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Technical support for Euro IG; around 4% of the market set to mature this month

Benjamin Franklin said that death and taxes were the only inevitabilities in life. I’d like to add the discussion of the January effect to his list. Every year I receive at least one piece of commentary telling me that January is always a good month for risk assets (we’re far from innocent ourselves – see here).

Basing investment decisions purely on seasonal anomalies isn’t a particularly reliable investment process and the sensible investor should take other, more robust information into account when making changes to their portfolio.

The improving economic outlook for Europe and the general lack of pessimism should help the European credit market rally this month. So too should the fact that about €64bn worth of investment grade bonds are set to have matured by the end of the month. I think it rather unlikely that we’ll see enough supply to offset the bonds that are maturing. J.P. Morgan recently publishing a research piece pointing out that gross European investment grade issuance has only ever been higher than €64bn a month on four occasions in the past, and all were prior to 2008.

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J.P. Morgan also point out that January has been on average the month when most issuance takes place throughout the year. The primary market has been true to form since 2014 began but it will need to maintain the pace of the roughly €16bn that was issued in the first week of the year to give investors with maturing bonds somewhere to put their cash.

If net issuance turns out to be negative in January it will be a key technical support that could see Euro investment grade spreads continue to tighten further. It will also give us all another nice data point to talk about come next January.

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Should the Bank of England hike rates?

Many of us have become accustomed to a world of ultra-low interest rates and quantitative easing (QE). Taking into account inflation, real short-term interest rates are negative in most of the developed world. Of course, these historically low interest rates were a central bank response –co-ordinated on some occasions – to the Great Financial Crisis of 2008. Whilst we are still waiting for the official data, it appears increasingly likely that 2013 marked the start of a synchronised recovery in the advanced economies. So is it now time for the Bank of England to consider hiking the base rate? Perhaps good – and not awesome – economic growth is more appropriate to avoid a bust down the line.

Economic theory and real world experience tells us that interest rates that are kept too low for too long will distort investment decisions and lead to excessive risk-taking. They may also result in the formation of asset price bubbles that ultimately collapse. With parts of the UK housing market (including London and the south-east) posting double-digit returns in 2013, the FTSE 100 within arm’s reach of an all-time high last seen during the tech bubble (and up over 60% since 2009), and UK non-financial corporate bond spreads 45 basis points away from 2007 lows; it is clear that ultra-low interest rates have had a great effect on both financial markets and the real economy.

At the risk of being called a party pooper, here are 5 reasons why I think we could see an interest rate hike before year end (the market is pricing in around February/March 2015), and certainly before the third quarter of 2016 (the time when the BoE think the unemployment rate will fall to 7%).

  1. Asset price bubbles are forming
  2. Unemployment is falling quickly towards 7%
  3. Inflation risks should not be forgotten
  4. The Taylor rule suggests interest rates are way below neutral
  5. The risk of Euro area break-up appears to have fallen

Asset prices bubbles are forming

There has been a significant run-up in UK financial assets over the course of the past five years, particularly since QE became a feature of the financial landscape. Investors in equity and bond markets alike have been enjoying the fruits of QE. Those that own financial assets have seen their net wealth increase substantially from the post-crisis lows. Consensus forecasts for 2014 suggests that most market forecasters expect another robust year for risk assets, fuelled by easy money and the search for positive real returns.

Of course, the greatest financial asset that the average UK household own is their own house. In 2011, it was estimated that around 15 million households are owner-occupied (a rate of around 65% of total households). Thus it is unsurprising that newspaper readers are usually hit with a headline about rising house prices on a daily basis. House prices, on a number of measures, have begun to accelerate again with low interest rates and tight housing supply a key contributor to the price increase. Low interest rates have given UK consumers the incentive to accumulate high levels of household debt compared to their incomes.  The average house price is now 5.4 times earnings, the highest level since July 2010 and well above the long-run average of 4.1.

UK house prices are re-accelerating and pushing higher

The Help-To-Buy scheme is contributing to the run-up in this highly leveraged and interest-rate sensitive sector (a topic I covered back in July here). By hiking the base rate this year, the BoE would hopefully achieve a reduction in speculation and debt accumulation in the housing sector. This would not be a popular action to take – it never is – but we should all be wary about the damage a rampant housing market can have on an economy.  BoE Governor Mark Carney – as head of the Financial Policy Committee – has already moved to stop the Funding for Lending Scheme and mentioned that placing restrictions on the terms of mortgage credit may be a tool that can be used to reign in house prices.

Whether macro-prudential policy tools will work or not remains open to debate. Ultimately, central banks are trying to focus in on one element of the economy by raising interest rates or restricting credit. We do have a real-life macroeconomic example currently taking place though. On October 1, the Reserve Bank of New Zealand imposed a limit on how much banks could devote to low-deposit loans and required major banks to hold more capital to back loans. It’s very early days but for the month of November, the Real Estate Institute of New Zealand reported a 1.2% increase in New Zealand house prices and 9.6% over the year. The RBNZ and BoE might find that trying to slow the housing market using macro-prudential measures is a bit like trying to stop a car by opening the doors and hoping that wind-resistance does the rest. You really need to put your foot on the brake.

The longer the boom lasts, the greater the pain when it inevitably ends.

Unemployment is falling quickly towards 7%

The unemployment rate has fallen from 7.9 to 7.4% over the past nine months and is a key tenet of the BoE’s forward guidance. The fast decline has seen some speculation amongst economists that the BoE may lower the unemployment threshold from 7.0 to 6.5%. Of course, the 7.0% threshold that it has set it is not a trigger to hike interest rates, rather it is a point at which the BoE would consider hiking rates. However, the labour market has improved much quicker than the BoE has been expecting with the unemployment rate now sitting at the lowest rate since March 2009. We are still well above the average unemployment rate seen during the period between 2000 and 2008, but I would argue that this was an abnormal period for the UK economy. It was a NICE period – non-inflationary, constantly expanding – and is unlikely to be repeated. Arguably the UK’s natural rate of unemployment is now a percentage point or two higher than that of the noughties, suggesting less spare capacity in the UK economy than many expect. It may not be long before we start to see wage demands start to pick up, leading to rising inflationary pressures. Higher wage growth in 2014 would bode well for consumption and household net wealth given the increase in house prices and investment portfolios.

The UK unemployment rate is below the long-run average

As it is generally accepted that monetary policy operates with a lag, (the BoE estimate a lag time of around two years), and the unemployment rate itself is a lagging indicator of economic activity. If the BoE waits until the unemployment rate hits 7%, or for confirmation that economic growth is strong, then it may be too late. A slight tap on the breaks by hiking the base rate may be appropriate.

Inflation risks should not be forgotten

Ben wrote an excellent piece on the UK’s inflation outlook last month. To quote:

Current inflation levels may seem benign. However, potential demand-side shocks coupled with a build-up in growth momentum and the difficulty of removing the huge wall of money created by QE will pose material risks to inflation in the medium term. Markets have become short-sightedly focused on the near term picture as commodity prices have weakened and inflation expectations have been tamed by the lack of growth.

In addition, central banks have a nasty habit of keeping monetary policy too loose for too long. It even has a name – “The [insert FOMC Chairperson Name] Put”. The easy-money policies of the FOMC in the 1970s are seen as a key contributor to the runaway inflation seen during the period.  Eventually, the FOMC reversed its own policies, hiking rates to 19% in 1981.

Of course, what central bankers really fear is that ultra-easy monetary policy and the great experiment of QE will lead to an increase in inflation. A return of inflation will only be tamed by hiking rates. Whilst the inflation rate has been moderating in the UK and is close to the Bank of England’s target at 2.1%, it follows almost 5 years of above target inflation. Whist it is not a clear and present danger, the experience of the 1970s suggests that we cannot ignore the threat that inflation poses to the UK economy, especially as rising inflationary expectations are often difficult to contain.

The Taylor rule suggests interest rates are way below neutral

The Taylor rule provides a rough benchmark of the normal reaction to economic conditions as it relates interest rates to deviations of inflation from target and the output gap. According to the Taylor rule for the UK, a base rate of 0.5% is around 2.0% below where it should be given current rates of growth and inflation.

The BoE base rate remains highly stimulatory

Negative real interest rates have done the job by stabilising the economy, but is it now time to tap the brakes? With the UK economy growing at an annualised rate of more than 3% in the second and third quarters of 2013 (above the long-term average of 2%), the UK may be operating much closer to full employment than many currently estimate. Forward looking survey indicators and economic data suggest the UK economy is growing strongly, with business confidence at a 20 year high and the UK Services PMI for December suggesting a strong broad-based upturn. Of course, the BoE would like the other components of GDP like exports and investment to contribute more to economic growth. A rising currency wouldn’t help this. But sometimes it is difficult to have your cake and eat it too, especially if you are a central banker.

The risk of Euro area breakup appears to have fallen

Now it’s time for the “Draghi Put”. Draghi’s famous “whatever it takes” speech is probably the most important speech ever given by a central banker. The speech has had a fantastic effect on assets from government bonds to European equity markets and everything in between. More importantly, as I wrote here back in July 2013, despite the problems that Europe faces – the concerning outlook, the record levels of unemployment and debt, the proposed tax on savers in Cyprus – no country has left the EMU. The EMU has in fact added new members (Slovakia in 2009, Estonia in 2011, Latvia in 2014). European countries remain open for trade, have continued to enforce EU policies and have not resorted to protectionist policies. EU banking regulation has become stronger, the financial system has stabilised, and new bank capital requirements are in place.

This bodes well for the UK, as stabilisation in the Eurozone suggests stronger export demand, increased confidence, and higher investment in the UK from European firms. Perversely, an interest rate hike might actually improve confidence in the UK economy, signalling that the central bank is confident that economic growth is self-sustaining.

The BoE must walk the tightrope between raising rates slightly now to avoid higher inflation and financial instability or risk having to do a lot more monetary policy “heavy-lifting” down the line. A base rate at 0.5% is way below a neutral level and the BoE has a long way to go before getting anywhere near this level. It could act this year and gradually start raising interest rates to lessen the continued build-up of financial imbalances. The difficult action in the short-run to raise the base rate will help to support “healthy” economic growth in the long-run.

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Emerging market debt: 2013 returns post-mortem and themes for 2014

Emerging market (EM) fixed income posted its third negative performance year since 1998, driven by rising US Treasury yields, fears of tapering, and concerns around declining capital inflows from developed markets into emerging markets.  A number of EM countries were also hindered by country-specific drivers such as slowing growth, decreasing productivity, twin deficits, and exposure to a slowing Chinese economy.  EM fixed income still saw inflows for 2013 of $9.7bn, although this was way behind the $97.5bn inflows of 2012, and the asset class has seen outflows of around $40bn since May (source EPFR, JP Morgan).

Asset allocation and active duration management were key to performance in 2013

Within the asset class, EM corporate bonds outperformed EM sovereign debt, with the former returning -0.6% and the latter -5.3% in 2013. This sub-asset class benefited from its shorter duration and tangential spill-over (or higher correlations?) from the stronger performance in global investment grade and high yield credit. EM corporate bond spreads, measured by the JP Morgan Corporate EMBI index, are now flat to hard currency sovereign debt which translates into a narrowing of 66 bps since the beginning of 2013.

Therefore, the asset allocation between EM sovereigns in both hard and local currency and EM corporates was one of the key calls for performance in 2013. Sovereign bonds underperformed over the year, with hard currency debt delivering a negative return of -5.3%, also due to the fact that it has the longest duration of all three sub-asset classes. However, local currency debt faced a particularly challenging year, delivering a negative total return of -9.0% which can be mostly attributed to the foreign exchange component of the bond, while the carry, i.e. the additional return due to higher local interest rates, compensated for the back-up in yields.

It is worth though having a closer look at the underlying dynamics as it helps to further understand the drivers of performance in 2013 and how 2014 will be different.

1) Most of the negative return of EM hard currency sovereign debt was driven by rising US Treasury yields and less by the perceived deterioration in EM credit profiles and widening of EM spreads.
The negative impact of widening credit spreads was modest, contributing -0.5% to the total return of hard currency sovereign debt as the chart above shows. To put this into perspective, spreads widened by 50 bps in 2013, while 10 year US Treasury yields backed up by 116 bps. Hence, duration management was key in 2013. With tapering priced in and the US Treasury forward curve pricing 10 year US Treasury yields at around 3.5% by year end, an additional backup in US rates should be less pronounced in 2014 than it was in 2013. The risk to this outlook is for stronger than expected data and/or worsening of inflation expectations, which is not priced in at the moment. That is, a bear flattening of the US curve through pushing forward the anticipated hikes in the Fed Funds rate (currently priced for 2015 and beyond) is a risk to be monitored carefully.

The hard currency sovereign debt performance of stronger EM countries was not necessarily better

2) The performance of hard currency sovereign debt was not necessarily better for countries that are perceived to be more resilient, i.e. have lower debt levels, stronger liquidity, fiscal and current account position, sustainable growth as well as reform momentum, than for those that are perceived to be more vulnerable.
Let’s take Mexico, one of the stronger emerging market economies, and South Africa, an increasingly vulnerable emerging market country, as an example. Mexican government debt denominated in hard currency returned -7.1%, while the total return for South Africa’s government bonds stood at -6.9%. One explanation is that the channel of adjustment in the current account deficit countries is weaker currencies and/or higher interest rates which may not be such a negative factor for sovereign debt spreads. Countries that allow for a free floating currency minimise net international reserve losses, which is supportive for the performance of hard versus local currency debt. In fact, the major performance difference between these two countries was precisely on their local currency debt (see below), where Mexico justifiably outperformed South Africa.

3) Another characteristic of 2013 was the outperformance of those bonds associated with higher credit risk, such as high yielders and frontier markets.
The JPMorgan Next Generation Markets Index (NEXGEM), an index for frontier market sovereign bonds rated BB+ and lower, returned +5.1% in 2013. This may seem counterintuitive given the recent change of sentiment towards EM assets, but it is refreshing that the market differentiated between the various emerging market issuers and rewarded the stable or improving credit profile of the weaker issuers with positive returns and re-priced deteriorating stories into negative returns. Argentina, for example, returned +19.1% on the delayed court decision regarding the holdouts, as well as on expectations for better economic policies with a new government in 2015. Venezuela, on the other hand, returned -12.3% on continued growing macroeconomic and political imbalances. In addition, Eichenberg and Gupta find that countries which allowed for large increases in their current account deficits and for a sharp appreciation of their currencies, saw indeed a stronger valuation correction, but also suggest that bigger and more liquid emerging markets experienced, generally speaking, more pressure on currency and debt valuations. Identifying the critical bottom-up, idiosyncratic factors was hence key in 2013 and will remain so in 2014, given the large rally we have seen in most of these frontier market bonds and, therefore, less favourable valuations.

Weakening EM currencies provided the strongest headwind for the asset class

4) Local currency debt was the key underperformer.
The bulk of the losses in emerging market debt issued in local currency was due to currency depreciation, which was one of the key transmission mechanisms in 2013 to potential lower capital flows into emerging markets. As such, various currencies will continue their move to fair value or undervaluation, if warranted, through 2014 as well. An eventual narrowing of current account deficits in countries that require an adjustment but do not face major structural rigidities, such as Brazil, India or Indonesia, should slow the depreciation pressure and, thus, performance in 2014 should not be as negative. That is, the balance of risks and market focus should then be centred on the capital account.

5) Positive carry and a lower duration have provided an anchor of support for local currency debt returns.
Local currency yields rose by 135 bps in 2013 to 6.85%, driven by currency weakness (South Africa), monetary policy tightening (Brazil, Indonesia), fiscal deterioration and inflation risk (Brazil), political and external account concerns (Turkey), as well as a higher floor from US yields. The carry, however, and a lower average duration on local currency debt, for which a comparable index has a duration of 4.6 years, allowed for the total return in local currency terms to be flat in 2013 and provide a better cushion for 2014.

6) Political risks were pretty muted in 2013 (with a few exceptions), but are likely to increase significantly in 2014.
Though countries like Turkey and Ukraine as well as the Middle East faced serious political crises, politics did not play a major role for the asset class in 2013. However, 2014 will be a year in which the return impact from idiosyncratic political events in emerging markets could increase substantially. Twelve of the major emerging market countries will have presidential and/or parliamentary elections, including all the ‘fragile 5’ countries, i.e. Brazil, India, Indonesia, South Africa and Turkey – and we will comment in more detail on this in a forthcoming blog closer to the election dates. The prospect of these elections could potentially reduce the net capital flows into these economies on a temporary basis, such as through local capital flight, delayed foreign direct investment (FDI) and/or portfolio flows as well as increased demand for foreign exchange (FX) or credit default swap (CDS) hedging etc., pending the outcome of the elections and subsequent prospects for future economic policy and support for reforms.

In summary, the asset allocation between EM sovereigns in both hard and local currency and EM corporates should be less important in 2014 than it was in 2013, given that the forward yield curve implied levels for US interest rates is already pricing 10 year yields in the mid 3% range. Furthermore, the relative value opportunity between these three asset classes has decreased after the underperformance of sovereign debt in 2013 and the narrowing of EM corporate bond spreads on the back of  the rally in global credit in both the investment grade and high yield space. In addition, valuations for local currency debt look better, also on the basis of the exchange rate adjustments seen in 2013 and higher yields. In other words, we expect the difference on performance, on aggregate, to be more muted at the top down level.

On the other hand, idiosyncratic EM events, including political events, will become more relevant, which makes bottom up security selection and timing, i.e. the repositioning through bouts of volatility, even more critical in 2014 . Global macro factors and drivers of global risk appetite, such as economic growth and inflation, China’s rebalancing efforts, commodity prices as well as developments in the Eurozone, will remain equally important.

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2013 Bond Vigilantes Christmas Quiz – the answers and the winners

Thanks for all the entries to the 2013 quiz. The winner is Adam Weidner who gets to choose where we send a £200 charity donation, and a copy of Morrissey’s autobiography. We’ll be in touch, and tweet the charity name on @bondvigilantes. The five runners up who win a Moz book are Jonathan Moore, Mark Nelson, Adrian Coates, Joshua Giersch and Richard Milne. Have a great 2014.

1. “The band the Beatles could have been” was Wings, according to Alan Partridge. Here’s Band on the Run.

2. French Club Olympique de Marseille, winners of the Champions League in 1993, play in blue and white and took their colours from the Greek flag in honour of the ancient founders of the city of Marseille who came from Phocaea.

3. Duran Duran had three of their members with the surname Taylor (John, Roger, Andy). They were not related.

4. Noli timere – “do not be afraid” – was the final thing said (actually texted to his wife) by poet Seamus Heaney, who died this year.

5. If you swap the soda water for gin in an Americano, you end up with a Negroni.

6. Once 21 million bitcoins have been made, production automatically stops. We’re about halfway towards that total now.

7. “I am not in the office at the moment. Send any work to be translated”.

8. North Korea’s Kim Jong-il, according to his official biography, hit 11 holes in one at his first attempt at golf, and then retired from the sport.

9. Graced fair wound is an anagram of FORWARD GUIDANCE.

10. The KLF burnt a million quid on the Isle of Jura in 1994.

11. The best-selling vehicle in the US in 2013, was, as usual, be the F-Series pickup.

12. Incoming Fed chief Janet Yellen said that letting inflation rise could be a “wise and humane policy”.

13. George W. Bush wrote that note asking for a bathroom break.

14. Music video number 1 was Michael Jackson’s Billie Jean.

15. Music video number 2 was Fatboy Slim’s Weapon of Choice.

16. Music video number 3 was Madonna’s Music.

17. I’m guessing there are many different estimates of the US government’s net P&L on the GM, AIG and Citibank positions that it took in the middle of the credit crisis. But by the power of Google I come up with a $10 billion loss on GM, a $22.7 billion profit on AIG, and a $15.5 billion profit on Citibank, making a net profit of $28.2 billion. But we accepted anything near that or with a sensible explanation, especially if you provided a spreadsheet and NPVed some cashflows.

18. This is the marker at the top of Mont Ventoux in Provence.  Are you bored yet with my tales about my awesome cycle up the tough route this year – ruined for me only by the news that someone else did the same climb on a Boris Bike recently?

19. Verizon issued $49 billion of corporate bonds this year, the biggest deal ever.

20. The national anthem of the Netherlands spells out the name of the founder of its royal house, Wilhemus, through the first letter of each stanza.

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The year of the Snake – 2013 returns in fixed income markets

2013 has offered another injection of both adrenaline and performance to fixed income investors. A rapid sell-off shook emerging markets just before the summer while the Fed was conducting a “tapering yes/tapering no” ballet that lasted for more than six months. European peripheral countries finally came out of recession, although unemployment levels remain alarmingly high. In parallel, global high yield markets delivered further stellar performance, while Japan started to feel the effects of the unprecedented monetary and fiscal revolution driven by Shinzō Abe.

However, a common theme clearly emerged: the developed economies appear to be finally growing at a reasonable pace. Markets largely normalised as volatility and correlations returned to pre-crisis levels. While central bank intervention (set to continue for some time) has been the mantra in a liquidity driven environment, the world is transitioning back towards a growth based model. The US is well positioned to lead the pack, although high debt levels in Europe may continue to leave governments with limited room to support the recovery via fiscal stimulus. However, the good news here comes from a healing and deleveraging banking system, as well as rock solid support and a clear accommodative stance by the ECB and its leader Super Mario Draghi.

In this context, many fixed income asset classes offered satisfactory returns. Which assets have been top performers? The results are surprising. Who would have said, back in January 2013, that – together with a new Pope from Argentina, China landing on the moon and an economic bailout in Cyprus – Spanish “Bonos”  would have offered total returns in excess of 11% YTD, for example? Let’s take a closer look at government bonds, corporate bonds and major currencies compared to the US dollar (all total return YTD figures are measured from 31 December 2012 to 17 December 2013 in local currency).

Government bonds

Risk-free government bonds have been negatively affected by expectations over rising rates and tapering uncertainty. The UK gilts index – with an average duration of over 9 years – has been the most negatively hit, followed by US Treasuries (5+ years duration) and finally by less volatile German bunds (6+ years). It was a different story for some countries in the European periphery, where Greek government bonds offered tremendous total returns above 50%, followed by Spanish and Italian sovereign debt. Following the May debacle, emerging market government bonds in hard currency (measured by the commonly used JPM EMBI Index) took a significant hit and offered a negative return below 6%, despite a decent rebound after the summer, while the local currency index (JPM GBI-EM) looks set to end the year broadly flat (while once translated in USD, it is negative by around 8%)

Following 2012’s fall from grace for linkers, due to both falling inflation expectations and very low inflation in Europe and US, 2013 has continued to see the US, European and EM markets negatively affected while the UK market is about to close in a marginally positive territory thanks partly to the decision to maintain the link to RPI earlier this year (here’s a blog from Ben on the topic).

Looking back: government bonds

Corporate bonds

A great degree of value over the past year was to be found in corporate bonds. Companies are benefitting from the broad-based economic recovery around the developed world and from the subsequent increase in consumer demand (higher consumption = higher corporate revenues) and public investments. A conservative management of financial resources and balance sheets by bond issuers on average (especially in Europe), improving economic prospects, forward guidance on interest rates and a low inflation environment have all supported the ride of corporate bonds. Names active in the high yield space – especially in the US and Europe – have been amongst the standout performers within credit. Financials have also had a very strong run, especially in the subordinate space, helped by a healthy investor demand for higher yielding and more cyclical paper, as well as a general financial deleveraging process that is going in the right direction to restructure their balance sheets.

Performance highlights include European high yield (+9.9%), European subordinated financials and US high yield banking (+7.1% and +8.9% respectively) and an overall good showing from BBB non-financial corporates in Europe (+4.4%, to compare against -0.8% in the US). Emerging market corporate debt was in negative territory overall (-1.0%), while the high yield portion was marginally positive (+1.1%).

Looking back: corporate bonds

Currencies

The most noticeable development amongst major currencies has been a general lack of excitement around the US dollar from global investors, probably due to the ongoing tapering tantrum together with fears around the US fiscal cliff and the recent government shutdown. The USD index (DXY in Bloomberg) has generated a rather lacklustre  performance of +0.4% YTD. We need to make a clear distinction between two separate trends this year: the index generated positive returns for around 6% between January and early July, while it lost ground in the second part of the year (around -5.6%) due to uncertainties around the US government shutdown and Fed’s decision to maintain loose monetary policy. However, today the US economy is growing, its current account deficit is decreasing, the nation is moving towards energy independence, and Fed policy is now clearer following its tapering announcement on 18 December: we strongly believe that US dollar is good value and is set for a strong rebound.

Amongst G10 currencies, the Euro and GBP have gained significant value over the USD in recent months. Thanks to surprisingly strong economic developments in both the UK and the Eurozone, sterling and the euro have been amongst the best performing global currencies between March and December. Stay tuned on the British pound, because the UK’s 5.1% current account deficit in Q3 is the 3rd is the worst in UK history (and worse than Indonesia, India and Brazil). This suggests that there is no sign of the UK economy rebalancing and the UK’s economic recovery in its current form is nowhere near as sustainable as the US recovery.

The Japanese Yen has lost significant value (-15.4%) versus the US dollar due to the fresh efforts of the Bank of Japan to create inflation (and nominal growth) in the country. Some emerging market currencies offered strong performance, including the Argentine peso, Chinese Renminbi, Hungarian Forint, Polish Zloty, and Mexican peso, but the majority of EMFX has underperformed the US dollar, notably the Brazilian real, Indonesian Rupiah or South African rand, with the latter being the only currency to return less than the Yen at the time of writing.

Looking back: major currencies performance vs. USD

In conclusion, who would have expected such an interesting ride for fixed income asset classes this year? What is going to happen in 2014? Will next year be a negative or positive one for financial markets, and fixed income specifically? Read our latest Panoramic here and continue to stay tuned to this blog, explore recent posts (here from Ben, here from Mike and here from myself) and read more in the upcoming weeks.

Before saying goodbye, let me ask you something related to the Chinese calendar. The Year of the Snake, which began  on 10 February 2013, will be over at the end of January 2014. In the Chinese zodiac, the snake carries the meanings of cattiness and mystery, as well as acumen, divination and new beginnings. Do you see any fit with 2013? The new year of the Horse will start on 31 January 2014. The horse is considered energetic, bright, warm-hearted, intelligent and able. Any hint? Good luck and happy 2014!

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Bundesbank: no deflation in sight. Really?

Today I came across an article in which the Bundesbank took the festive season as an opportunity to discuss if all the Christmas sales discounts are going to turn into a permanent phenomenon for the Eurozone. “No deflation in sight” (in German) concludes that the Eurozone is unlikely to experience continuously falling prices, ie deflation. The Bundesbank does however identify some parallels between today and the 1930s – the last period of deflation in Germany. The Bundesbank attributes the current disinflationary trend in the Eurozone to the austerity imposed on the peripheral economies. It is striking that this line of argument offers the opportunity to draw some historical parallels. In the early 1930s, chancellor Brüning’s retrenchment policies (in form of emergency decrees) in response to the global economic crisis and the perceived lack of German competitiveness included severe wage cuts for civil servants, public sector job cuts, reduction of pension payments and entitlements as well as higher income taxes.  These policies marked a period of severe economic downturn and deflation with major historical consequences.

Germany’s economic downturn in the early 1930s

However, the Bundesbank seems to take some comfort out of the fact that the deflationary experiences in the periphery have not been as severe as in Germany in the 1930s and not sufficient to drag the entire Eurozone into a deflationary spiral so far. The German central bank anticipates that the austerity measures will show their positive effects on the peripheral economic competitiveness soon which should pay off in form of a return to modest economic growth in 2014 and 2015. While the high unemployment rates in the Eurozone, and in the periphery in particular, will continue to ease any inflationary pressure, the paper concludes that the pickup in economic activity will provide an anchor to the downside. In other words, the worst is over, and that’s why there is no deflation in sight. SocGen’s Sebastien Galy critically points out that the Bundesbank bases much of its analysis on the assumption of a strong positive correlation between growth and inflation which historically has not always been evident and doesn’t seem to be consistent with the trend of disinfloyment that the US is currently experiencing.

Two different monetary policy approaches during economic downturns and periods of austerity

The Bundesbank also sees the deflation risk contained in the Eurozone as the ECB’s monetary policy response is very different to the 1930s. Back then, the economic downturn was aggravated through the monetary policy response of the Reichsbank. As the chart above shows, the central bank kept interest rates at a very high level which led to unbearable financing costs in the real economy and suppressed credit growth further. The reasons for this policy approach were certainly very complex, but, without delving too deep into any academic debate, it seems that the German room to manoeuvre might have been restricted by the Young Plan and that the shock of hyperinflation in the 1920s built a psychological barrier to loose monetary policy. The Bundesbank article points out that today’s monetary response by the ECB is very different. Today’s historically low ECB refinancing rate of just 0.25% is a reflection of the ECB’s very expansive monetary policy approach in response to the Eurozone crisis and is, therefore, providing another anchor of price stability, i.e. reducing the downside risk of deflation.

However, the psychology of deflation doesn’t get sufficient focus by the Bundesbank in this particular article in my view. The authors touch upon the concept of inflation expectations and their impact on consumption behaviour (if you expect prices to go down, then you delay purchases which puts further downward pressure on prices), but don’t go into much detail. As the latest M&G YouGov Inflation Expectations Survey showed, expectations were still well-anchored in November, but on a declining trend across Europe, and it will be interesting to see how inflation expectations have adjusted considering that recent data showed that not only did the periphery experience real wage declines in the third quarter, but German workers also saw real wage declines for the first time since 2009. This is certainly a surprising, if not worrying trend with regard to both disinflation and the Eurozone rebalancing efforts.

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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.

ben_lord_100

Disinfloyment – the state of strengthening labour markets and falling inflation

Whilst I was listening to Ben Bernanke last night, who announced his decision to reduce the monthly rate of purchases of treasuries and mortgage backed securities by $10 billion per month, it became clear that the time has come to coin a new phrase. With the employment picture improving substantially in the last few months from a very weak point, and with GDP growth moving in a similarly positive direction from a similarly weak point, it is entirely justifiable in my opinion that the Fed continues to provide historically vast quantities of liquidity, albeit at an ever so slightly slower pace. The Fed sees growth returning to between 2.8% and 3.2% for the next couple of years, and it sees unemployment falling to between 5.5 and 5.8% within that horizon. Take a step back, briefly, and you would look at these predictions for the economy and expect the policy rate to be substantially higher than zero. So why did Ben Bernanke spend so long anchoring the market’s expectations for the future path of interest rates, and why is he still creating $75 billion of cash each month?

In the 1970s the more economically developed nations were experiencing an unexpected new phenomenon: low employment and high inflation. This, as we all now know, came to be known as stagflation. Today, the US, and just very recently the UK, is experiencing the opposite: rapidly improving employment and falling inflation. I am going to call this disinfloyment.

Chairman Bernanke said that low inflation is “more than a little concern”. One has to think that it was the improving economic and political picture, as well as perhaps some concern over early bubble formations, that brought about the decision to taper, on the one hand, and the inflation picture that brought about the strengthening forward guidance and lowering and weakening of the unemployment rate ‘knockout’ on the other. Otherwise, given a better broader economic outlook, you would expect a truer normalisation of policy, with the provision of liquidity being stopped and rates being hiked. The concern I think Bernanke has, and the question I would have asked him, would have been “what if zero interest rates, massive liquidity provision, and forward guidance do not manage to generate inflation at or above target? What then Ben?”

If the Fed were to find itself in a position of full employment, acceptable growth, and disinflation, with policy rates and long term interest rates near their extreme floors, and the efficacy of increased liquidity provision being increasingly marginal of benefit, or perhaps worse, then the Fed is alarmingly close to the limits of its powers. Perhaps only helicopter drops would remain a viable tool at this point. It is the awareness of this that I think is framing current Fed action. At 1.5% 10 year treasury yields earlier this year, rapid liquidity provision, and zero interest rates, there was almost nothing the Fed could do to counteract falling inflation; it simply couldn’t add much more stimulus. The utterance of the ‘t’ word in May, and now the first minor reduction in the pace of stimulus last night has seen 10 year yields rise to 3%, and from this point there is scope for data to disappoint to such an extent that yields fall, forward guidance is pushed out further, and QE can be increased so as to stimulate the economy.

So disinfloyment is a state of the economy that policymakers are rightly very scared of, as, depending on the economy’s starting point, it is a state in which economic policy is getting ineffective. But do I actually think that this is a term that we will hear more of in the next couple of years? Probably not.

For disinfloyment to become a problem, the employment picture must continue to improve, and inflation must continue to fall or fail to rise. Whilst I believe the former to be highly likely at this point, I find that latter harder to believe, and the Fed’s projection yesterday was for inflation to return to 1.4% to 1.6% in 2014. Whilst this is clearly still below target, it is less worryingly so than it is today. Bernanke told us yesterday that he presently sees the glide-path for tapering to continue at $10 billion at each meeting, until liquidity provision stops at the end of 2014. I believe that there is a very difficult line for the Fed to tread over the next 12 months. As tapering continues and the markets come to expect the end of the stimulus, long-term yields will rise (as we saw in the Summer) and the economic data risks going in the wrong direction for the tapering to continue. For a gradual rise in rates not to detrimentally affect the recovery, the economy must be growing with such underlying momentum as to shrug off these higher rates: and in this environment, surely inflation would be returning? So: either the Fed finds the recovery to be too fragile to continue tapering, in which case it continues to increase the supply of money each month, thereby risking higher inflation further into the future when the economy improves; or the recovery is sufficiently strong, and inflation (excluding commodities, which the Fed cannot control) is rebounding.

Markets are being staggeringly complacent about inflation at the moment, aided by presently low inflation in the developed world. We would do well to remember that monetary policy since the start of the Great Financial Crash has been designed with one major purpose: to avoid the spiral of deflation witnessed in the 1930s. Deflation, clearly the greater evil of the dichotomy, has been avoided so far. But now developed economies are recovering, liquidity-driven positions are coming back out of commodities and emerging markets, which are pushing down inflation numbers around the world. 2014 will be treading a fine line between these disinflationary forces prevailing, and so monetary policy having to re-start the liquidity machines, and recoveries managing their ways through this transition and finding underlying momentum. Respectively, we either continue to risk higher inflation further in the future through increasing the supply of money, or we start to see it come through sooner than we all presently think: either way, we get inflation. Lest we forget: the Fed will have increased the supply of money by $4.25 trillion at the end of the tapering cycle. When the velocity of money starts rising on top of the increases in money supply, nominal output will start to rise unless the money supply is taken out to an offsetting extent. It is this that I find so unlikely, and it is this that would increase the probability of disinfloyment. In my opinion, we are more likely to get nominal output surprises, and so returning inflation, than anything else in the UK and US. We won’t hear too much, at that stage, about disinlfoyment.

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.

jim_leaviss_100

Who is to blame for shrinking real wages in the UK? Nobody?

The squeeze on UK consumers through falling real wages has been regarded as a significant factor in the (until recently) anaemic economic recovery.  Employers have taken a good share of the blame for this – but is that fair?  Have employers deliberately kept earnings below inflation as a means of boosting their own profitability, or was this an unintended outcome of upside inflation shocks?

If we look at Eurostat’s nominal wage growth series in the UK since the credit crisis, it’s only in the last couple of years that nominal wage growth has been well below the Bank of England’s inflation target of 2%.  In 2008 nominal wage growth was 6.1%, 2009 1.8%, 2010 3.6%, and 2011 2.1%.

It’s only in 2012 that Nominal Wage Growth fell way below the BOE’s inflation target

And yet over those same years, Labour Productivity per Hour Worked (again Eurostat) was awful.  -1.2% in 2008, -2.3% in 2009, +1.1% in 2010, and +0.7% in 2011.  In other words companies appear to have, ex ante, attempted to compensate their workers for expected inflation, assuming that the Bank of England hit its inflation target, and have overcompensated them, ex post, for improvements in productivity.

Labour productivity has been very weak – and often negative

So has the problem for earnings been the unexpected inflation overshoot (since the credit crisis started CPI has been above the Bank’s 2% target in all but 6 months, in 2009), not the wage setting behaviour of companies? Had inflation come in at, or above target, workers would have been better off in real terms until 2012, and certainly better off than you might expect given the historically strong relationship between wage growth and productivity.  I’m not sure I’m blaming the Bank of England here either – to achieve the 2% inflation target, rates would have had to have been inappropriately high for the domestic demand conditions and the distressed balance sheet of the UK public and private sectors.  And productivity is weak in part because employment has been unexpectedly strong relative to the weakness of the economy.  So a low inflation, high productivity UK economy sounds nice – but in the circumstances would likely have only have been possible with a much deeper recession and higher unemployment rate.

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