Recap 2015-02-09: Musings on the Long End

Commentary:

I’ve been thinking a bit more about the US long end. As long time readers know, my long time view is that the 30y should oscillate around a 3.0% level for the foreseeable future. That was one reason I turned bearish on duration in December, and even more so in January. At ~2.5% currently, yields remain too low IMO, assuming a fully functioning market, where both supply and demand are allowed to clear. But clearly, there are exogenous impacts on both sources currently. So that naturally leads to the question – what if yields remain below my estimate of fair value for an extended period? Why would that be, and what would be the potential ramifications?

I’ll try to answer the first part of the latter question first. I’ve discussed in the past that EU rates have likely been a major driver for the US long end, especially since mid 2014. One forceful data point in support of that view was the stability in the Bund-Treasuries yield spread over that time period. (until recently, at least) The view that foreign factors have had an outsized impact on US yields is also supported by a Goldman statistical published today, where they estimate using some interesting methods that foreign factors are responsible for roughly 90bps on the US 10y:

So if that is indeed the case, what aspect of the foreign situation is most responsible for this? In my humble opinion, the largest culprit is the repricing of EUR growth. The ECB has conducted a survey of growth expectations 5y forward for some time. In conjunction with this, the Euro swaps market is pricing in a 30 year real yield level of -60bps. That puts the differential between the two series at an eye watering 230bps:

Now, you may say, so what if a bunch of economists have one expectation for growth and traders are pricing in a long term yield of something very different? Well the answer is that in a broadly ‘free’ market, this is not supposed to happen. The reason is that if economic agents (including the government) are able to borrow well below long term growth rates, they would be able realize significant capital gains simply by owning a portfolio of assets that broadly replicate GDP growth. In a broadly ‘free’ market, such activity would eventually result in an excess of loans relative to demand, there by pushing interest rates higher until those types of ‘arbitrage’ activities cease.

Now obviously, the key point there is that this is in a broadly ‘free’ and functioning fixed income market. The European FI market is currently clearly not meeting that definition. One major reason is that the EU remains a bank oriented economy, whereby credit creation remains sharply constrained by the levels of bank capital relative to regulator-directed minimums. The second is that the ECB is projected to buy between €400 billion – €500 billion of sovereign debt in 2015 relative to a net supply of €270 billion and a gross supply €900 billion. (Those numbers are Pimco’s, but most folks have similar figures)

My take on the short history of QE in the US is that the largest effect is via spread compression vs risk free rates. In other words, the risk free rate has remained broadly around ‘fair’ while instruments with credit risks saw their yields fall relative to treasuries. That is only reason why US yields turned UP as the Fed started their prior QE programs. The market discounted the fact that better growth would result in less QE down the road. The reduction in net Treasury supply was offset by increased issuance in other sectors; in aggregate, fixed income investors held riskier bonds, at a tighter spread to treasuries.

But is this the right story, especially for Europe? Thus far, the answer is either No or Maybe. As the chart above shows, the linkage between real yields and growth expectations have clearly broken down since central banks began expanding their balance sheets. To be clear, the dichotomy in the US exists as well, but to a smaller extent. So the question is in particular how much the US and EU markets affected each other, and how much of the move in yields vis-à-vis growth expectations is a result of domestic central bank policy.

Of course, hard & conclusive quantitative answers will not be forthcoming anytime soon. But one hypothesis is particularly intriguing. It may be that the stock effects of QE are finally having an impact on long dated risk free yields now. Some rightly point out that this may be specious since QE began over half a decade ago, and it doesn’t make sense that we are just seeing the effects now. But one counter to that point is that it is possible that the stock effects of QE are themselves time varying and non-linear, and will remain somewhat volatile until they are better understood. Put differently, just because we didn’t see any effects immediately doesn’t mean there isn’t any effect at all, over the lifetime of the program. It may be that the full effects of the stock of asset purchases globally are only felt, at an increasingly acute rate, above a certain threshold.

If this hypothesis has merit, then the impact could persist for as long as central bank balance sheets are large. Current projections of said balance sheets imply effects lasting over a decade.

So what if the 30y rate is permanently reset relative to long run growth? Here are a few thoughts:

• Rates Implied Volatility is likely to fall, since there is a limit to how far yields can decline to the downside
• Lower Mortgage Rates, since the mortgage rate is the current nominal rate plus a spread that represents the annual cost of a prepayment option, both of which are lower
• Real Estate Prices are likely to appreciate above where historical metrics suggest
• Equity valuations are likely to hit higher levels via lower discount rates
• Curve inversion may no longer mean that a recession is imminent. In the extreme example where nominal 30y rates are at 0% while nominal growth is at 10%, a Fed hike to 50bps is unlikely to derail the expansion. Similarly, if long dated yields are mispriced by say 100bps, the yield curve could invert by 50bps or more before we see a recession. Recall that in the last recession, 2s30s inverted almost 2 full years before a recession was officially declared.

The size of the effects above is likely strongly correlated to the length of time that 30y discount rates remain depressed. Note that I am not saying that I expect this to occur. But arguably the lower yields deviate from fair levels, the stronger the evidence supports such a hypothesis.

Also worth reading: (Note that some of these posts refer to the level of rates, while others refer to the direction. Take care to note the difference)

http://www.pimco.com/EN/Insights/Pages/All-the-Children-Are-Above-Average.aspx

http://macro-man.blogspot.com/2015/02/what-now.html

http://www.macrofugue.com/say-good-bye-to-the-new-normal/

Side note: the recent Greek headlines are clearly a negative for both the EUR and long dated EUR yields as well. The risk of a EUR breakup and another funding crisis is clearly aggravating concerns that last peaked in 2012. The fear is that other periphery countries follows Greece in leaving the Euro. That is not particularly likely, but understandable. An actual Greek exit is likely to drive EUR breakup fears to a new local high. But it is arguably that the longer term effects may actually result in a lower EUR risk. That’s because the likely financial headlines following a Greek exit of the EUR is likely to sharply color voter sentiment on the costs of an exit. The effects of currency de-peggings and financial crises in general is a front loaded growth shock, usually followed by a better growth outcome subsequently. It is likely that in the case of Greece, the initial headlines from a Grexit would be bad enough to dissuade voters in other periphery countries from following a similar path. But the lack of signs of funding stress and credit differentiation across EUR assets confirms that this worry remains a marginal driver, at least for now.

Notable:

• Greek PM Tsipras gave a speech Sunday and reiterated many of his prior economic and fiscal objectives, setting the stage for a further clash with Eurozone officials. He reiterated that his government would not seek an extension of the current bailout and repeated his request for a bridge deal until a permanent plan can be put into place in June.
• China Trade Balance was strong, although it was driven by a surprising drop in Imports, which fell -19.9% YoY vs -3.2% exp and -2.4% prev. Exports fell -3.3% vs +5.9% exp and +9.7% prev. The Chinese New Year may well have had an impact.
• Japan Eco Watchers Outlook Survey improved to 50 vs 47.5 exp and 46.7 prev

Upcoming:

• Mon: Australia NAB Business Confidence
• Tue: UKIP, US NFIB Survey,
• Wed: US Oil Inventories, UK RICS Housing Balance, Australia Employment,
• Thu: BoE Inflation Report, US Retail Sales, Jobless Claims
• Fri: EU GDP, US UMichigan Sentiment
• Mon : US holiday, NZ House Sales, Retail Sales, Japan GDP, RBA minutes