Beginning of November, we published a blog announcing the release of our Q4 YouGov Inflation Expectations Survey for early December. We are now in the final stages of collating and analysing the survey results and will publish the full report in the coming days on Twitter (@inflationsurvey) and our bond vigilantes blog. For those of you who are not aware (where have you been?!), the survey was created by M&G’s retail fixed interest team in partnership with YouGov. We ask over 8,000 consumers from the UK, Europe, Hong Kong and Singapore what their expectations are for inflation over the next 1 and 5 years. This has grown ever more important as central banks have sought to manage interest rate expectations through forward guidance.
The results of the Q3 Survey published last September as well as previous surveys are available here.
So congratulations to the 15 winners listed below, who were chosen at random amongst all our @inflationsurvey followers and who will each receive a copy of Frederick Taylor’s “The Downfall of Money”. We will DM each of you asking for your address so we can send you the book.
Simon Lander @simonlander01
Ian Burrows @ian_burrows
Richard Lander @richardlander
Iain Martin @_IainMartin
Morningstar UK @mstarholly
Brian Simpson @simpsob1
Amir Rizwan @amirriz1
Tim Sharp @tm_sharp
Leanne Hallworth @leanneha41
Kevin Fenwick @kevinfenwick
qori nasrul ulum @reme_dial
Alexander Latter @AlexanderLatter
Ace AdamsAllStar @AceAdamsAllStar
At the end of October, the Citigroup Inflation Expectations survey showed a record jump in UK inflation expectations. The medium term expectation for UK inflation rose from 3.3% in September to 3.9%, and the number of people expecting inflation over 5% also rose significantly. Inflation expectations have become increasingly important in the UK because, as part of Bank Governor Carney’s new forward guidance regime announced in August, the Bank can raise rates even if unemployment remains high if inflation expectations become “unanchored”. Of course the period when the Citigroup survey was conducted was one where the major UK energy suppliers had announced annual price hikes of around 10%, and this spike in inflation expectations may well not persist. But it will have worried the Bank, and the gilt market fell on the release of the data.
Whilst UK inflation was making the news for its potential to surprise on the upside, Europe faced a very different scenario. October’s euro area CPI reading came in at an annual rate of 0.7%, down from 1.1% in September and below the market’s expectations. A Taylor Rule would suggest that with inflation so far from the ECB’s target of 2%, the central bank should be aggressively easing monetary policy (beyond today’s 25 bps cut, and beyond the zero bound to include QE?).
The next M&G YouGov Inflation Expectations Survey for the UK, European and Asian economies will be released in December. These M&G YouGov surveys are based on the best practice methodology discussed by the New York Fed (for example asking people about inflation rather than “prices of things you buy” as that sort of question tends to make people think solely of milk, bread and beer). We also have a bigger data sample than many of the other inflation surveys. Finally we also ask some interesting supplementary questions on issues like government economic policy credibility. As inflation expectations become increasingly important to central banks we think that we need to pay more attention to them – to date they have been well anchored, despite money printing through QE, but if this changes then so will central bank behaviour.
The Q4 M&G YouGov Inflation Expectations Survey will be released through Twitter. Follow @inflationsurvey to get the release time and date, and also to access the detailed report in December. The feed will also tweet on other inflation surveys and measures of inflation expectations. We hope you find it useful.
To encourage you to follow @inflationsurvey and be first to get the survey results, everybody who does so (and existing followers) will be put into a draw to win one of 15 copies of Frederick Taylor’s The Downfall of Money. This is the story of Germany’s hyperinflation of the 1920s, where the Reichmark fell to 2.5 trillion to the US dollar, and the economy collapsed – arguably sowing the seeds of the Second World War.
I was recently fortunate enough to see a presentation by Phillip Turner from the Bank for International Settlements (BIS) on a paper he published earlier this year. ‘Benign neglect of the long term interest rate’ is a highly informative and interesting piece. In it he argues that after decades of the market determining long term interest rates the “large scale purchases of government bonds have made the long term interest rate key in the monetary policy debate”, and that a policy framework should be implemented around long term rates.
The use of central bank balance sheets isn’t as novel a concept as one might think when they hear (as I did repeatedly over 4 days of conferences and seminars in conjunction with the IMF/world bank annual meetings) QE described as unconventional monetary policy. In fact Keynes argued that central banks should stand ready to buy and sell government bonds as a means of affecting the price of money (the interest rate) from as early as the 1930s. Furthermore, the Thatcher government engaged in “quantitative tightening” as recently as the early 1980s by issuing more long dated gilts than were required to finance government spending. The rationale was that issuing more gilts would drain liquidity, curtail broad money growth and slow inflation more effectively than just increasing the Bank Rate.
Setting policy for longer term interest rates may be new territory for today’s generation of policy makers however it shouldn’t be for some. It’s often forgotten that the Fed actually has a triple, not dual mandate. Along with maximising employment and promoting stable prices they are also charged with providing moderate long term interest rates.
What constitutes a moderate long term interest rate is a matter for debate but the paper makes clear that adjusting the short term rate is not necessarily an effective measure in influencing the 10yr yield.
Turner argues that it may be more efficient to alter the average maturity of the outstanding government bonds – those not held by the central bank – through open market operations. The BIS has calculated that shortening the average maturity by one year will lead to a 1% reduction in the yield on a 10 year note. Essentially the message is that the longer the average maturity of the outstanding debt the tighter the policy.
The inherent irony of lowering long term rates to stimulate the economy is that it reduces the incentives for banks to perform their socially useful function of maturity transformation – borrowing short and lending long. The lower long term interest rates the less of an incentive banks have to lend further out along the yield curve. The graph below shows that the term premium in the US 10yr has been negative for a large part of this decade.
However I believe that tougher regulation (larger capital buffers), increased litigation costs and a general de-levering of the economy will restrict the level of bank lending regardless of how steep the yield curve is.
This chart shows the maturity distribution of bonds held by the Fed.
I’ve calculated that the average maturity of all Treasuries in issue is roughly 6 years, whilst the average of those on the Fed’s balance sheet is about 10 years. Operation Twist was a conscious effort by the fed to lower long run yields and they are still buying bonds at the long end. Given that factors other than the steepness of the yield curve are driving bank lending perhaps the Fed should be buying fewer Treasuries with 7-10 years to maturity in favour of even more longer dated ones. Also if and when they decide to sell their holdings they should consider this (and the on-going) analysis on the wider implications of altering the average maturity of the Treasury free float.
There are plenty of other interesting observations and questions raised in the paper so I recommend reading the whole thing…..especially if your job involves managing a central bank balance sheet.
Today’s release of jobless claims shows that the US economy is continuing its healthy response to the stimulus provided by the Fed. Momentum in the US labour force remains in a positive direction.
The very long term chart below shows today’s headline number of 331,000 to be relatively low historically. However, this is actually understating the current strength of the labour market.
In order to interpret the jobless rate more effectively we need to look at it as a percentage of the ever increasing labour force, and not just the headline number. We have made those adjustments in the chart below.
The fact that the economy has thankfully responded to low rates is good, though not new, news. However, the one thing that is very different this time is where we are in the interest rate cycle. At previous lows in jobless claims the Fed has typically been tightening to slow the market down. This time they are still in full easing mode with conventional and unconventional policy measures. This contrasts dramatically with the lows in jobless claims in the late ’80s and the beginning and the middle of the last decade, when the Fed was already in full tightening mode. This is highlighted in the chart below.
As you would expect to see, interest rate policy works with a lag. Given that we are unlikely to see conventional tightening for a while, one would expect the US economy to remain in decent shape.
A bear market in bonds can be seen as predicting a future normalisation of rates. If, like the Fed, you recognise that this time around things are not all normal, then you could expect short rates to stay low and employment growth to continue. The extent of the current bear market in bonds is therefore limited by the new environment we are in, where conventional economic systems have been amended and changed by the financial crisis.
So far this year returns for the high yield market seem solid if unspectacular; 2.9% for the global index, 4.5% for Europe and 3.4% for the US. However, these overall numbers mask some interesting gyrations within the markets. It’s been a mixed year for government bonds but a solid year for credit spreads. Indeed, recent moves in the sovereign bond markets continue to focus investors’ minds on the haunting spectre of interest rate risk. The high yield market is not entirely immune to such fears but we need to remember that interest rates are only one driver of performance. High yield returns are also subject to factors such as changes in credit spreads, default rates and carry.
To illustrate this, we have two sets of bonds below: two long dated BB rated bonds (issued by German healthcare business Fresenius and US listed packaging group Owens Illinois) and two short dated CCC bonds (issued by the global chemicals company Ineos and another packaging group, Reynolds). The BB bonds carry relatively more interest rate risk than the latter due to their longer maturity, but less credit risk given the higher credit rating.
Modified Duration (yrs)
Fresenius 2.875% 2020
Owens Illinois 4.875% 2022
Ineos 7.875% 2016
Reynolds 8.0% 2016
Source: Bloomberg, M&G, August 2013
So how have these bonds fared over the past few weeks ? The chart below shows the relative price performance.
The chart shows that none of the bonds were immune to the volatility we saw over the summer. Indeed this was a relatively rare period where interest rate duration and credit risk premia moved in tandem. However, what is clear is that the longer dated bonds suffered more during the correction. When we consider total returns, this becomes more stark. The table below shows the impact of the different coupons over the three months in question. Again, the shorter dated CCC bonds fare better.
Period 01/05/13 – 19/08/13
Fresenius 2.875% 2020
Owens Illinois 4.875% 2022
Ineos 7.875% 2016
Reynolds 8.0% 2016
Source: Bloomberg, M&G, August 2013
The point here is that judiciously taking on more default risk in the form of a higher coupon and or spread whilst at the same time minimising your interest rate risk by focusing on short dated bonds, is one way that fixed income investors can ride out greater volatility within the government bond markets and still look to generate positive total returns. In this environment, default risk (as opposed to duration) really is the lesser of two evils.
The governor at the Bank of England stepped forward last week with guidance about its future plans and conditions regarding the tightening of monetary policy. Ben gave his views on the announcement here last week, but what I am going to focus on is the 7 percent unemployment rate ‘knockout’.
Firstly, why has the Bank of England decided to use the unemployment rate as an indicator of inflationary pressures? Well, in the press conference they expressed that this is a good indicator of excess capacity. This has some obvious logic to it, so let’s explore this knockout level in an historical context.
Below is a chart of UK unemployment going back 20 years. As you can see, the rate was below 7 percent from 1997 to 2009 – a period of good economic growth where the bank acted regularly to tighten policy to keep inflation under control. In fact this new knockout does not appear to be new news, as the bank rate has rarely increased when unemployment exceeded 7 percent over this period.
Looking at the next chart you can see the regions that currently have unemployment at 7 percent or below and the ones that do not. This regional disparity is not as strong as in Europe, but is something one should take into account.
Mobility of labour is needed for the rate to fall below 7 percent, with work relocated to labour and labour relocated to work. This is beyond the Bank of England’s remit, and is more of a central government economic project. The better regional labour mobility is, the quicker the UK can get unemployment below 7 percent. So, the easier it is to move house, or the quicker transport links are, the quicker unemployment can get below 7 percent. If regional labour mobility in the UK is very rigid then getting below 7 percent may not occur for years.
One new factor that we should take into account is the developing context of the wider European labour market. The UK workforce is not only competing as a whole internationally, but within the domestic economy it now also competes with international labour. The free movement of labour in the European Union combined with high rates of unemployment on the continent means that UK unemployment (spare labour capacity) can no longer be set with reference to our domestic borders. The huge pool of available labour could well dampen reductions in UK measured unemployment, aided by the UK’s tradition of welcoming foreign labour, its diversity of population (especially in areas seeking workers), and the fact that English is a well taught second language abroad. This could well act to reduce the ability of unemployment to fall in the UK despite low policy rates.
Even if the UK economy does respond to monetary policy and we reach escape velocity, labour immobility in the UK and or the supply of continental labour will have a baring on when the 7 percent unemployment rate is knocked out. Using this as a signal to raise rates could well mean that rates stay low for a long time even as the economy recovers.
Listening to the Bank of England Quarterly Inflation Report press conference – the first with Mark Carney steering the ship – a song immediately sprung to mind. The song was written by a former student of the London School of Economics, Sir Michael “Mick” Jagger with his colleague Keith Richards in 1965. There is no better way to analyse the current thinking of the Bank of England than through one of The Rolling Stones best songs, (I Can’t Get No) Satisfaction.
“I can’t get no satisfaction”
The new BoE Governor began with the positive news that “a recovery appears to be taking hold”. This wasn’t news to the markets, as more recently we have seen a remarkably strong string of economic data. However, the very next word in Mr Carney’s introduction was “But…”. What followed was, in my opinion, the most dovish sounding central bank policy announcement since the darkest days of the financial crisis.
Carney firmly announced his arrival as the global independent (excluding BoJ) central banking community’s uber-dove through the acknowledgement of a broadening economic recovery in the UK, and then making explicit that the BoE remains poised to conduct more, not less, monetary stimulus. Until now, these two conditions were considered by bond markets to be pretty much incompatible.
“’Cause I try and I try and I try and I try”
Carney told us that the BoE will maintain extreme monetary slack (in terms of both the 0.5% base rate and the £375 billion of gilts held) until the unemployment rate has fallen to at least 7%. He went even further than this, stating the MPC is ready to increase asset purchases (QE) until this condition is met. However, there are two conditions under which the BoE would break the new, explicit link between monetary stimulus and unemployment: namely, high inflation and threats to financial stability. Did the new governor have to put these caveats in place because other members of his committee would only agree to the announcement if they were mentioned?
“Supposed to fire my imagination”
The new framework announcements were broadly in-line with what we were expecting. In that respect, the Governor’s major announcement was not too much of a surprise. The market agreed and there was a relatively muted response. Carney was supposed to fire our imaginations, so the question is – did we learn anything new? The “yes” and “no” arguments are outlined in the below table.
“When I’m watchin’ my T.V. and that man comes on to tell me how [the economy should] be…
The market suspected Mr Carney would bring in some forward guidance, but I think the most interesting implication of this announcement today is that he felt the need to do something, but did not feel the need to increase asset purchases through QE. Mervyn took on the first part of Friedman’s equation, the supply of money. This was not inflationary as the transmission mechanism was broken, and the cash was hoarded and not released into the real economy. Could Carney be the governor to focus on the second part of the equation, money velocity? Forward guidance is designed to give individuals and companies the confidence to borrow in order to spend or invest. If they do, velocity will return as the transmission mechanism repairs. I believe we are considerably less likely to see an increase in QE under the new governor.
If forward guidance does not have the consequences Carney intends, and my belief that he is more focused on the transmission mechanism than his predecessor, what might Carney do next? At that point, he might increase schemes akin to Funding for Lending, and hand banks cheap funds at the point at which the banks release the loans to borrowers. This way, banks are heavily incentivised to lend at levels that are attractive to individuals and companies.
“He’s tellin’ me more and more, about some useless information”
Carney told us that if and when unemployment reaches 7%, policy will start to tighten. But then he stated that if inflation exceeds 2.5% on the BoE’s shocking 2 year forecast (is this a rise in the inflation target?), or if inflation expectations move beyond some unannounced bound, or if financial stability is under threat, then he might have to break the newly explicit link between unemployment and monetary policy. And then he stated that even if unemployment hits 7%, this will not trigger a policy change, but a discussion around one.
I don’t think we actually got pure forward guidance, but a pretty muddled variant thereof. Bond markets are rightly unsure as to how to react, and have struggled for a satisfying interpretation. All we can really take from the BoE is that they will need to be sufficiently satisfied that the UK economy has reached escape velocity before hiking rates or reversing policy.
The early summer surge in bond yields will have focused the minds of many investors on the allocation of assets in their portfolios, particularly their fixed income holdings.
The largest risk to a domestic currency fixed income portfolio is duration. When investors discuss duration they are more often than not referring to a bond or portfolio’s sensitivity to changes in interest rates. Corporate bonds however also carry credit spread duration – the sensitivity of prices to moves in credit spreads (the market price of default risk).
Exposure to interest rate risk and credit risk should be considered independently within a portfolio. Clearly the desirable proportion of each depends heavily on the economic environment and future expectations of moves in interest rates.
I believe that the US economy and, to a lesser extent, the UK economy are improving and at some point interest rates will begin to move closer to their (significantly higher) long-term averages. We may still be a way off from central banks tightening monetary policy, but they will when they believe their economies are healthy enough to withstand it. Since a healthier economy increases the probability of tightening sooner, and is positive for the corporate sector, one should endeavour to gain exposure to credit risk premiums while limiting exposure to higher future interest rates.
In the latest version of our Panoramic series I examine the US bond market sell-off of 1994 to see what we can learn from the historical experience. Additionally, I analyse the power of duration and its importance to fixed income investors during a bond market sell-off.
Moody’s, the credit rating agency, published a report a few days ago on the asset backed securities market. One section of the report has attracted some media attention – it details the agency’s thoughts on UK interest-only residential mortgage-backed securities (RMBS).
Moody’s reaches the fairly unsurprising conclusion that when interest rates start rising in the UK delinquencies on interest-only mortgages will pick up. They go on to say that this effect will be greater in the non-conforming sector than in the prime segment of the market. This makes sense, as borrowers who have an impaired credit history usually fall into the non-conforming bucket and are therefore, on average, more likely to have trouble paying their mortgages than those who qualify as prime borrowers.
This isn’t as bad for RMBS deals that are backed by interest-only mortgages as one might think. A large proportion of RMBS deals are structured with features that protect investors in the more senior notes to the detriment of those who own the more junior ones. A variety of trigger levels are usually built into the deals which amongst other things reference delinquencies and credit enhancement. If these triggers are hit, cash flows are diverted to the most senior tranche of notes, bringing forward their maturity date and increasing their yield.
A deal I have been looking at recently is 95% backed by interest-only mortgages and has a trigger when 7.5% or more of the mortgages are more than three months in arrears. Delinquencies are currently much lower than that but if they did breach the 7.5% level the deal would switch from paying pro-rata to sequential. This means that any excess cash that is generated through repossessions or borrowers re-mortgaging will all be paid to the lenders at the top of the stack instead of being shared by all the note holders. An increase in interest rates and delinquencies would in this instance clearly be of benefit to the senior notes.
Another dynamic to be aware of is when the mortgages backing the deal were originated. Mortgages taken out closer to the peak of the credit bubble in 2007 are generally of a lower quality because lending standards were weaker and borrowers generally have less equity in their property. As a result, these mortgagees have less of an incentive to keep paying their mortgage each month.
Holders of junior notes in later vintage deals should definitely be worried by the prospect of higher interest rates in the future. Senior note holders – whilst remaining attentive to movements in the market – should be fairly comfortable with the credit quality of their bonds, even in a climate of higher interest rates.
Just when you thought the Fed had well and truly killed the carry trade, a surprisingly dovish Mario Draghi reminded markets yesterday that Europe remains a very different place from the US. Having previously argued that the ECB never pre commits to forward guidance, yesterday marks something of a volte-face. ‘The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.’ The willingness to offer guidance brings the ECB closer to its UK and US peers, the latter having been in the guidance camp for some time. This firmly reinforces our view that the ECB retains an accommodative stance and an easing bias.
The willingness to offer forward guidance to the market no doubt came after some long and hard introspection within the Governing Council. So why the change ? Firstly, the ECB is worried that it may miss its primary target of maintaining inflation at or close to 2% over the medium term. Secondly, Draghi indicated an increasing concern that the real economy continues to demonstrate ‘broad based’ weakness, and finally, as has been the case for some time, the Council worries that the Eurozone continues to labour with subdued monetary dynamics. This sounds increasingly like Fed talk of recent years.
Draghi also expressed his concern yesterday during his Q&A at the effective tightening of monetary conditions via higher government bond yields (see chart) since the Fed’s tapering discussions. Frankly the last thing the Eurozone needs at this stage in its nascent recovery is higher borrowing costs.
Draghi in communicating that the next likely move will be an easing of policy has attempted to talk bond yields down. European risk assets appear to have taken his comments positively but the bond market remains sceptical. At the time of writing only short to medium dated bonds are trading at lower yields.
In conjunction with revising down its 2013 Italian GDP forecast from -1.5% to -1.8%, the IMF has publicly urged the ECB to embark upon direct asset purchases. Is this a likely near term response ? For now those calls will likely fall on deaf ears especially with German elections later this year. The ECB clearly believes that its next move would be to cut rates further in response to a weaker outlook. Buying time seems to be the current approach.
However, should Eurozone inflation expectations continue to undershoot (the market is currently pricing 1.36% and 1.66% over the next 5 & 10 years, see chart) and economic performance remain downright lacklustre across Europe, then the ECB will have to think very carefully about what impact it can expect from a ‘traditional’ monetary response. QE may be some way off, and would no doubt see massive objections from Berlin, but in the same way that the ECB never pre commits, maybe just maybe, QE will be on the table sooner than the market is currently anticipating.