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Making sense of financial markets is notoriously hard. One might be able to construct a story around anything and use post-hoc reasoning to explain why this and that were bound to happen, but hindsight is always 20-20 and what seems so clear in the rear view mirror might not always be so obvious while one is in the midst of it. This is what makes timing the market so incredibly difficult. When you look back at a peak in, say, the stock market, you will probably find a lot of persuasive evidence for why things turned bad around that particular point in time – be they of a technical nature, leading indicators or the general macroeconomic news flow. And as you study stock market history, you think you’ve understood, and drawn your lessons from history and believe you will see it coming next time. But will you? Will you manage to exit the market right before the crash? Or will you sell ahead of a minor dip that one year later turns out to have been a great buying opportunity? And if you are wrong at first, how long will you wait on the sideline until the market vindicates you?
With that somewhat philosophical and contemplative pre-amble, I put before you the 100-Trillion-Dollar Question: have we witnessed the bottom in interest rates and hence the end of the 35-year bond bull market? Only time will tell, and looking back at this current period 10 years from now we will surely know. But what about our assessment of this question now while we are in the thick of it?
There is some evidence that we have indeed seen the lows in rates, and I am somewhat inclined to buy into this hypothesis, though I wouldn’t stake my life on it. As my colleague James Stretton remarked in last week’s Weekly Bulletin, central bankers in the US, Britain and the eurozone have turned surprisingly hawkish; although this “hawkishness” has to be understood in relative terms and in comparison with their former dovish stance.
The Fed raised rates in June, despite softer-than-expected non-farm payroll numbers in May and weakening auto sales, and stayed the tightening course it had embarked on. This was in stark contrast to previous notions of ‘data dependence‘ where minor disappointments in economic data caused the Fed to put off rate hikes. The BoE, staring down the inflation barrel with CPI and RPI readings well above its 2% target, courtesy of a plummeting pound, has publicly floated the idea of raising rates to the pre-Brexit referendum level later this year. Meanwhile, the ECB is making attempts to guide markets towards an end to QE. Central bankers, it seems, are finally prepared to end the era of ultra-loose monetary policy. If they get their way, then the current bond bull market is indeed over.
Recent price action appears to confirm that interest rates have bottomed out. Take the 10-year Bund yield for example. It reached a low in July 16 of -0.19%, bounced up and then fell back to -0.15% at the end of September. Then Trump came along, eurozone inflation was finally on the rise and Bund yields took off, having tested 0.50% a number of times since. Currently trading at 0.60%, it appears the 10-year German government bond has now managed to cross that hurdle. Looking at the US, the 10-year Treasury yield hit a low in June 2012 of around 1.45% and then declined again in July last year to 1.35%. It is now yielding 2.35%.
If one agrees that rates have carved out a bottom, then the question becomes ‘where do we go from here?’. Are we going back to the days where 10-year government bonds paid coupons with a four-handle or will we be stuck in an environment with inflation running slightly below 2% and real rates close to 0%? The Fed’s very own projections in the form of dot plots suggest a long term federal funds rate of 3.0%, but with five-year inflation expectations running at 1.9% this seems very optimistic. I guess the rates outlook for the future pretty much depends on whether you buy into this secular stagnation theme of low inflation and low growth due to excess savings, deflationary pressures from technological progress and high debt levels. If you do, then the fun was probably as good as over before it actually started; if you don’t and instead think that inflation is making a roaring comeback, then have fun trading what could be a very brutal bond bear market.
For me, the more interesting question is what our monetary overlords are going to do when the next recession hits. The Fed has room to cut, but would the BoE dare to take rates negative? Would the ECB lower its repo rate down to the current Swiss levels of -0.75%? While QE definitely helps governments with their public finances in times of economic trouble, I have my doubts about the efficacy of negative short-term interest rates. More than anything, they appear to affect currency markets by encouraging carry traders to borrow and sell your currency and by discouraging everyone else from parking cash in your currency. It is no coincidence that Sweden, Denmark and Switzerland were the first in line to try out negative interest rates in order to stop their currencies from strengthening versus the euro so that their economies could remain competitive vis-à-vis their most important trading partners. When the ECB began cutting its repo rate all the way down to -0.40%, it drove EUR/USD to a low of 1.0388.
This ’beggar thy neighbour’ policy paid off: The eurozone as a whole is running a current account surplus, successfully exporting not only goods, but also its deflation. Whether the same recipe is going to work in the event that we enter another global recession remains to be seen. I have the naïve hope that central banks wouldn’t engage in a race to the bottom as part of an all-out currency war (I think what we have witnessed up until now are rather small skirmishes), which would mean that there is a floor on how negative individual countries can take their interest rates.
Therefore, and at the peril of eating my own words at some point in the future, I do think that we have seen the bottom in interest rates. However, that doesn’t mean we won’t see it again.
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