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Thursday 28 March 2024

Guest contributor – Jean-Paul Jaegers, CFA, CQF (Senior Investment Strategist, Prudential Portfolio Management Group)

A lot has been written on the recent softness in US inflation data, as headline inflation pulled back, with a similar trend in core inflation. Admittedly, a number of unusual factors have partly been a driver behind this, although more importantly there is quite some persistence in the broad-based softness in inflation. In recent communications by the Federal Open Market Committee (FOMC) members (more specifically by Chair Yellen) the uncertainty in the outlook for inflation has been highlighted and only part of the recent softness in inflation was deemed transitory. Interestingly, in Fed communications there is more and more reference to “financial conditions”. This is important.

The policy rate set by the central bank indirectly impacts the economy, not directly. It is therefore important to assess financial conditions in order to assess the impact that a central bank’s monetary policy stance is having on the real economy. The chart below illustrates that although the policy rate corridor has been raised, financial conditions have eased over that same period. Thus for the real economy, one could possibly argue that Fed policy has so far had limited direct impact.

The Fed has been referring in minutes that “a few” members of the FOMC are more worried about the risk of financial stability than Chair Yellen. And potentially, easier financial conditions may at the margin encourage the Fed to lean a bit against asset price bubbles.

Central bankers have made relatively explicit statements that as financial conditions have become easier, policy needs to be tightened in order to have the appropriate effect on the economy. This would be an important nuance as a continuation in easing of financial conditions (i.e. lower USD, higher equity prices, lower interest rates, etc.) could potentially strengthen the case for a continuation in tightening either via the policy rate or through balance sheet adjustment. Thus if the Fed were to start focussing more on financial conditions and financial stability, it may potentially sound more hawkish than inflation data and dynamics would currently suggest. Central banks want this tightening to come about gradually, but the brief history of unconventional monetary policy suggests that asset re-pricing tends to occur abruptly.

How could this potentially impact the investment landscape? For fixed income investors, the narrow spreads for high yield bonds might be something to shy away from as the volatility may pick up for risk assets. More focus on the risk of financial instability, in the absence of inflation picking up will likely result in a flatter yield curve (due to a flatter term premium and absence of an inflation risk premium). For equity investors that have so far enjoyed a ‘Goldilocks’ environment of stable growth, monetary accommodation and low inflation, this may be something to monitor. Looking at history, the track record of central banks addressing worries about potential financial instability has often been less impressive, as the transmission mechanism and policy dynamics are extremely hard to control and assess. Now is the time to keep an eye on the developments in financial conditions, as year-to-date the market has experienced quite an easing, and this has sparked enough interest in the Fed that it has featured as an important undercurrent of recent communications.

This content is prepared for information and does not contain or constitute investment advice. Neither PPMG, nor any of its associates, nor any director, or employee accepts any liability for any loss arising directly or indirectly from any use of this material.

Guest contributor – Jean-Paul Jaegers, CFA, CQF (Senior Investment Strategist, Prudential Portfolio Management Group)

Recently Jim Leaviss and I travelled to Tokyo to discuss local economic developments and Bank of Japan (BoJ) policy with economists and analysts based in Tokyo.

There was generally broad agreement that the potential path for Japanese government bond yields (JGBs) is asymmetric. The scope for lower interest rates was viewed as limited given the BoJ is aiming for an upward sloping yield curve and would not be comfortable if long-end yields fell by too much. Moreover, the move into negative territory with the policy rate has generally been perceived as quite negative by the wider public, affecting consumer confidence.

Market watchers have hinted at a preference from the BoJ to spend less than the ¥80 trillion rate, and a switch in policy from quantity to price targeting could be read as a way to taper bond purchases. However, there are a number of risks to the BoJ rate of government bond purchases. Firstly, if international bond yields continue to drift higher, the BoJ may be forced to increase purchases for a period of time to above their comfort level. Secondly, the BoJ risks falling behind the curve, as they attempt to balance the objectives of the yield curve control policy against the prospect of falling inflationary pressures.

japan-research1One of the options to balance this risk would be to reset the yield curve targets from time to time, or to start using a ‘dot-plot’ as a guidance for yield curve targets to avoid any disruptions. However, this could be challenging in practice, as bond markets would likely take this as a negative signal and sell JGBs. The experience of the Federal Reserve in 1942-1951, where policy capped interest rates directly, shows in particular that the exit strategy is challenging.

With the introduction of yield curve control the BoJ has in a way isolated the Japanese bond market from international developments. Consequently, volatility in bond markets has migrated onto the exchange rate. Given the yen is the transmission channel, a scenario of yen appreciation (for example US protectionism driving the US dollar down) would be an important element to keep an eye on.

japan-research2

Should yield curve control prove effective and the BoJ stick to its policy, there remains the question of how an exit strategy would look. The more one thinks about it, the more one tends to arrive at the conclusion asymmetry for bond returns is quite likely. This could be either by policy choice in an environment where global rates continue to drift up, or the result of the BoJ resetting the target to slightly higher levels. Any sign of upward management in yield curve control, in particular if the BoJ were eager to move away from negative policy rates, would signal to an investor on which side of the trade investors want to be. In the pure sense of control, such a scenario looks quite asymmetric for the investor (which for investors is a good thing), but also illustrates the challenge that increased control at a moment in time might come at the cost of less control going forward.

This content is prepared for information and does not contain or constitute investment advice. Neither PPMG, nor any of its associates, nor any director, or employee accepts any liability for any loss arising directly or indirectly from any use of this material.

Guest contributor – Jean-Paul Jaegers CFA (Senior Investment Strategist, Prudential Portfolio Management Group)

Getting a sense of when recessions are about to happen is a near impossible task, as evidenced by official institutions that often fail to forecast recessions, and organisations like the NBER (National Bureau of Economic Research) that specialises in dating US business cycles, dating recessions only with a number of quarters of hindsight.

Accepting that it is a complex task however, we can attempt to gauge potential contractions through the use of economic data sets that are cyclical and timely. There is no flawless measure and economies are rather complex, hence we choose to look at a selection of time series that measure economic conditions from different angles. Some measures used are from a business perspective, some from the labour market and some from consumers.

We will apply a technique called a Markov model, which solves for two-states – a high-state and a low-state (ie it estimates two distributions that best describe the aggregate distribution). It takes the most recent observation and assigns a likelihood for currently being in each of those two states. This approach is often used for detecting turning points. Our assumption here is that the low-state is representative of a recession or economic contraction. For this exercise we show the probability of the low-state (ie recession). In addition, as the measure can indicate a high likelihood of recession more often than actually happens in practice, we also list some measures on accuracy.

In the charts below the grey-shaded periods are recessions as defined by the NBER, and the green line is the probability as estimated by the Markov model.

A quantitative analysis of US recession probabilities

A quantitative analysis of US recession probabilities

A quantitative analysis of US recession probabilities

We can see that industrial production has historically been a very accurate predictor of recessions, having predicted all 8 recessions since the 1960’s, whilst also giving few, if any, false signals. Industrial production has been weak recently, and based on this measure, the likelihood of recession is currently very high at around 94%.The Philadelphia Fed Business Outlook Survey, which questions manufacturers in Pennsylvania, southern New Jersey and Delaware about their view of business conditions, is also indicating a high probability of recession. It too has a fairly decent track record, although it has given some false signals in the recent past. Set against this however, using different combinations of ISM manufacturing and non-manufacturing tells the opposite story. Whilst ISM manufacturing data has been very weak, non-manufacturing (although also weakening recently) has been stronger, and a combination of the two currently indicates a meaningfully lower likelihood of recession. One of the bright spots of the US economy in recent times has been the labour market and unsurprisingly, when we use labour market measures, we find a very small probability of being in a recessionary environment of just 1% to 2%. Consumer confidence is riding high at the moment, helped by the strong jobs market and falls in gas prices, and consumer based measures also suggest low likelihoods of being in a low-state at this moment.

A quantitative analysis of US recession probabilities

So an assessment of a quantitative technique on a range of time-series does currently not give a widespread indication of worryingly high likelihoods of recession. The disturbing element however, is the signal from industrial production, which has historically had a good success rate at accurately predicting recessions.

Guest contributor – Jean-Paul Jaegers CFA (Senior Investment Strategist, Prudential Portfolio Management Group)

One asset class where seasonality matters hugely is inflation linked fixed income. This makes a lot of sense, as inflation is the underlying macro variable, and inflation by its nature is very seasonal. For example, post Halloween sales or Holiday packages tend to happen in regular periods. As a result, seasonality becomes predictive and obfuscates the underlying trend. Therefore, institutions like statistics bureaus publish seasonally adjusted series for consumer prices (CPI).

When we compare seasonally adjusted and non-seasonally adjusted CPI series published by the US Bureau of Labor Statistics and look at the average seasonal factor they have applied over the past 10 and 15 years, we see a pattern as shown in the chart below. In the first half of the year consumer prices tend to rise, whereas in the second half of the year consumer prices tend to fall. This is a very persistent pattern.

It is one thing to observe a pattern in macro variables, but the more crucial element is whether it matters for financial markets. Purely rational investors should anticipate seasonal patterns and therefore seasonality should be a non-profitable strategy. For example in inflation swaps, the forward curve includes seasonal factors, thus opening an inflation swap in December and closing this in June does not result in gains if inflation prints come in according to the normal seasonal pattern. For cash products this becomes a little bit more difficult as there is not a forward curve, there are lagged cash flows, and it requires arbitrage as there are two assets involved.

One way to look at cash products would be to look at the implied breakeven, that being the nominal yield of a regular government bond minus the yield on an inflation linked bond of the same maturity, issued by the same government. The result is the inflation compensation and an inflation risk premium implied in nominal bonds. Thus looking at this differential between nominal bonds and inflation linked bonds we can get a sense of how the inflation component that is priced-in for nominal bonds behaves. Below we can see that in the period when inflation ‘seasonally’ tends to rise, implied breakevens on average tend to rise. We see implied breakevens on average tend to fall in August, September and November, which also coincides with the period inflation ‘seasonally’ tends to be weak. As an aside, the ECB and the Fed in recent years (http://www.federalreserve.gov/econresdata/notes/feds-notes/2014/residual-seasonality-in-core-consumer-price-inflation-20141014.html ) also have made the observation that seasonality in consumer prices has become stronger, some of which is due to changes in methodology/measurement.

Why does this matter?

In the below chart we can see that the priced-in inflation compensation (ie implied breakevens) is very low at the moment, as consensus struggles to see what could be a catalyst for inflation, and given the supply/demand dynamics in energy, energy is expected to remain weak. However, we should keep in mind that the implied breakeven includes an inflation risk premium. This of course varies over time and is very hard to measure, but academics estimate it to be somewhere between 40-75 basis points. Thus when we observe 1.5% for the next 10-years, it actually is probably closer to pricing an investor compensation for inflation of somewhere around 1% for the next 10 years. Moreover, inflation is a rate-of-change concept, thus base effects are important and roll out after a 12 month period (ie for inflation to remain constant, prices have to keep on falling/rising at the same pace as in the prior 12 months). Thus with some tailwind from seasonals in the first half of next year, in combination with the base effect of energy rolling out, there could be scope for breakevens to drift higher.

Financial repression by central banks pushed real yields down (preferably into negative territory to be most effective), but with the US economy normalising it would most likely be that real yields will be allowed to stay at current levels or even drift a bit higher at a measured pace (otherwise it would tighten conditions too much). Here we have seen some recovery from the 2012 bottom.

If we have a situation where the Federal Reserve hikes in December just as the base effects of energy start to fall out of the inflation numbers (compare headline at 0.2% with Core at 1.9%), coupled with the fact that implied break-evens tend on average to rise in the first few months of the year due to seasonally stronger rises in consumer prices, this could potentially provide quite some headwind for Treasuries over the next six months.

Author: Jean-Paul Jaegers

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