Central banks were busy in the summer

Kamyar Hazaveh's picture

Summertime is usually a period of reduced activity in the capital markets. The last few summers, however, have been eventful. We have received some of the most important policy announcements in July and August. Why? First of all, the Federal Reserve’s annual research retreat in Jackson Hole, Wyoming occurs late in the summer. This event which brings together researchers and economists from around the world is a "who's who" of central banking. Second, the multiple episodes of market meltdown since the Global Financial Crisis (GFC) have happened during the summer months forcing the policy announcements to occur in or around the Jackson Hole symposium. This blog post goes over some of the major policy announcements given by central banks this summer, our view of their implications for capital markets and how this information affects our bond portfolios.

The storyline starts in 2012

The European Central Bank (ECB) has clearly won the headline catching contest this year. Up until this summer, the eurozone had been enjoying a cyclical rebound from the bottom of the last debt crisis in 2012. The rebound caught the economists and most forecasters by surprise as cyclical indicators in depressed southern European economies showed signs of life in 2013 from depressed levels. This resulted in a change of attitudes towards European assets and a wave of portfolio inflows back into the European capital markets (bonds and stocks) which was later on blamed for the strength of the Euro. Looking back, most observers attribute the strength of the rebound to Mr. Draghi's historical "whatever it takes" pledge made in 2012 at a conference in London. The European economy was due for a cyclical rebound in 2013 and the ECB President’s speech re-enforced the return of confidence to the European banks and capital markets allowing the cyclical forces to fully play out.

This year, as market participants were becoming increasingly comfortable with the European rebound story, we expressed our skepticism and called a cyclical slowdown in Europe. The low inflation numbers earlier this year which Mr. Draghi dismissed due to on-off factors were an early telltale sign of weakness in demand and a reminder of powerful deleveraging forces. In the beginning of the year, Mr. Draghi went to great lengths to explain why the nature of disinflation in Euroland is different from Japan and the ECB does not necessarily need to act [1]

Fast forward to today; Mr. Draghi has laid out of one of the most aggressive monetary easing programs in the developed world in the face of continued disinflation and renewed recessionary developments in Europe ex-Germany. These easing programs go by different acronyms but they are meant to achieve several goals: to pin down the bond yields up to five years to basically zero or negative (short deposit rates are -20 basis points); to bring the credit spread for consumer and real estate loans down; and to force investors to take more duration and credit risk in the European bond market with spillover effects to other risky assets. By pledging to bring the size of the ECB's balance sheet back to 2012 levels, Mr. Draghi's has in effect launched a substantial quantitative easing program.

Chart 1. Bull-flattening in Europe

Source: Bloomberg

The story in Japan has been eerily similar to the Euro region. In 2013, on the back of cyclical strength and the growth-friendly fiscal and monetary policies of Prime Minister Abe, Japan experienced a period of improved growth and inflation up until the consumption tax hikes in April 2014. Japan has previously experienced similar tax hike in 1997 which pushed the Japanese economy into tail spin and a recession. This year, however, the administration of Mr. Abe and Mr. Kuroda, the head of the Bank of Japan (BoJ), have been adamant that there is no need to do any additional easing and the growth and inflation will come back to the upward trajectory of pre-April tax hike. The economic performance in Japan since April has proven to be quite the contrary as the performance of the economy even after adjusting for the effects of the April tax hike, has showed striking resemblance to the 1997 recession. There has been substantial depreciation of the Yen and a slew of Mr. Abe's advisors (BoJ economists and even Mr. Abe himself) have been on a campaign to do damage control [2].

In the U.K., the economy has enjoyed one of the strongest cyclical rebounds in the developed world since the GFC mainly due to the pent-up demand. The U.K. economy had under-performed the rest of the world in the years following the crisis and a cyclical rebound was overdue. The rebound caught the consensus by surprise in 2013. This year, having caught up to the recovery story in the U.K., strategists and economists have revised economic and market forecasts to acknowledge the strength in the U.K. recovery.

Mr. Carney at the Bank of England (BoE), has also been forced to acknowledge the cyclical strength in 2014 and has recently re-enforced speculations about a spring 2015 rate hike as employment and activity numbers in the U.K. remain healthy. Front-end bonds have under-performed and the British Pound has been strong excluding the recent bout of volatility due to the Scottish referendum. Similarly, Federal Reserve Chair Mrs. Yellen has been surprised by the strength of the cyclical indicators of employment in the U.S. Despite mediocre growth all year, job creation has surprised to the upside and unemployment rate has continued its downward trend to beyond the thresholds of prior forward guidance.

Both Mr. Carney and Mrs. Yellen have been caught in an awkward situation regarding forward guidance. It seems that neither the time guidance (considerable time) nor the thresholds (unemployment rate) can stand the test of the economic cycles and markets. Frustrated with specifying a time commitment or threshold, and after venturing into participation rate, wage growth and other obscure metrics, both central banks have resorted to "economic slack" and full data dependency as a way to explain their interest rate decisions. It is worth mentioning that economic slack is probably the vaguest measure in the field of economics with widest historical revisions. Resorting to slack and data dependency basically tells the market nothing about the time and speed of rate hikes. At this stage, it seems that the BoE and the Fed will hike whenever Mr. Carney and Mrs. Yellen want to – which is more like the less transparent Greenspan's Fed which is ironic given the BoE and the Fed's campaigns on increased transparency since the GFC. Forward guidance is basically dead. The bond market knows this and the underperformance of the front-end bonds is a testament to that.

Chart 2. Front-end weakness (relative to the curve) in the U.K. and the U.S.

Source: Bloomberg

This was no more apparent in candid questions from Mr. Carney in August from a couple of journalists at a press conference. [3] In Mrs. Yellen’s case, at a press conference in September she downplayed the time aspect of forward guidance and basically unhinged the front-end rates in the U.S. [4]

The outlook and investment implications

It is our assessment that despite Mr. Abe's and Mr. Kuroda's attempts to calm the perceptions about the weak prospects of the Japanese economy and the failure of Abenomics in returning Japan to growth and inflation, Japanese economy will increasingly edge towards its low trend growth in the months ahead. Markets are waking up to this reality and the collapse of the Yen is a first step. There will probably be a rebound from the first half decline in economic activity and inflation sometime in Q3 and Q4 of this year but as time passes it will become increasingly clear that Abenomics needs another round of fiscal and monetary stimulus to remain on track. This is especially likely if the administration forges ahead with the planned tax hike (already legislated) in 2015.

European economic growth and inflation will likely experience a gradual rebound as a lower Euro and low rates fuel another anemic cyclical recovery. With Mr. Draghi's pledge for further asset purchases, these developments have the potential of becoming more pronounced specially if the monetary measures are followed by fiscal measures. However, it is likely that the European economy will be back to the abyss once again in the medium-term as the effects of fiscal and monetary stimulation that are planned today wear off.

We remain under-invested in both the Euro and Yen as currencies in our global bond portfolios. This underweight positioning has been reduced somewhat as our views regarding the European and Japanese economies have materialized this year (profit taking) but remain close to maximum underweight limits. This enables us to invest the proceeds into higher-yielding assets in developed and emerging markets fixed-income products.

In Europe, at this juncture, we favor credit spreads to duration risk as forward rates normalize post Draghi's latest round of stimulus. Longer term, as the Japanification of the European economy becomes more entrenched; long-end duration in Europe will become a valuable source of fixed income risk-adjusted return. In Japan, we do like long duration bonds as another round of monetary easing will likely take rate forwards in Japan to new lows. The long end of the Japanese bond market remains the least prone to a cyclical back-up in rates, if we were to experience one towards year-end.

In the U.S. and the U.K., both BoE and the Fed are reacting to the cyclical strength in the context of structural weakness and over-indebtedness. It is likely that both markets and central banks are over-estimating the durability of this cyclical rebound. Besides, the fears of rate hikes are already reflected in the front-end yields. What this means is that probably front-end yields already reflect enough risk premium to compensate bond investors for the risk of rate hikes. This is no more apparent in the performance of the front-end of the U.S. curve in 2014. Despite the chorus of strategists and economists calling for higher rates in the front-end of the U.S. curve, the 2-Year Treasury has generated enough income to compensate the investor for higher rates this year.

Chart 3. The 2-Year Treasury has had positive return in 2014 despite large yield rise.

Source: Bloomberg

In the U.S. and the U.K., we do have exposure to both U.S. dollar and British Pounds as currencies and favor the carry of the front-end in the 5-Year to 10-Year sector of the curve. The Canadian bond market continues to remain expensive with Mr. Poloz downplaying the risk of rate hikes in Canada. This rhetoric has been behind the weakness of the Canadian dollar and we anticipate this to persist. Having said that, we do not have rate exposure to the front-end of Canada as there are no risk premiums to be earned up to 2-Year. Our exposure remains concentrated in 5-Year to 10-Year part of the curve with emphasis on spread products and added convexity.

Conclusion

The global economy remains uncertain and over-levered. The temptation to try to explain the strength of risky assets to the performance of the underlying real economies is strong and certainly possible as there are signs of economic improvement especially in North America and select emerging markets. However, the extraordinary actions of central bankers this summer around the world after six years of unprecedented monetary accommodation is a reminder that all is not well with the global economy. In addition, these limited signs of strength in parts of the world are happening in the current environment of zero interest rate policy (ZIRP). It is unclear how much of this rebound would continue if and when some of the current monetary accommodation is removed.

It is in this uncertain world that central bankers are taking newer and bolder initiatives. These policies have immense implications for bonds and other asset classes. They are also unconventional and potentially risky for domestic and the global economies.

The divergent policy paths of the central banks around the world or at least the perception of de-coupling has meant larger moves in currencies rather than interest rates as the latter have remained calm and low across the developed world but currencies have been volatile. Constructing a balanced currency, credit and rate exposure remains the best recipe for success in a policy driven, centrally-planned developed world.

Understanding the global economy and central banking, connecting the dots and constructing efficient portfolios that are positioned for this new brand of super active central bankers is best left to the professional portfolio management teams that have the focus and dedication to the fixed-income asset class.

The performance of major fixed-income indexes this year show that trading and professional portfolio management are important aspects when it comes to allocating a portion of investors’ portfolios to fixed-income. Adhering to simple ideas such as "rates are going higher" and allocating one's capital to floating rate funds has a high chance of leaving money on the table, as well as forgoing the diversification benefits of the fixed-income asset class as it was the case in 2014.

Bond markets around the world are notoriously efficient and incorporate new central bank and macro data in no time. To be able to understand and navigate interest rates requires dedicated teams and resources. At Signature we do realize that.

References

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