US Bond Prices Sending Out Confusing Signals
With 10-year US Treasury yields dropping below 2.5% at one point during early June in spite of improving forward economic indicators, the US bond market has continued to send out confusing signals, in our view. Purchasing manager indexes have remained well over the 50 mark that separates expansion from contraction for many months, consumer demand has remained relatively buoyant, and nonfarm payrolls show job creation running at over 200,000 per month for 13 of the 21 months to May 2014.1 Would companies be hiring at this rate if prospects for the economy were quite as bad as the low bond yields suggest? And would they be rebuilding inventory at the pace they have been in the past couple of months? Business inventories in March were 4.7% higher than a year earlier, according to the US Department of Commerce.
The US Federal Reserve (Fed), in our opinion, has to some extent contributed to the confusion sparked by the seeming paradox of falling bond yields and rising equity prices by highlighting ongoing concerns about the employment participation rate and housing. Yet the basic fact remains that the US economy is in a relatively good place, in our view. True, economic growth declined in the first quarter of this year. But leaving aside weather factors, much of the negative impact came from fiscal retrenchment on the part of the government, while the private sector continued to stride ahead. This is especially evident in the services sector. The closely watched Institute for Supply Management (ISM) survey of the services sector jumped to its highest level in nine months in May, lifted by rising new orders, business activity and hiring. Likewise, the ISM’s survey of manufacturing came in at 55.4 for May, well above the 50 mark that separates expansion from contraction.
The 10-year US Treasury yields dropped from the 3% level briefly reached in late December due in part to the negative growth seen in the US economy during the first quarter. But the continued rally in bonds might also be as much, if not more so, a reflection of factors that have relatively little to do with prospects for the US economy. The Fed’s forward guidance that base rates will remain low for some time is doubtless just as important, in our view. Also, long-term bond issuance by the US Treasury has dropped even as pension funds and insurance companies continue to be mandated to seek out perceived risk-free investments. In addition, some investors have been trying to rebalance their portfolios after last year’s big runup in equity prices left them overexposed to stocks. And a number of market participants who had shorted the Treasury market in the expectation of rising yields have been forced to scramble back in.
Low inflation has also favored US Treasuries. But US inflation, while remaining under control, has started to pick up. Core personal consumption expenditures (PCE) showed that prices in April were up 1.4% on the previous year—still well below the Fed’s 2% unofficial annual inflation target—but signaling that inflation fast normalizing in the US after a period when deflation was a concern in some quarters.2 To the extent that price rises are a lagging indicator of increasing demand in the economy, the acceleration in price increases may be viewed as a welcome development.
Yet with current base rates remaining “at or close to zero,” prospects for interest rate increases still look a long way off. While forward indicators show the US economy is regaining momentum, growth remains relatively subdued. Some recent statistics on housing, retail spending and income growth show that US consumers are seeing only modest improvements.3 The Fed’s Beige Book survey of economic activity carried out from April to May 23 determined that the US economy was recovering at a “moderate” to “modest” pace after brutal winter weather. The deceleration in nonfarm job creation to 217,000 in May from the exceptionally strong figure of 282,000 in April, together with a decline in exports and widening trade gap in April, mean the economy may not be growing quite as rapidly as some had hoped.4 Certainly, the muted reaction of 10-year Treasury bond prices to the May jobs figures would seem to signal that in spite of economic improvements, the risk of a big uptick in inflation is limited and a sudden change in the Fed’s policy stance is unlikely.
All in all, conditions are progressively improving, in our view, but the Fed continues to indicate that it is not close to tightening interest rates. As a consequence, it is difficult to see the likelihood of anything but a gradual, but not disruptive, rise in bond yields in the months ahead. Yet we think it is also important to remain alert to the complacency that seems to have seeped into sections of the financial markets, as seen in the low levels of stock market volatility and narrowing spreads for corporate debt. And it cannot be completely discounted that faced with such market complacency, central banks could begin to strike a more hawkish tone.
Global Economy Shows Momentum
There have been a number of developments, both economic and political, in recent weeks that have been generally viewed as positive for financial markets outside the US and Europe. On the broadest level, the decision by the European Central Bank (ECB) to impose a negative deposit rate on banks, plus hints from the ECB that it may institute an asset-buying program along the lines of the Fed’s quantitative easing, is likely to result in fresh capital inflows into a host of markets, especially in Australasia, which currently offer much higher yields. The ongoing recovery in Japan plus the Bank of Japan’s assurance that it will keep buying enough government bonds and other assets to pump up Japan’s monetary base at an annual pace of about ¥60–¥70 trillion (US$592 billion–US$692 billion) also point to further sources of liquidity to help drive Asian assets.5
More fundamentally, several indicators that the global economy is gaining momentum have emerged. A key global output gauge reached an eight-month high in May as both services and manufacturing picked up steam. A rise in global inflation in April signaled by the Organisation for Economic Co-operation and Development is another indicator that the global economy is recovering.
Admittedly, much of the improvements come from large, developed countries, but news elsewhere has been less negative than in late 2013 and early 2014. Though the International Monetary Fund (IMF) recently recommended that China target a 2015 growth rate of 7% – compared to the IMF’s April estimate of the country’s growth rate of 7.3%,6 for the next year – amid lingering market worries over a property bubble and overinvestment in the country, we do not see China’s economy facing a “hard-landing” scenario. In fact, the Chinese economy is showing signs of steadying based on recent data. Chinese manufacturing activity picked up in May as a series of government stimulus measures took effect, while a controlled decline in the value of the yuan has helped boost exports. The stabilization in China’s economy and demand for raw materials also contributed to the stronger-than-expected growth in Australia during the first quarter of 2014.7 Elsewhere, the decisive victory of a coalition headed by Narenda Modi in India’s general election has the potential to transform that country’s economy and lift the growth rate from the unsatisfactory rate of 4.7% seen in fiscal year 2013–2014.8 Modi’s popularity has been built on the back of effective infrastructure development, pro-growth policies, and a relative lack of corruption in the important state of Gujarat, where he was chief minister from 2001 to 2014.
Other noteworthy political events included Egypt’s election of army chief Abdel Fattah el-Sisi as president, which was widely expected. However, voter turnout was much lower than expected, leaving markets anxious to see how far el-Sisi will be able to push economic and social reforms. While Egypt’s finances continue to be propped up by low or no-interest loans from its Arab neighbors, increases in income and corporate taxes were announced during May to try to stabilize the fiscal situation. Foreign investment in Egypt had been picking up in recent months, buoyed by hopes that el-Sisi would introduce wide-ranging economic reforms in the largest country in the Arab world. Yet the announcement in late May of plans to impose a 10% capital gains tax together with hikes to corporate taxes has started to hurt investment sentiment.
The army has been equally prominent in Thailand, where it intervened (not for the first time) to topple the elected government. Financial markets have reacted quite positively to the military coup in the belief that the army’s intervention could help restore some order to an economy that has slowed considerably over the past year, with private consumption slumping to its weakest level since the Asian financial crisis. Finally, newly elected Ukrainian President Petro Poroshenko has been taking some interesting steps in an attempt to resolve the crisis in the eastern part of the country. His offer of greater local autonomy along with attempts to isolate the more violent elements of the separatist movement come on top of a Russian military pullback from the Ukrainian border and a statement from Russian president Vladimir Putin that he would respect Poroshenko’s election. Helped by Western aid, Ukraine has started to honor its debts on Russian gas imports, while Poroshenko has made promising noises about re-booting an ailing economy, as well as combating rampant corruption and stifling bureaucracy.
Overall, we are encouraged by the recovery in a number of emerging markets in recent weeks, which seems to indicate investors are able and willing to differentiate between companies and countries with sound fundamentals and those that are more speculative plays.
Disappointing eurozone growth in the first quarter (when gross domestic product grew at a quarter-over-quarter rate of 0.2%), some loss of momentum in activity, as indicated by purchasing manager indexes, and an annualized inflation rate of just 0.5% in May, together made inevitable the ECB intervention of June 5.9 In a series of initiatives that had been well signaled in advance, the central bank cut rates and imposed negative interest on the deposits banks hold at the ECB. It also announced measures to spur lending to smaller businesses through “targeted” long-term refinancing operations (TLTRO), which will see the ECB provide up to €400 billion in cheap loans to banks on the condition they are used specifically for lending to companies and households.
Arguably, the ECB’s cut in the benchmark interest rate from 0.25% to 0.15% is the move least likely to make much of a difference. Although such cuts have been a vital ingredient in ensuring the eurozone debt crisis did not spiral out of control, the ECB has little to show in terms of growth, inflation or lending statistics from successive and more substantial cuts to base rates over the past three years. Meanwhile, the ECB’s comparatively cautious approach to monetary policy combined with the improvement in the region’s sovereign debt situation and the problems of some emerging markets means the euro has, until recently, risen against the US dollar and other currencies, thus undermining the eurozone’s export performance and contributing to weak inflation.
A desire to weaken the bloc’s currency is an important reason for introducing negative deposit rates. A similar move certainly helped weaken the Danish krona when the Danish National Bank imposed negative rates in 2012–2014. The ECB’s move toward further monetary stimulus at a time when the Bank of England and the Fed are withdrawing or thinking of withdrawing their own liquidity measures should also, logically, bring down the value of the euro. However, it is not clear that a decision to lower the deposit rate for banks from zero to -0.1% will actually achieve the avowed aim of encouraging banks to lend to businesses. The introduction of a “targeted” €400 billion LTRO program may be more significant in this regard. Although such a program may prove complex to operate and although a similar scheme by the Bank of England had very limited success, there is at least a chance it could have a positive impact on loan demand among households and corporations and thus stimulate activity in a way that the previous LTRO initiatives—which were more intent on stabilizing the financial sector—did not. Perhaps equally significant was the announcement by ECB President Mario Draghi that the bank was working on a scheme to promote the purchase of asset-backed securities (ABS).
The ECB stopped short of a radical quantitative easing (QE) initiative involving periodic purchases of government and mortgaged-back bonds of the kind rolled out in the US, Japan and the UK, but the possible future purchases of securitized assets would be the nearest thing to QE attempted in the eurozone. Interestingly, Draghi said work on ABS purchases had the full backing of the ECB’s council of governors. Up to now, ECB reticence on QE stemmed in part from traditional German resistance to most kinds of unconventional monetary measures. Yet German resistance has diminished in recent months, with the president of the Bundesbank, Jens Weidmann, saying that QE was not out of the question.
The lingering question is whether euro-style QE will make much of a difference in the UK. The jury is still out on the effects of quantitative easing in the UK. Critics argue that QE is well past its “sell-by” date there and has simply been feeding a dangerous asset price boom, most evident in housing prices, even as the UK has continued to post a large current account deficit. Yet an annualized growth rate of 3.1% in the UK in the first quarter (much better than in the US or Europe and the highest level in 10 years) is starting to broaden out beyond homebuilding and household consumption. Business investment in the UK grew at an annualized 8.7% clip in the first quarter, which could perhaps feed income sustained pay increases, while manufacturing output rose by an annualized 3.5% for the same period.10 How much of this improvement is due to QE and how much to strident fiscal policy?
By injecting further money into financial circuits, radical policy initiatives by the ECB could at least help keep government bond yields low. Yet the experience of the US and Japan suggests the main drop in sovereign bond yields tends to occur ahead of the actual introduction of QE, indicating the ECB could be faced with a rise in longer-term interest rates (especially if the US shows more certain signs of rebounding) that may impact the eurozone’s recovery regardless of the central bank’s next policy move.
This may prove a sticky issue. True, long-term rates in Europe have come down due to low inflation expectations, expansionary monetary policies, abundant global liquidity, and the contraction of sovereign risk premia in the eurozone. Yet real long-term interest rates in the eurozone as a whole are still higher than real growth as a consequence of disinflation and general economic sluggishness. With large levels of public and private indebtedness still hanging over peripheral eurozone countries, real interest rates could ensure that growth remains lackluster, especially as the structural reforms that need to be introduced around the region will most likely take a long time to kick in. Even as it unveiled its latest set of policy measures, the ECB downgraded its forecast for eurozone growth to 1% this year from a previous forecast of 1.2%.11 Just as significantly, the bank lowered its forecast for average inflation in the eurozone from 1.0% to 0.7% this year and sees it picking up to just 1.4% in 2016—still well below its target of below but close to 2%.12
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