Iggo's insight

Living in a box

The US yield curve has rarely been inverted when the Fed funds rate has been this low. In fact, it has rarely been inverted when the Fed funds has been below 4%. Today the curve is very flat, but that doesn’t mean longer-term yields can’t move lower. Indeed, 30-year Treasuries remain a decent hedge for portfolios that are exposed to NASDAQ type equities or the racier parts of high yield. From a cyclical point of view, a flat yield curve is not a great sign, but I struggle to see significant increases in yields when the Fed is doing QE and when it has one eye focussed very much on credit markets. If only inflation were to rise a little.      

Sell-off... oh not really 

Core global bonds have just gone through another short-lived sell-off, the second or possibly third since the height of the crisis. As was the case in late May/early June, there has been a clamour to explain the sell-off as reflecting the global economic recovery. A steeper yield curve is a necessary condition for those investors believing in a V-shaped recovery, with an increase in inflation and the shift to a value and cyclicals led equity regime. Unfortunately the increase in 10-year US Treasury yields from 50bp to 73bp between the 6th and 13th of August, looks to be reversing. Sobering messages about the ongoing impact of the pandemic on economic activity from both the Federal Reserve (Fed) and the European Central Bank (ECB) this week have pulled the rug a little from under the strong recovery scenario.  

Rate cyclicality 

In the United States, at least, recessions in the past were generally foreshadowed by rising real (inflation adjusted) short-term interest rates and an inversion of the risk-free yield curve. Once the economy fell into recession and then started to recover, the opposite interest rate relationship was established – real short-term rates became negative and yield curves steepened. That steepness reflected that monetary policy was being set at cyclically easy levels and an anticipation of future increases in growth, inflation and policy rates. Interest rates and yield curves moved very cyclically. Equity investors were able to take strong signals from these moves, with cyclical-value type stocks recovering as the yield curve steepened. 

More constraints now  

Since the Global Financial Crisis (GFC) things have changed, and the Fed finds itself in a much more difficult position than it would have in the past. First, the Fed has twice now had to confront the lower effective bound for the policy interest rate. It kept the Fed funds rate at 0.25% for nearly six years following the GFC and a similar period of low and unchanged rates might be in the offing in the wake of the pandemic. Not being able to cut the nominal policy rate further means that the Fed has little control over the “real” short-rate. If inflation was rising, real rates would decline but the Fed can’t directly control inflation, as we have learnt. Since 2009 the Fed, and other central banks, have addressed the lower bound problem through quantitative easing, driven by econometric modelling to find an equivalence between (unattainable) lower rates and the amount of QE and balance sheet expansion.   

Flat 

Being beholden to QE now means that yield curves tend to flatten. If bond investors think that short-rates are on hold for a long time then there is an incentive to buy duration and play the carry and roll-down game, especially if the central bank is buying in size. On balance, between 2009 and 2015 the US yield curve modestly flattened. This accelerated in 2018-2019 and today the curve is very flat. It is not inverted, and it is worth noting the observation that the nominal curve between 10-year yields and 2-year yields has never been inverted for anything other than a brief moment when the Fed Funds rate has been below 4.0%. With the 10-year yield currently at 0.64% and the Fed Funds at 0.25%, there isn’t a lot of bullish upside for Treasuries if the Fed sticks with its “no negative rates” stance. Still, a near 40 basis points (bps) rally on the current 10-year benchmark would deliver a nice 3.5% or so capital gain. 

Credit fears also impacting the rates complex 

So the “zero lower bound” and QE induced curve flatness are two constraints on the interest rate markets being able to properly reflect the cycle. A potential third is that policy has become more credit focussed over the last decade or so. Reducing longer-term rates through QE helped the credit markets in the face of a bank-led crunch after the GFC. An even more credit focussed set of policies this time around successfully reduced the risk of a systemic credit event. The Fed provided a backstop, the banks were encouraged to lend and the markets remained opened, allowing corporates to refinance debt in droves. I am not sure that the credit market would have behaved the same had the yield curve steepened like in previous cycles. As it turns out, spreads have fallen from their widest levels much quicker than they did (relatively) in 2009. Today the corporate bond credit spread in the US stands at around the 15th percentile of its historical (outside of recession) range. Credit has got as expensive as equities.        

Inflation is the key 

The final piece in the puzzle is inflation. Despite July numbers being higher than expected in some countries, inflation remains low and there are plenty out there arguing it will remain low. If they are wrong and inflation does rise, then real short-rates will fall further and the yield curve will steepen even with QE (perhaps with an added shove from increased government bond issuance). Presumably higher inflation alongside a recovery in real growth will push nominal GDP higher and allow leverage in the economy as a whole to come down. This should mean that the debt profile would be easier to manage. 

In a corner

While I don’t want to be too dramatic about it, the Fed is in a bit of dilemma. It can’t get real rates lower by itself because there is a reluctance to go into negative territory (and few Fed officials are likely to be convinced by the experience of Europe); it has resorted to QE instead to create some lower real interest rate equivalence and this has also formed part of its credit control framework. Asset purchases tend to put pressure on curves to flatten especially if forward guidance suggests a long period of stable rates. If it gives up on QE the market will think it is giving up on trying to raise inflation and this will be taken as bad for credit and equities. So what to do? 

Average price target? 

Next month the Fed is expected to announce some changes to its long-term monetary policy framework. Many observers expect that to include an “average inflation target” which in theory means the Fed will allow inflation to rise above 2% for a long enough period to compensate for when inflation has been below 2%. It likely will need to back this up with forward guidance suggesting that rates won’t be increased until it is convinced its inflation target (and maybe an unemployment target) has been met. 

The pro-cyclical scenario 

So here is the scenario. Based on the policy stimulus that has already been put in place, a more aggressive pro-inflationary stance from the Fed, permanently bigger budget deficits and changes in some of the longer term factors that have kept inflation low (global labour substitutability, supply chain changes, higher share of health-care spending in GDP, etc) – inflation does rise above its recent levels. That ultimately allows the Fed to stop growing its balance sheet and the economy slowly reduce its real level of indebtedness. The equity rally could then become more broad-based, Europe and emerging markets would outperform the US and break-even inflation rates would rise globally.

But short-term…

How likely is all of that? It’s hard to attach a great deal of confidence to these scenarios transpiring in the short term. Indeed, in the foreseeable future there are factors that could cause another wave of risk-off price action in markets. If the US does not announce another fiscal stimulus package there will be something of a fiscal cliff this fall. At the same time, markets will have to deal with all kinds of election scenarios. And let’s not forget that infection rates seem to be rising again in Europe and globally the number of daily cases has not yet put in a convincing peak (running around 250,000 cases a day according to data from the Johns Hopkins University of Medicine Coronavirus Resource Center).

The demand for duration remains strong 

As such in rates space, even with the US curve so flat, I quite like the long-end of the market. I still like to be long duration and long growth equities (NASDAQ) or higher beta credit, rather than all-in on the value-cyclical recovery trade. It’s hard for the Fed to get out of its box. However, it is also important to follow the metrics closely. If coming months see more surprises on the upside for inflation that would be a significant development. If the curve can start to steepen without duration hungry global investors “whack-a-moleing” it back down again, that would be significant. Watch break-even inflation rates and gold. They have both moved up a lot (in US dollars). If these moves extend, that would be significant too.

Dollar pricing in election volatility 

Part of those latter moves reflect some evidence of a lack of confidence in the US dollar. That may just be pre-election nerves (hardly detectable elsewhere). Or maybe the FX markets also see the Fed’s problem. I suspect further dollar weakness is ahead and a period of rising volatility is going to accompany the run in to the election. Before I sign off it is worth considering a re-run of the 2000 election debacle. The result was close then and a recount was demanded in Florida. The legal wrangling and the uncertainty of the final outcome went on until well into December before George W. Bush was finally declared president-elect. It was a period that saw the S&P, dollar and Treasury yields all trade lower. President Trump may not easily accept the result of a close election – he has already alleged that the election could be subject to fraud. If it’s close and the US political circus descends into a big legal scrap, you probably don’t want to be owning any US assets. In itself that could get inflation and the US yield curve higher. It’s going to be interesting. 

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