efforts will exert downward pressure on bond yields and bond volatility. However, we think that the upside to bonds and downside to rates volatility is quite limited in the circumstances. After all, yields and their volatility should be fundamentally higher given the extraordinary dynamics at work in this cycle. And term risk premia, as estimated by central banks, support this view. Despite all the manipulation of the rate structure we are seeing, term risk prema in bonds are deeply negative. Investors are not convinced that QE, yield curve control or even negative rates will succeed in permanently lowering the neutral rate to levels matching current bond yields. They clearly have an eye on the inflation risks over the horizon.
- Overweight resources relative to financials, bond proxies, and non-resource USD earners. Tactically, we want to position for inflation risk, pricing distortions to banking, limited upside to bonds, and a potentially weaker USD. Within the ASX 200, we think that an overweight resources position, funded out of financials, A-REITs, staples and healthcare names is an appropriate way to generate this alpha. We hedge our exposure by also taking on some “unloved” quality names in our long basket.