In January 2015, the Bank of Canada (BoC) cut the overnight rate from 1% to 0.75% in a move that came as a surprise to some market participants. This led to a substantial rally in the Canadian bond market to the extent that, at some point, the pricing in the front-end of the Canadian yield curve was implying substantial probability of another one or two rate cuts. The flip side of the rate cut was the substantial depreciation of the Canadian dollar.
The BoC was not alone in its assessments of the economic risks. Central banks around the world have been campaigning since last fall to provide easier financial conditions to an ailing global economy plagued by weak and falling demand – recently evident in the collapse of the commodity complex. Every nation is trying to claim a larger share of a shrinking pie which is the global growth. This is happening after six years of easy money policy, and although it has succeeded in avoiding a repeat of the Great Depression it has also failed to bring the global economy back to pre-2007 strength.
In January, after months of debate and political wrangling, the European Central Bank (ECB) finally announced its sovereign bond purchase program sending long-dated rates in Europe, and globally, to new, historic lows. Fast forward to today, much of the global easing has been wiped out in the last month with global developed market yields back to the year highs in a sell-off that has been marked by extreme volatility currently blamed on the lack of liquidity in a post Dodd-Frank world. The question naturally is…where to now?
The frenzy of forecasts, noise, and misinformation…
Fundamentals have not been the best predictor of financial asset returns in the last six years. In fact, the best strategy in this cycle has been to anticipate central bank policy actions and its financial market consequences. This year’s bonds, stocks, and U.S. dollar rally, driven by the ECB sovereign bond buying program, is the latest case in point.
Because of the impact of unconventional policy in driving the value of major financial assets to new record highs, there is unprecedented interest in central bank policy actions. Additional global central bank transparency and communication, since the financial crisis, has opened the door for more analysis by a larger group of analysts. This is exacerbated by the fact that valuations are full and mainly justifiable in comparison to low interest rates – every asset looks good relative to current low interest rates, not necessarily in absolute terms on its own.
This multi-asset class interest in central banking is nowhere more obvious than in the U.S. Federal Reserve (Fed) policy. Regardless of whether you are invested in equities, credit, or currencies you are affected by the Fed’s actions this year and probably should have a view on the impact of changing policy on your asset class. This has created a slew of analyses of the Fed policy by strategists and commentators, some with incomplete information and limited experience with rate decisions by central banks and their reaction functions, let alone the pricing of the Fed policy in the bond market. Combine that with the usual difficulty of forecasting economic trends and the result is a lot of noise regarding the Fed policy from every corner of the financial markets.
Reading the tea leaves correctly is difficult…
Many frequent, daily economic releases are noise and do not make trends. Trends, even if detected correctly, affect the economy differently in different cycles, at different parts of each cycle, and at different time horizons. That is why even the best economists and strategists are often caught wrong footed. The impact of economic outcomes on financial asset returns is even more multi-faceted and complicated and requires individual asset class expertise.
Take the impact of lower gasoline prices that, based on economist forecasts in Q4 of 2014, was going to lead to an increase in consumer spending as early as Christmas time – turbo-boosting U.S. growth in 2015. Consumer spending in real terms has been healthy but the major detractor in the U.S. economy has been the blow to the energy sector and energy states that account for the bulk of non-residential investments, capital spending, job creation, and wage growth. The economists did not see the negatives and focused on the positives.
Another example is the impact of the U.S. dollar strength on the U.S. economy. Many economists and Fed forecasters were of the opinion that exports are only a small portion of the U.S. economy. Therefore the strength of the U.S. dollar will not severely impact U.S. growth or the Fed’s rate hike plans. Today, it has become painfully evident that trade is a large detractor when looking at corporate profits and the first half U.S. GDP growth. The Fed is also mentioning the dollar impact more frequently in recent communications.
Realizing the timeframe of the trends which affect the economy is equally as important. For example, home ownership in the U.S. has been falling since the financial crisis and, as a result, multi-family construction has seen a boom. In the long-term, having a bigger share of the population in the rental market is probably a positive as it adds to labour mobility (i.e. a modern economy where a worker goes where the jobs are). But in the near term suppresses the multiplier effect coming from single-family housing construction. Another example is high levels of student debt, which is not necessarily a bad thing in the long run as debt accumulated for the purpose of education is the most productive type of debt. Although in the short term the debt affects the demand for housing and family formation as young graduates are burdened by the accumulating amount during their studies.
Reading the tea leaves, identifying true trends and its impact on the economy and financial markets over different time horizons is difficult. Simple one-line arguments such as “lower gasoline prices are good for the U.S. economy” are not going to cut it.
Central bank policy outlook…
In Western Canada, the impact of lower oil prices will be significant and will likely spill over to other provinces that provide oil-related services and products. Although economists did not forecast a BoC rate cut, the bond market was not really surprised by the cut in January. Central bankers in other commodity producing nations (e.g. Norway, Australia, etc.) had already lowered benchmark rates and the front-end of the Canadian bond market was expecting a rate cut going into the January BoC announcement. Today, as much as I agree with the BoC's initial move to cushion the economic blow of lower oil prices, I believe it is wrong to assume that the headwinds are temporary and front-loaded in the first quarter as the BoC is currently telegraphing. The possibility of further weakness during the year is real and the Bank will likely acknowledge that possibility at some point this year.
In the U.S, the Fed has been caught in an uncomfortable situation. Fed Chair Janet Yellen says that she is data dependent when it comes to the interest rate decision but the Fed changes the nature of that data continuously from unemployment rate to wage growth to inflation to the U.S. dollar, etc. The truth is that after six years of unprecedented easy monetary conditions, the U.S. economy is not reaching the Fed’s desired so-called "escape velocity". Inflation is more or less tame with a respectable core component while growth is mediocre (the first half 2015 real growth is expected to be below 2%). Unemployment keeps falling and productivity is weak while wages are in no man’s land at the moment with the bulk of job creation in lower paying service jobs, especially after the blow to the energy sector and energy producing states. I expect the manufacturing sector to linger while the service sector continues to grow leading to an overall lackluster economic growth picture in the U.S. for the time being.
There are increasing signs that monetary policy is incapable of bringing additional future growth forward and rejuvenating the economy. In this context, there is a desire at the Fed to claim victory at this juncture and gradually remove monetary accommodation. This has been extremely hard as the Fed is trying to achieve this in the context of a slow global economy. As a result, any indication of rate hikes has resulted in the strength of the U.S. dollar which puts pressure on the U.S. economy. The Fed is still determined to go ahead with the rate hike(s), which at this point looks more philosophical than economic, but has a hard time accomplishing it when the global growth picture is weak. With the inflation prints widely expected to return to normal, a mediocre economic picture and the Fed determined to get back to normal rates, the risk of a policy mistake is high. Communication is noisy with the Fed governors expressing divergent and changing views based on the principle of data dependency, which is discredited by the changing nature of data.
In Europe, ECB President Mario Draghi has been quick to claim victory and take credit for the cyclical recovery. After lagging the markets for months, private and public economic expectations have also now caught up and in many cases have surpassed the realized outcomes. Mr. Draghi has encouraged the policymakers to use this window to do structural reforms – as if the window is long enough for such change. We think that the cyclical recovery in Europe will not be long enough to allow policymakers to adjust and rotate their economies towards competitiveness. To keep the economic cycle up, Mr. Draghi needs to deliver another bout of euro depreciation but since the latest round of easing was delivered only four months ago, it is hard to see the ECB take any new initiatives in the near future.
The Bank of Japan (BoJ) continues with its asset purchases program with no end in sight. In its latest assessment of the economic environment, the BoJ now expects to reach its goal of 2% inflation in three-and-a-half years instead of the previously promised two (yes, when the BoJ cannot achieve its goals, it simply moves the goalposts). This is significant in the sense that it shows that despite unprecedented easing and determination to fight deflation in Japan, central banks constantly overestimate their ability in changing economic outcomes that are structurally embedded in the economy. At this juncture, economic data in Japan is mediocre but not weak enough for the BoJ to change course, in our opinion. The BoJ may consider cutting short-term interest rates as a policy option in the future which will likely impact the yen sharply. Japan continues to provide a decent template for trading interest rates in Europe and the rest of the developed world.
The sharp re-pricing in the last month has brought global yields to year-to-date highs in 2015. The sell-off in the global bond market has been violent in an environment of illiquidity. The nature of the global sell-off is worrying as the declines in the European stock market, the USD/EUR currency pair, and long-bonds in Germany have been almost equal in magnitude and have occurred in perfect correlation. This is an extremely difficult setup for portfolio managers created by policy-induced, elevated financial asset prices globally – valuations across major asset classes are full.
In terms of the absolute level of yield, bond yields are still close to historical lows. Having said this, after six years of global unconventional policy being used to suppress bond yields, all other asset classes have followed suit. Through this cycle, absolute yields and in most cases the risk premia in investment grade, high-yield, emerging market debt, and global equities, remains low relative to historical standards. After the sell-off, bonds only look marginally more attractive in relative value to other asset classes.
The sell-off in bonds is also largely concentrated in term premium which has meant that longer dated bonds have suffered more losses. We are underweight the longer-maturity sectors of the curve in our Canadian and global bond portfolios to harvest better income (carry and roll) in shorter maturity debt. The longer maturity debt that we hold is largely held in Japan and Europe where the bid for long bonds is expected to continue through the quantitative easing programs by the ECB and the BoJ. The sell-off in German bunds is inconsistent with the level of euro as a currency. Our expectation is that in order to maintain European growth, the ECB has to lower interest rates in Europe which have risen in the recent sell-off.
In currencies, we remain an underweight position in the euro and yen relative to portfolio benchmarks in the global bond portfolios that we manage. We have trimmed the currency positioning substantially in recent months as the catalysts for immediate central bank action in Europe and Japan are not present and the strength of the U.S. dollar is taking its toll on the economy and complicating the Fed’s plans for rate hikes.