matt_russell_100

The power of duration: a contemporary example

In last year’s Panoramic: The Power of Duration, I used the experience of the US bond market in 1994 to examine the impact that duration can have in a time of sharply rising yields. By way of a quick refresher: in 1994, an improving economy spurred the Fed to increase interest rates multiple times, leading to a period that came to be known as the great bond massacre.

I frequently use this example to demonstrate the importance of managing interest rate risk in fixed income markets today. In an investment grade corporate bond fund with no currency positions, yield movements (and hence the fund’s duration) will overshadow moves in credit spreads. In other words you can be the best stock picker in the world but if you get your duration call wrong, all that good work will be undone.

We now have a contemporary example of the effects of higher yields on different fixed income asset classes. In May last year Ben Bernanke, then Chairman of the Fed, gave a speech in which he mentioned that the Bank’s Board of Governors may begin to think about reducing the level of assets it was purchasing each month through its QE programme. From this point until the end of 2013, 10 year US Treasuries and 10 year gilts both sold off by around 100bps.

US UK and German 10 year yields

How did this 1% rise in yields affect fixed income investments? Well, as the chart below shows, it really depended on the inherent duration of each asset class. Using indices as a proxy for the various asset classes, we can see that those with higher durations (represented by the orange bars) performed poorly relative to their short duration corporate counterparts, which actually delivered a positive return (represented by the green bars).

The importance of duration

While this is true for both the US dollar and sterling markets, longer dated European indices didn’t perform as poorly over the period. There’s a simple reason for this – bunds have been decoupling from gilts and Treasuries, due to the increasing likelihood that the eurozone may be looking at its own form of monetary stimulus in the months to come.  As a result, the yield on the 10-year bund rose by only 0.5% in the second half of 2013.

Whatever your view on if, when, and how sharply monetary policy will be tightened, fixed income investors should always be mindful of their exposure to duration at both a bond and fund level.

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Seeking relative value in USD, EUR and GBP corporate bonds

In terms of investment grade credit, it has been a common theme for global fixed income investors to think of EUR denominated credit as relatively expensive versus USD credit. Conversely, many see GBP corporate bonds as relatively cheap. But can it really be as simple and clear-cut as this? To answer this question, I have compared monthly asset swap (ASW) spreads of IG credit, issued in these three currencies, both on an absolute spread and a relative spread differential (EUR vs. USD and GBP vs. USD) basis.

At first, I looked at the three BoAML corporate master indices for publicly issued IG debt, denominated in USD, EUR and GBP. As shown below, until the onset of the financial crisis in the middle of 2007, USD IG credit was trading at spread levels of around 50 bps, which is almost exactly in line with GBP and on average only 15 bps wider than EUR IG credit. During the financial crisis, USD spreads widened more dramatically than EUR and GBP spreads. At peak levels in November 2008, when USD spreads reached 485 bps, EUR and GBP credit spreads were significantly tighter (by 215 bps and 123 bps, respectively). Subsequently, GBP IG spreads surpassed USD spreads again in May 2009 and have been wider ever since.

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In contrast, EUR IG credit spreads have been consistently tighter than USD spreads. Even at the height of the Eurozone crisis in late 2011, the EUR vs. USD credit spread differential was negative, if only marginally. Over the past three years, USD IG credit has been trading on average at a spread level of 166 bps, i.e., nearly 30 bps wider than EUR IG credit (137 bps average spread) and c. 50 bps tighter than GBP IG credit (215 bps average spread). Hence, when only looking at an IG corporate master index level, it is justified to say that subsequent to the financial crisis EUR credit has been looking relatively expensive and GBP credit relatively cheap compared to USD credit.

Taking only headline master index spreads into consideration is an overly simplistic approach. A direct comparison between the USD, EUR and GBP corporate master indices is distorted by two main factors: index duration and credit rating composition. As shown below, there are substantial differences in terms of effective index duration between the three master indices. Over the past ten years, the effective duration of the USD master index has been on average 6.2, whereas the EUR and the GBP indices exhibited values of 4.4 and 7.3, respectively. Currently, index duration differentials account for -2.1 (EUR vs. USD) and 1.4 (GBP vs. USD).

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These significant deviations in duration, and thus sensitivity of bond prices towards changes in interest rate, render a like-for-like index comparison problematic. The same applies to differences in credit rating composition. Take, for example, the rating structures of the USD and the EUR master indices in March 2010. Whereas the USD index hardly contained any AAA (below 1%) and only c. 18% AA rated bonds, the EUR index comprised nearly 6% AAA and c. 26% AA bonds. In contrast, the ratio of BBB bonds was significantly higher in the USD index (almost 40%) than in the EUR index (c. 22%). The credit quality on that date was distinctly higher for the EUR index than for the USD index, and directly comparing both indices would therefore be a bit like comparing apples to… well, not necessarily oranges but maybe overripe apples, for lack of a more imaginative metaphor.

Duration and credit rating biases can be removed from the analysis – or at least materially reduced – by using bond indices with narrow maturity and credit rating bands. As an example, I plotted relative spread differentials (i.e., EUR vs. USD and GBP vs. USD) for the past 10 years, based on the respective BoAML 5-10 year BBB corporate indices. To add another layer of complexity, this time I did not use headline corporate index level spreads but differentiated between financials and industrials instead. As only relative spread differences are shown, positive values indicate relatively cheap credit versus USD credit and, conversely, negative values signal relatively expensive credit.

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Until October 2010, the graphs follow a very similar path, EUR and GBP credit spreads trade fairly in line with USD spreads up to the financial crisis, when USD spreads widen more strongly than both EUR and GBP spreads, pushing spread differentials temporarily into deeply negative territory (below -220 bps in the case of financials). Then things got more interesting as spread differentials seem to decouple to a certain extent from October 2010 onwards. At this level of granularity it becomes clear that it is an inaccurate generalisation to refer to EUR credit as expensive and GBP credit as cheap versus USD credit.

In terms of 5-10 year BBB credit, EUR financials have in fact been trading consistently wider than USD financials, although the spread difference has been falling considerably from its peak Eurozone crisis level of 201 bps in November 2011 to currently only 10 bps. EUR industrials have been looking more expensive than USD industrials since early 2007 (c. 35 bps tighter on average over the past 3 years). The trajectory of GBP financials spread differentials has been broadly following the EUR financials’ humped pattern since late 2010, rising steeply to a maximum value of 259 bps in May 2012 and subsequently falling to current values at around 115 bps. GBP industrials have been looking moderately cheap compared to USD industrials since late 2010 (c. 37 bps wider on average over the past 3 years), but the spread differential has recently vanished. Hence, regarding 5-10 year BBB credit, currently only GBP financials are looking cheap and EUR industrials expensive versus the respective USD credit categories, whereas GBP industrials and EUR financials are trading in-line with USD credit.

To sum things up, when comparing USD, EUR and GBP IG credit, headline spreads are merely broad-brush indicators. To get a greater understanding of true relative value, it is worth analysing more granular data subsets to understand the underlying dynamics and the evolution of relative credit spread differences.

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jim_leaviss_100

US Treasuries – are we nearly there yet? Maybe we are.

Before we get all beared up about tapering, it’s worth seeing how far we’ve come already, and what the end game should be. The sell-off in US Treasury bonds has already been severe. 10 year yields have risen from a low of 1.4% in July 2012 to nearly 3% today. Most street strategists have yields rising further in 2014, with the consensus 10 year forecast at 3.37% for a year’s time.

But as well as looking at the spot yield, we should see what the yield curve implies for future yields. The chart below shows the 10 year 10 year forward rate – in other words the expected 10 year UST yield in a decade’s time backed out mathematically by looking at long dated UST yields today. You can see that the implied 10 year yield is now over 4%, at 4.13%.

The other thing I have put on the chart is a shaded band representing the range of expectations within the Federal Open Market Committee (FOMC) for the longer run Federal Funds rate. You can find this range of expectations here on the third slide of the charts from yesterday’s FOMC minutes. Four members think that that the long run Fed Funds rate is as low as 3.5%, and two think it is as high as 4.25%. The median expectation is 4%.

The bond market expects 10 year USTs to yield 4.13% in a decade’s time

Now the 10 year bond yield is effectively the compounded sum of all short rates out to 10 years, plus or minus the term premium (which we will discuss in a minute). If the FOMC members are correct that 4% is the long run interest rate, then if the term premium is zero, the 10 year forward rate at 4.13% has already overshot where it needs to be, and we should be closing out our short duration positions in the US bond markets.

The term premium is important though (this blog from Simon Taylor is good at explaining what it is, and showing some estimates). The term premium is compensation for the uncertainty about the short rate forecast. Historically it has been positive, as you might expect, reflecting future inflation or downgrade risks. In recent years though it has been negligible, even negative – perhaps due to a non-price sensitive buyer in the market (the Fed through QE), but also perhaps due to deflation rather than inflation risk? It is likely however that the term premium rises at a turning points in rates – and also that if inflation ever made a sustained comeback, with central banks refusing to fight it, like in the pre-Volker years, the risk premium would rise strongly. We also know that markets tend to overshoot in both directions. Nevertheless, whilst it’s too soon to say that we’ve seen the highest yields of this cycle, as a value investor you could say that yields are moving towards fair value.

anthony_doyle_100

A Fed taper is on the table

The FOMC took markets and economists by surprise in September this year when the committee members decided to hold off from tapering and maintain its bond-buying programme at $85bn per month. Three months down the road and the consensus for the December meeting outcome is that the Fed will not reduce the pace of MBS or treasury purchases. Consensus has been wrong before; will it be wrong again tomorrow? We think it will be a closer call than many expect.

In our opinion, there are several good reasons for the Fed to taper very slowly. Firstly, inflation is a non-issue, below target and close to lows not seen for decades. Secondly, the 30 year mortgage rate has risen from 3.5% in May to around 4.5% today, impacting US housing affordability and already tightening policy for the Fed. Thirdly, there is continued concern that 2014 may bring a return of the political brinkmanship that characterised late September, with the US Treasury signalling that the debt limit will have to be raised by February or early March to avoid default. Ultimately, the Fed is nowhere near hiking the FOMC funds rate.

There is no doubt after the September decision that tapering is truly data dependent and in this sense, macro matters. Fortunately, Ben Bernanke has told us what economic variables he and the FOMC will be looking at a press conference in June. The Fed wants to see a broad based improvement in three economic variables – employment, growth and inflation – before reducing the scale of bond buying.

The table below shows that the data has improved across the board. Annualised GDP is stronger, the unemployment rate is lower and the CPI is only 1.2%. Other key leading economic indicators like the ISM and consumer confidence are higher while markets are in a remarkably similar place to where they were three months ago with the 10 year yield at 2.86%.

US macroeconomic indicators chart

After the surprise of September’s announcement, we believe that every FOMC meeting from here on out is “live” – that is, there is a good chance that the Fed may act to reduce its bond-buying programme in some way until it reaches balance sheet neutrality. A reduction in bond purchases is not a tightening of policy, we view it as a positive sign that policymakers believe that the US economy is finally healing after the destruction of the financial crisis. As I wrote in September, interest rate policy is set to remain very accommodative for a long time, even after balance sheet neutrality has been achieved.

Given the positive developments in the US economy over the past three months, the December FOMC announcement could announce a) a small reduction in bond buying and b) an adjustment of the unemployment rate threshold or a lower bound on inflation. Whatever the case, quantitative easing is getting closer to making its swansong.

Anjulie-Rusius_100

A shifting Beveridge Curve – Does the US have a long term structural unemployment problem?

I am sure that many of us are familiar with some of the better known economic theories concerning unemployment which have previously been discussed or alluded to on this blog e.g. Okun’s Law and the Taylor Rule, but perhaps a lesser known theory (which has been receiving growing attention from economists in recent times), is the Beveridge Curve.

Using data on job vacancies and unemployment, the Beveridge Curve indicates how efficient an economy is at matching unemployed workers to job vacancies and can indicate where in the business cycle an economy sits. Looking specifically at data for the US from December 2000 onwards, the jobs market behaved as you’d expect; changes in the supply or demand for labour causes movement along the curve (this is particularly apparent during the highlighted recessionary periods). But what is particularly interesting – and glaringly obvious – is the shift which occurred post June 2009. The looping movement “back up the curve” is less surprising as after an economic contraction, this would be precisely what you would expect during a recovery period (i.e. falling unemployment teamed with an increase in the job vacancy rate as firms start to hire again).

Slide1

But what could have caused this shift in the Beveridge curve, which if it remains, could imply a long term increase in structural unemployment?

1) Inefficiency. The shift is essentially indicative of an increase in the job vacancy rate. So perhaps we could argue that there has been a short-term reduction in the efficiency of job matching due to labour market conditions. Indeed, this inefficiency could in part have arisen from a decrease in labour mobility, linked to the US housing market. Since home prices are still below the pre-crisis peak, this could result in reluctance from jobseekers to sell their homes, which could in turn geographically limit their search. If this were true, in time the curve would be expected to shift back in line as the housing market recovers and jobs and workers get matched more quickly.

2) The labour force participation rate. Perhaps the shift has been caused by the post-crisis increase in unemployment. As the theory would have it, as the number of job seekers increases relative to the population, this would cause an outward shift of the Beveridge Curve. The US has however witnessed the exact opposite since 2009 – a fall in both the unemployment and labour force participation rates. On this point, research from Unicredit suggests that the fall in the latter is causing the unemployment rate to be understated were it not for the decline in the labour force participation rate, unemployment would stand at 11.5%. This signifies that the US may well have an underlying structural unemployment problem that is currently being ignored.

Slide2

3) Long term unemployment. If caused by a fundamental mismatch between an employer’s requirements and an employee’s skill set (which deteriorates as more and more time is spent out of work), long term unemployment could cause the Beveridge Curve to shift outwards. Indeed, the proportion of unemployed workers who have been without work for 27 weeks upwards has increased since June 2009 and remains high, suggesting that a long term structural shift may have occurred in the US.

Slide3

4) Increasing frictional unemployment. To cause an outward shift of the Beveridge Curve, frictional unemployment – the time period between jobs, caused by redundancies and resignations – would have to increase. Although this could have caused the initial shift, to my mind, this argument is inconsistent with longevity of the shift. If the shift were solely due to frictional unemployment, this impact should have been eroded since 2009 as labour market performance gained some ground.

5) Economic and policy uncertainty. I think it’s fair to say that the US has seen its fair share of economic uncertainty since 2009 and significant political headwinds in 2013 alone. Firstly, with regards to the sequestration earlier this year which saw fiscal contraction manifest most notably via the expiration of the temporary payroll tax and budget caps. Secondly (although more recently so this will not yet be reflected in the data), political headwinds have continued in the form of the prolonged Government shutdown. As such, these headwinds could potentially explain the lasting effect of the shift, in 2013 at least.

On the whole, the outward shift of the Beveridge Curve indicates that there has been a significant change in the US labour market. The key question however is whether or not this shift will prove to be a short term phenomenon that will erode over time as the US recovery strengthens. If we suppose that the shift is temporary and that the US will revert to norm, reading off the graph, this suggests that unemployment for August 2013 should have been in the region of 5.5%, which is well below the Fed’s trigger level to raise interest rates. On the other hand, is this too optimistic and have we instead witnessed a long term shift that is here to stay? The Beveridge Curve is one to watch.

mike_riddell_100

Why the US Dollar now looks cheap against, well, basically everything

Back in January I wrote about why we loved the US dollar and worry about EM currencies, and did an update on EM in June (see EM debt funds hit by record daily outflow – is this a tremor, or is this ‘The Big One’?).  Another EM piece will follow soon (the short version is that while it was ‘just’ a tremor,  I’m increasingly worried that ‘The Big One’ is coming).

The US Dollar was strong through Q1 and Q2, but an interesting development in Q3 was that while the US Dollar held up OK against most EM currencies, it performed abysmally against other developed currencies.  Below is a chart of the US Dollar Index, a gauge of US Dollar performance against a basket of major world currencies, where the basket contains EUR (57.6%) JPY( 13.6%) GBP (11.9%) CAD (9.1%) SEK (4.2%) CHF (3.6%). The Dollar Index is back to where it was at the beginning of the year, and despite the relative strength of the US economy versus other developed countries, the Dollar Index has now returned to the average level of the last five years.

US Dollar Index has cheapened all the way back to 5yr average

The reasons that led us (and an increasing number of others) to be so excited about the US dollar over the past 18 months were namely compelling USD valuations following a decade long slump, an improving current account balance, the rapid move towards energy independence, and a strengthening US economic recovery where a surging housing market and a steadily falling unemployment rate made it likely that the US would lead most of the world in the monetary policy tightening cycle.

The long term positives for the US dollar are still there, but have recently been overshadowed by negative ones.  So what has changed?  Recent US Dollar weakness is probably to do with the Fed’s non-tapering in September, the ongoing budget nonsense, and a very big unwind in a whole heap of long USD positions.

It makes sense to be more bullish on the US dollar because these negative forces appear to be dissipating.

Firstly the non-tapering event.  Treasury yields and the US dollar had already started to drop ahead of the non-tapering decision thanks to a slight weakening in US data, with US 10 year yields dropping from 3% on September 5th to 2.9% on September 18th and the Dollar Index falling 2%.  Nevertheless markets were still taken by surprise, and Treasury yields and the US Dollar had another leg lower with US 10 year yields briefly dropping below 2.6% at the end of September, and the Dollar Index falling almost another 2%.

But then on Wednesday we had September’s FOMC minutes, which were surprisingly hawkish.  The decision not to taper was a close call, where most members still viewed it as appropriate for tapering to start this year and for asset purchases to be finished by the middle of next year.  Yes, the US government shutdown that has occurred since the meeting took place appears to be already starting to hit US economic data (estimates vary enormously for the total hit to Q4 US GDP), and the weaker data is therefore likely to push the start date for tapering back a little.  But if you assume that the US government shutdown is a one off event (admittedly not a particularly safe assumption), then the shutdown should merely slightly delay the tapering decision and the normalisation of US monetary policy, it should not result in a permanent postponement.

That said, something that was a little disconcerting from the minutes of the September FOMC meeting was that the jump in mortgage rates played a key role in the decision not to start tapering, with some members worrying that a reduction in asset purchases “might trigger an additional unwarranted tightening of financial conditions”.  HSBC’s Kevin Logan makes the good point that higher mortgage rates present Fed policy makers with a dilemma; if rates rise because the markets expect a tapering of QE, and that in turn stops the Fed from tapering, then it makes any QE exit pretty tricky and it appears that the Fed now has an additional criterion for reducing QE – not only must the economy and labour market be doing better, but long-term interest rates cannot rise too much in advance, or even during, the tapering process.  If the Fed’s decision not to taper was heavily influenced  by higher mortgage rates, though, then their fears should now be allayed given the chart below.  This chart, together with the effect that mortgage rates have on the US housing market, has clearly taken on added importance.

Mortgage rates now appear key to whether & when to taper

What about the ongoing budget nonsense?  This one takes a bit of a leap of faith, but markets are clearly starting to price in the risk of something going very badly wrong as demonstrated by the jump in T-bill yields and the surge in 1yr US CDS (i.e. the cost of insuring against a US default, see chart below).  But market stresses should make the prospect of a deal more likely, and this appears to be starting to happen.  It’s dangerous reading too much into the headline tennis, but the latest news is that Republican and Democratic leaders are open to a short term increase in the debt limit.  And don’t forget, the debt ceiling has been raised 74 times since March 1962 – past performance is no guide to the future as everyone knows, but while this episode is particularly chaotic, is this time really different?

Government shutdown is starting to cause market distress

Finally, the technicals for the US Dollar are now much more appealing.  US Dollar positioning has seen a sharp reversal from earlier this year, and Deutsche Bank estimates the US dollar is the only substantial short in the market (see charts below).  Does this matter?  To finish with a quote from John Maynard Keynes* regarding investing, “It is the one sphere of life and activity where victory, security and success is always to the minority and never to the majority.  When you find any one agreeing with you, change your mind.  When I can persuade the Board of my Insurance Company to buy a share, that, I am learning  from experience, is the right moment for selling it”‘.

In a complete reversal from earlier this year, investors are very short USD

*Keynes is famous for amassing a fortune through investing, but in 1920 he had to be bailed out by his father together with an emergency loan from Sir Ernest Cassel, and he came very close to being wiped out in the 1929 and 1937 stock market crashes.  So clearly the consensus can occasionally be right.

jim_leaviss_100

How do house prices feed into inflation rates around the world? It’s important for central banks, and for bond investors.

After the collapse in real estate prices in many of the major developed nations during and after the Great Financial Crisis, housing is back in demand again. Strong house price appreciation is being seen in most areas of the US, in the UK (especially in London), and German property prices have started to move up. We’re even seeing prices rise in parts of Ireland, the poster child for the property boom and bust cycle. I wanted to take a quick look at what rising house prices do for inflation rates. Not the second round effects of higher house prices feeding into wage demands, or the increased cost of plumbers and carpets, but the direct way that either house prices, mortgage costs and rents end up in our published inflation stats. Also, the question about whether central banks should target asset prices is another debate too (there’s some good discussion on that here).

Slide1

There is no simple answer to the question “how do house prices feed into the inflation statistics”. It varies not just from country to country, but also within the different measures of inflation within one geographical area. But given central banks’ rate setting/QE behaviour is determined by the published inflation measures it’s important to understand how house prices might, or might not, drive changes in those measures.

The US

“Shelter” is around 31% of the CPI which is used to determine the pricing of US inflation linked bonds (TIPS), but just 16% of the Core PCE Deflator, the measure that the Federal Reserve targets. The PCE is a broader measure, with much bigger weights to financial services and healthcare, so shelter measures therefore have to have a smaller weight in that measure. The CPI shelter weight looks high by international standards. For the Bureau of Labor Statistics, the purchase price of a house is not important except in how it influences the ongoing cost of providing shelter to its inhabitants. The method that the BLS uses to determine what those costs might be is “rental equivalence”. It surveys actual market rents, and augments this data by asking a sample of homeowners to estimate what it would cost them to rent the property that they live in (excluding utility bills and furniture). You can read a detailed explanation of this process here. In both the CPI and PCE, pure market rents are given around a quarter of the weight given to OER, Owners’ Equivalent Rent. There are problems with this – and not just with the accuracy of the homeowners’ rental guesses. Having rents and rental equivalence in the inflation data rather than a house price measure means that you can have – simultaneously – a house price bubble, and a falling impact from house prices in the inflation data. We’ve seen times when a speculative frenzy means house prices rise, but the impact of that speculation is overbuilding of property (just before the 2008 crash there was 12 months of excess inventory of houses in the US compared to a pre-bubble level of around 5 months) leading to falling rents. The reverse happened as the US recovered. House prices continued to tank, but because of a lack of mortgage finance more people were forced to rent, pushing up rents within the inflation data.

The UK

How house prices feed into the UK inflation data depends on whether you care about CPI inflation (which the Bank of England targets) or RPI inflation (which we bond investors care about as it’s the statistic referenced by the UK index linked bond markets). House prices directly feed into the RPI, but because house prices have little direct input into the CPI, the recent trend higher in UK property will lead to a growing wedge between the two measures – good news for index linked bond investors! The RPI captures house price rises in two ways – through Mortgage Interest Payments (MIPs) and House Depreciation. Mortgage payments will increase as the price of property rises, but they will most quickly reflect changes in interest rates. For example Alan Clarke of Scotia estimates that a hike in Bank Rate of 150 bps would feed almost immediately into the RPI, adding 1% to the annual rate. This is despite the trend in the UK for people to fix their mortgage payments. Housing Depreciation linked to UK house prices with a lag, and is an attempt to measure the cost of ownership (a bit like the BLS’s aim with rental equivalence) but has been criticized as overstating the cost of ownership in rising markets as house price inflation is almost always about land values accelerating rather than the bricks and mortar themselves. Land does not depreciate like other fixed assets (no wear and tear). Housing is very significant in the UK RPI, making up 17.3% of the basket (8.6% actual rents, 2.9% MIPs, 5.8% depreciation).

The UK’s CPI is a European harmonised measure of inflation. It only takes account of housing costs through a 6% weight on actual rents. There has never been agreement within the EU about how wider housing costs should be measured! Countries with high levels of home ownership have different views from countries with a high proportion of renters. Housing is around 18% of the expenditure of a typical person in the UK, so the Office of National Statistics regards the current CPI weight as a “weakness”. They therefore are now publishing CPIH, which includes housing on a rental equivalence basis (the same idea that the ONS measures “the price owner occupiers would need to rent their own home” as a dwelling is a “capital good, and therefore not consumed, but instead provides a flow of services that are consumed each period”). CPIH has a 17.7% weight to housing, but remains an experimental series, and plays no part in the official monetary targets.

The Eurozone

The European Central Bank targets CPI inflation, at or a little below 2%. As mentioned above the harmonised measure that Eurostat produces does not include any measure of housing other than actual rents, with a weight of 6%. If you think house price inflation (or deflation) is important for policymakers this low weighting has probably never mattered since the Eurozone came into existence. Although there have been pockets of very high house price inflation (Spain, Ireland, Netherlands) because the Big 3, Germany, France and Italy have had very little house price movement I doubt that a CPIH measure would be terribly different. We are, however, now seeing some upwards movements in the German residential property market in “prime” regions – albeit it as Spanish and Dutch house prices continue to freefall. It’s also important to note the range of importance of rents within the individual countries’ CPI numbers. For Slovenians it makes up 0.7% of their inflation basket, but for the Germans it is 10.2%.

Japan

Housing makes up 21% of the headline CPI. Like the US CPI the Japanese statistical authorities use a measure of an “imputed rent of an owner-occupied house” as well as actual rental costs. Again the imputed rents from owner occupiers (15.6%) dwarf the actual numbers from renters (5.4%) – aren’t these large weightings to imputed rents here and elsewhere a bit worrying? How would you homeowners reading this go about guessing a rent for your property? I’d only get close by looking at websites for similar places to mine up for rent nearby. Is that cheating?

Slide2

So why does this matter? Well if there is no correlation between house price inflation and consumer price inflation then it probably doesn’t. But intuitively both the direct impact on wage demands of workers who see house prices going up, and the wealth effect on the consumption of those who see their biggest asset surging in value should be significant. Therefore central banks will be missing this if they use statistics where the relationship between house prices and their impact in those statistics is weak.

 

anthony_doyle_100

The Fed didn’t taper – what’s next for US monetary policy and bond markets?

Last night the Federal Open Market Committee (FOMC) delivered a massive surprise by deciding to not taper QE. For us, this isn’t a huge deal. Since May, the market has placed way too much emphasis and concern over tapering and lost focus on the fundamental economic situation that the US has now found itself in – an economy where unemployment has fallen to 7.3% (helped by a falling participation rate) and a central bank that remains dovish due to a declining trend in core inflation. Now we are through the Fed meeting, arguably the market will now re-focus on the economic data. With interest rate policy set to remain very accommodative for a long period of time – even after balance sheet neutrality has been achieved – the sell-off in government bonds may be close to coming to an end (as witnessed by the 19bps fall in the US 10 year yield from 2.89% yesterday afternoon to 2.70% this morning).

US 10yr bond yields during quantitative easing

Fed concern number 1: US core PCE inflation is flirting with historic low levels

It is well known that FOMC Chairman Ben Bernanke, a student of the US economic depression of the 1930s, has great concerns about deflation and in 2002 gave a speech outlining how the US could avoid a deflationary trap which gave him the moniker “Helicopter Ben”. In the speech, Bernanke makes the important statement that “…Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation.”

The Fed’s preferred inflation measure, the core PCE, is exhibiting a worrying downward trend. This greatly concerns at least one member of the FOMC – St. Louis Federal Reserve Bank President James Bullard – who believes the FOMC should have more strongly signalled its willingness to defend its inflation target of 2 per cent in light of recent low inflation readings. The Fed minutes from the June meeting (at which Bullard dissented) showed that Bullard believed that the Fed was not doing enough to protect against the threat of deflation and that the FOMC must defend its inflation target when inflation is below target as well as when it is above target.

A key component of the Fed’s dual mandate – price stability – is clearly below where the FOMC wants it to be. There are big risks to reducing stimulatory monetary policy when core inflation is running at recessionary levels and on this measure suggests any interest rate hikes a long way away.

 

Inflation trending lower on both total and core PCE

Fed concern number 2: the labour market

The latest payroll report was weaker than market economists had become used to, with payroll growth averaging around 148,000 over the past three months. This is some way off the 200,000+ numbers that the consensus was expecting earlier in the year and confirms a deceleration in the trend in nonfarm payroll growth. Yes, the unemployment rate fell to 7.3%, but this was largely the result of the labour force shrinking and a decline in the participation rate in August. The labour market is not as strong as the headline number suggests.

Arguably, the fall in the unemployment rate has surprised most Fed members. Nonetheless, unemployment is not expected to fall to the 6.5% “think about raising interest rates” level until late 2014. It would have been a confusing message to start to implement tapering given the lower trend in job creation. The Fed reiterated that the economy and labour market have to be strong enough before in contemplates reducing asset purchases going forward. This helps to explain why the FOMC sat on its hands in September.

 

Unemployment rate quickly falling towards Fed thresholds

Fed concern number 3: the increase in mortgage rates

Following the moves in markets over the summer, the average rate for a 30-year fixed mortgage has now increased to around 4.5% from 3.4% in May. Essentially, the market has already tightened for the Fed. The housing market is a vital component of US economic growth, and this increase will cut into housing affordability. It could also force potential homebuyers out of the market. A slowing housing market means fewer jobs, less consumption, and lower growth. The increase in yields in the government bond market has been brutal, and does pose some risks to interest-sensitive sectors.

 

The rise in 30 year mortgage rates will concern the Fed

Given the above, it appears that the Fed refused to be bullied into tapering today by the bond markets, though tapering speculation may have reduced the “froth” that had developed in risk assets over the first half of 2013. It is likely that low inflation, a recovering labour market, and a slowing housing market will ensure that interest rate policy remains accommodative for the foreseeable future. The “Fed fake” suggests that tapering is truly data dependent and not predetermined. Macro matters.

As the market begins to refocus on the economic data, it is likely that government bonds may find some support. Additionally, the FOMC may reduce bond purchases slower than anyone currently expects. We expect that market concerns over the impact of tapering decisions will likely diminish over time as the Fed slowly and gradually moves towards a neutral balance sheet policy next year.

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Jobless claims and Fed policy

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.

Slide1

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.

Slide2

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.

Slide3

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.

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Lower for longer – the path to Fed tightening

The disclosure of the latest Federal Open Market Committee (FOMC) meeting minutes last night has pushed the US bond market to new lows for the year, further extending the current bear market in world government bonds. Looking at what the Fed is doing is nothing new. Back in the day when I first started, we had dedicated teams of Fed watchers, trying to work out its next move, as rate changes were frequent and unpredictable. The current policy is to make less frequent changes and be more transparent. So what does the FOMC’s forward guidance by providing its internal thoughts tell us today?

The committee knows that what is discussed will affect the markets, so a stylised version of its discussion needs to be produced. The release of the minutes is a manufactured and glossy disclosure of its work presented to make the FOMC look good and influence its followers. So what was the message from last night?

Well, it is more of the same about the need to tighten as we previously blogged here. The Fed continues to follow the script. The basic scenario is that they need to get the party goers out of the bar with the minimum trouble. This is why the Fed is keen for us to see that they discussed reducing the unemployment threshold at the last meeting. This is akin to saying ‘drink up’ to a late night reveller, with the hint that once they’ve done so there is a chance the bar staff will pour them another drink.

The Fed wants a steady bear market in bonds in this tightening cycle as it is still fearful over economic strength and fortunately inflationary pressures remain benign. This is very different from major tightening cycles in the past such as 1994, when the Fed was more keen to create uncertainty and fear in the bond market as they wanted to tighten rapidly and were still fearful of inflation given the experience of the 70s and 80s.

So when will official interest rates go up? Strangely you could argue that the successful creation of a steady bear market in bonds extends the period they can keep rates on hold. Monetary tightening via the long end reduces the need for monetary tightening in the conventional way. For example, as you can see from the following chart, the 100bps or so sell-off in 30 year treasuries since May has translated into a similar move higher in mortgage costs for the average American.

22.08.14 30y mortgage costs

If the Fed has its way in guiding a steady bear market in bonds, then bizarrely short rates could indeed stay lower for longer.

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