US yields have clearly shifted over the past 6 months or so. The move is justified – stronger global growth, a large fiscal package and a pickup in inflation. At this juncture, where do things stand? Interest rate futures are still pricing a hiking cycle a ways under the Fed projections. There’s about 100bps priced between here and December 2019. Not a high bar – we could reasonably have that this year, hiking once per quarter. To our eye, the measured and linear pace priced by markets is going to have to contend with economic activity that may be decidedly nonlinear. We just don’t know what happens when you slash corporate and personal taxes at very low levels of unemployment, pour on an infrastructure package at the same time, and see a pickup in global growth. Are retail sales linear when every paycheck in the country gets a big boost? Are capex plans linear when corporate taxes get markedly reduced and regulatory burdens reverse? Are wages linear at 4.1% unemployment? Is the impact of a reduced Fed balance sheet – particularly in mortgages – and an ECB that’s edging toward the door linear on term premium? How about corporate holdings of bonds under a new and drastically different tax regime? Or are these things convex? We may find out soon. It didn’t make sense that interest rate volatility was so low – it is all about the convex tails.
The chart below shows the 3 prices series – the US 5 year yield, the US Dollar-Japanese Yen exchange rate and the price of gold – inverted here. Each of these markets have their own fundamental drivers, but for periods of time they can share the same set of dominant factors that determine price action. A story gets built around them that sounds compelling, and correlations become self-fulfilling…for a while. In previous years, these markets have been a popular way to trade interest rate views, but the recent divergence is fascinating. It’s a good example on the importance of focusing on the areas closest to home when taking macro bets, rather than being lulled into related markets that may be correlated at the time. If those correlations change, you can be right on the view, but wrong in the implementation. That’s no fun for anyone.
The narrative around each is decently intuitive – if you thought yields would go up, positioning in the currency markets where interest rate differentials are often dominant drivers makes sense. Nowhere is this more true than in Yen, which has arguably the most extreme form of easing in yield curve control, pegging the 10 year JGB around zero. Further, Japan appears to be the furthest major economy from tightening. This made sense for a while – as you can see in the run up to the US election and the reactions afterwards, perfectly fine way to play it. The gold view was also fairly compelling – low rates would lead to inflation, which gold is a great hedge against (not that we agree, but that was the view). So higher rates, particularly real rates, would push gold down. Again, in the run up to, and coming out of the election, this was an OK way to position. Spreading risk between the three expressions was a defensible thing to do. The second chart drums it home a different way – it shows just USDJPY and the US 5 year yield, and the 30 day correlation. That’s likely too short a window, and correlations are odd things, but it gets the point across – they correlated at 0.8 during these periods.
The recent move higher though…not so much. Gold has not fallen, and the Japanese Yen has gone the opposite way. Only the rates view worked. That 0.8 correlation went to zero on a dime. New narratives are popping up to rationalize it away and sound smart ex post – but ex ante it wasn’t clear at all. No one knows if it will continue or will revert either. Markets change and stories shift – the more things change, the more they stay the same.
Two years ago, Dudley was spooked by tightening financial conditions. Now, they can’t figure out why they are so loose.
I think there is a simple explanation. Two years ago rates were so low that credit could not go any lower, as they would go below the default rate. So it looked like financial conditions tightened. Now, as the fed raises rates, credit has stayed at the same price, so it looks like financial conditions are getting looser. Here is a chart of auto loans. Rate has not changed. Unless the central banks buys credit (as they have done in Europe, forcing HY below UST), the nominal rate cannot go any lower, but won’t go up right away either. If you are at the default bond in credit, do measures of financial conditions fail to make sense?
This FT piece by Gavyn Davies is getting some attention. He makes the case that the upturn in growth we are currently seeing is likely not a secular shift from possible stagnation, but a (welcome) cyclical burst. He references San Francisco Fed President Williams recent paper concluding that the equilibrium real interest rate (r*) is likely to remain much lower than in the past. Briefly, r* is derived by reflecting on an ex post realized output gap relative to the Feds policy stance. If the Fed sets policy rates at what they think ex ante are very accommodative real interest rates relative to the estimate of neutral rates at that time, and yet over the forecast horizon growth doesn’t respond, they conclude that they haven’t been as easy as they thought. They then mark down what the neutral rate must have been, and then judge their current policy stance in relation to the new neutral rate. The effect of this is that in the Feds mind, policy rates at 0.5% could go from being thought of as very easy, to not that easy, if growth didn’t respond. Even though the principal author of secular stagnation Larry Summers is clear that it is a hypothesis, this is lost on the commentariat who treat it as a gospel fact that we are doomed to live out as Japan for the medium to long term.
But is It true? Is it relevant for the future? How much weight should one put on the whole premise? To our eye it’s an exercise in false precision. These are the issues as we see them.
A while back I read a piece about political stability not being all it seems. It made the case that looks can be deceiving, and illustrated it something like this. Since 1945 Italy has had some 40 changes of prime minister. Saudi Arabia has had 6 rulers in the same period. North Korea has had 3. By that metric, Italy appears pretty unstable, while the other two look like oases of calm. But which keeps you up at night? For all the Machiavellian twists and turns in Italian politics, the political process has a way to reset the compression of the spring, to take out some of the tension every few years to stop it from popping, as the Italians turf out the incumbent and vote for a change. North Korea and Saudi Arabia on the other hand don’t have the mechanism, and need more and more pressure to keep it in place. The force underneath keeps on building though, the eventual reaction getting bigger. But that’s statistics for you – measured that way you get an answer on stability, but it’s probably the wrong one.
Everyone knows that bonds are rich. Right thinking people and smart beta types have looked for ways to get fixed income type results without buying bonds. At this point, it feels like bond markets are driving asset prices the world over. Negative interest rates have perversely led to bonds being used for capital gains while equity markets are being used for income. I’m pretty sure that wasn’t in the textbooks. Versions of these flows can be seen everywhere. Where bonds go, utility stocks, consumer staples, quality factors follow. Financials are the opposite of this flow, driven by net interest margins and return on equity. As bonds fall these stocks rally.
Here is a little thought experiment. Let’s compare the results of buying a basket of momentum stocks (single factor concentrated basket, price momentum) with the results of a basket tempered by volatility (2 factors, momentum (high is good), and volatility (low is good)). The difference between the two models shown below in blue, compared with the 10yr yield in red.
Hmmmmm… people love low volatility momentum stocks because they look like bonds. But as Minsky made clear, over time the things people buy for stability can become a source of instability. The seeds of the demise are being sown, the price moves have brought forward a lot of future income.
2nd quarter PCE is going to be 4.5% annual rate. Things are looking up. What if rates do go up. The exit door will not be wide enough.
Can trend following make money in a low rate environment, and is it all bonds?
We often get asked whether trend following strategies can make money in a low interest rate environment, or in a similar vein, if trend following is just a levered long bond position that’s now run its course. In short, we think that higher rates can help some aspects of trend following strategies, but certainly should not be a driver of a long term allocation decision. The portfolio benefit of an allocation to trend following to an investor or plan with more traditional equity and credit market exposures is not solely – or even largely – driven by the fixed income exposure. Using a simple trend following model in commercial markets (commodity, fixed income and currency – we explain here why we think that’s the right approach) below we break down the sources of returns in times of crisis, and suggest an economic rationale as to why it isn’t just about bonds.
Generally we aren’t ones to criticize the Fed – post crisis they have done an excellent job supporting a recovery through zero rates and unconventional measures, and have begun to step back without causing the panic and damage that was predicted. It’s an incredibly difficult job, with huge importance.
That said, our view is that the Fed has pretty much hit the mandate, the data supports that, and an end to zero rates is warranted soon. The drop in Q1 GDP looks increasingly like a quirk. In reading the dueling Fed blogs as to the cause of this drop (New York FED says winter and San Francisco FED says residual seasonality), we can’t help but think that either way, Q1 is not a true reflection of the economy now or going forward. Do you think productivity fell 3% in the first quarter? Although the Fed has consistently been too optimistic with GDP projections, it has also been too pessimistic on jobs. Only one of these is in their mandate. Put simply, the economy doesn’t feel like it needs the same rates as the depths of the crisis, particularly at a time when expansionary policies are starting to take hold elsewhere.