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Thursday 28 March 2024

Summary: The past year has seen a dramatic economic downturn across the globe.  We all know why the policy response to COVID-19 was to limit human interaction. GDP measures human interaction, and therefore GDP collapsed. In the article below we will put the monetary policy response to combat this into its historical context and discuss the future course of monetary policy.

The economic collapse we saw last year mirrors that of a natural, not economic, catastrophe. This can be seen by comparing the sharp spike and rebound we saw in data from last year (for example in unemployment) to other natural events in the past (see chart below).

Source: M&G, BLS, Bloomberg, December 2020

A sharp drawdown and a quick bounce back

The response to these historic state-wide disasters has been to mobilise emergency resources and fiscal expenditure to provide relief and to facilitate the rebound. The contemporary response this time round has had to be on a far larger scale due to the length and national/global nature of the pandemic. The medical intervention to care for those affected and provide ongoing protection via vaccination has been combined with a record-breaking fiscal and monetary response.

As we come out of lockdown, we can attempt to plot a guide to the recovery in a variety of ways. We can look at states that had a lower level of lockdown as a guide to what might happen when public health policy intervention is removed (see chart 1 below); we could simply model that all those who lost their employment in the leisure and hospitality return to work (chart 2); or we can plot likely employment based on various rebounds in GDP (chart 3).

Source: M&G, BLS, Bloomberg, December 2020

Source: M&G, BLS, Bloomberg, February 2021. Using Nonfarm payrolls

Source: M&G, Bloomberg, December 2020

These simple “rebound” models point to a potential return to around 4-5% unemployment this year. The latest OECD real US GDP growth projections for 2021 is 6.5%. This level would be consistent with an unemployment rate at 4.7%.  This GDP outlook is very positive for credit risk and traditionally would point to a tightening of policy. This time, however, things are different.

Bravo Yankee Papa

Monetary policy in the US has been led by three individuals over the last few years: Bernanke (Bravo), Yellen (Yankee) and Powell (Papa). Bernanke came to the fore of the public imagination with his comments on helicopter money, Yellen considered this approach and touched on its use, while Powell has gone full throttle and has rightly executed a fully-loaded helicopter drop given the scale of the crisis.

The Bernanke helicopter drop was a theoretical proposition of what to do at the limits of monetary policy, Yellen took us to the limit of monetary policy and Powell deployed the policy full scale. Like all monetary policy, helicopter money works with a delay. We know that interest rates take circa 18 months to have an effect in the real economy, but what is the delay for helicopter money? I would postulate it is very short given that the marginal propensity to consume is high. There will be some delay though. US citizens are once again receiving their electronic cheque in the post. They will be able to spend it on certain things (essential items, stocks, Bitcoin) but they will find it harder to spend it on others (travel, eating out and any other COVID-restricted activities). This causes a delay: think of it as a helicopter drop of cash but the shops are closed.

The Fed is completely aware of the chain of events they have set in order. They are not focusing on the likely outcome of their policy however, but are waiting for the data to appear:

“The fundamental change in our framework is that we’re not going to act pre-emptively based on forecasts for the most part and we’re going to wait to see actual data. I think it will take people time to adjust to that and to adjust to that new practice, and the only way we can really build the credibility of that is by doing it.”  Fed Chair Powell, 17 March 2021 via Bloomberg (19 March)

Why this change from proactive to reactive policy? The success of driving inflation to a consistently low level reveals the difficulty in which the Fed finds itself in trying to act at the zero bound. Inflation hovering just above zero is a danger for monetary policy, and therefore the Fed needs to run inflation at a higher level for a persistent length of time in order to regain monetary flexibility.

Conclusion

Central banks’ aiming for low inflation is an understandable goal, but monetary authorities have always realised that this is not without its risks. Bernanke acknowledged this with his helicopter comments, Yellen was well aware of this and was determined to push inflation expectations higher, while Powell is the one who faced the zero bound and has had to do the helicopter drop.  Neither he nor his successors want to be faced with only this as a policy option going forward. To get out of this situation, the economy needs to be run hot.

Summary: The last year was a tumultuous one: the pandemic has resulted in significant changes to everyday life, and this has naturally led to dramatic price action in markets. We have discussed the t-shaped recession and its shorter term effects several times in the past. Here I will explore what I believe to be the most significant long term differences to the outlook in 2021 compared to how the world looked at the start of 2020.

Politics

The biggest political consequence of the pandemic was the change in the political direction of the United States. The US economy weakened dramatically in an election year and Trump went from being the favourite to suffering a narrow loss. This, combined with previous elections, has led to a dramatic shift to the policy outlook in the United States. We now have a US political system that is determined not only to spend its way out of recession, but to spend to change the long term outlook for society.

Energy

The collapse in the oil price was an understandable reaction to the collapse in the economy last year, and was particularly accentuated by the nature of lockdown and the background trend away from fossil fuels. February last year ended with a particularly disorderly OPEC meeting: the cartel had fallen apart with obvious implications for the short and long term price of oil. However, the shock to the system provided by the collapsing oil price has led to an increase in production discipline within OPEC; in fact, the collapse in price also encouraged the US administration to work hand-in-hand with OPEC to put a line under the collapsing oil price. The price shock also stymied private sector supply in the medium term as capex and exploration plans understandably were cut. We now have a more disciplined cartel, with less likely challenge from new entrants.

Central banks

Central banks have been amazingly proactive over the past year. Their actions worked substantially well in limiting the economic damage caused by the various restrictions imposed to fight the virus. The central banks have not only embarked on a cyclical response, but in my view have begun a more structural change in their raison d’être. This is best typified by the Fed, which has quietly adjusted its mandate to become more focused on employment goals than inflation targeting. This is a change being echoed by other major central banks. The central banks want to escape the zero bound so they can again have room to react in case of a future downturn –  this is best achieved by creating inflation.

Eurozone

As a loosely configured federal state but with a less well-established link between government and the central bank than that of other major economic blocks, the Eurozone has more difficulty in responding to the pandemic. The main permanent change last year was the development of the centrally-funded, jointly-issued “Euro” debt issued in response to the pandemic. This jointly-guaranteed issuance, the proceeds of which will be directed to members of the union that need it, is a huge step towards confronting the fiscal transfer issue created by the political and economic development of the European Union.

Brave new world

Many things are largely unchanged in the bond world compared to where we were last year: bond yields are still close to the zero bound, while global investment grade credit spreads ended 2020 almost precisely where they began. What has changed is the broad economic and political outlook. Looking beyond the huge potential economic rebound in 2021, the four major changes above all point towards structurally higher growth and higher inflation than we would have expected at the start of 2020, and to longer term changes ahead.

This year has seen the sharpest and largest economic downturn the modern global economy has ever seen. However, as I have commented several times this year, this recession is a rather strange one: for once, this time really is different (see chart below).

This recession has not been caused by any of the usual suspects: namely tight financial conditions, a real or market bubble bursting, a sharp rise in commodity prices or some combination of these. We have not seen the effect of this recession in many of the typical areas of weakness that follow such a downturn: I’m thinking of everything from the housing market and disposable incomes, to the huge rally in financial asset prices we have seen this year. Finally, this year has pushed investors to accept more than ever the bizarre situation of paying for the privilege of lending out their money — testing the zero bound in interest rates and leading to some very strange consequences indeed.

As we sit at this zero bound, I believe there are some important consequences for investors, ranging from the purpose of investing to the independence of central banks.

The theory of investing

The cornerstone of saving is security and return. In the following Panoramic we are going to focus on risk-free bond returns, and particularly on the strange consequences we see when this asset class has a negative return.

When buying a bond, you receive a set of cashflows in return for your investment. This is illustrated simply below.

This shows the income you receive and the final redemption payment. This income stream in the theoretical example generates a positive yield – the sum of the cash flows earned is positive. This is the fundamental basis of bond investing. However, recently this cashflow dynamic has been spun round. The actual example shows the cashflows you receive as a result of your investment in a negative-yielding bond, as we see in German bunds, for example. The cashflows earned are negative and the investor ends up with less money than originally invested.

Positive-yielding bonds offer a positive total return if held to maturity. Negative-yielding bonds provide a negative total return if held to maturity. Economic textbooks show savers receiving income, and building their wealth. Meanwhile, borrowers pay income for the privilege of borrowing. Yet, in a negative yield world, the saver receives the negative cashflow of the borrower, and the borrower receives income for borrowing. This is a very strange world indeed! In the past, this would have been very much a theoretical exercise, but now it is a real-world phenomenon, which investors are accepting – see the amount of negative-yielding debt illustrated below. [1]

How did we get to this point? The bull market of the last cycle has driven bond yields to new lows, while many central banks have cut rates to try to stimulate inflation in economies.  The question now is whether this downward trend can continue forever. I don’t think so: at some point, the consequences of having negative rates become too great for investors to accept. At this point we hit the “zero bound” – near zero, though not necessarily exactly at zero. The chart of 10-year rates below shows the trend over the last 30 years, with rates declining and halting at the zero bound. So why do rates stop at the “zero bound”?

Why there is a zero bound

Bond yields have difficulty going much below zero because if investors are faced with owning negative yielding debt in Japanese yen, for instance, they have an alternative. They can simply hold Japanese yen cash instead. Rather than exchanging 100 yen and receiving fewer yen at maturity if purchasing a bond, an individual could simply hold 100 yen in cash and not suffer the loss. Holding cash has its risks and potential costs in terms of security and storage. These costs effectively set where the zero bound falls, and why it is not exactly zero: it would be zero, were there no costs to holding cash instead of bonds. The presence of this alternative risk-free investment explains why central banks around the world have not enacted a significant negative rate policy: the existence of cash is the main barrier to negative rates.

The risk/reward of the zero bound – There Is No Yield (TINY)

Once we recognise there is a zero bound somewhere, what does that actually mean for bond investors?

When looking at the risk/reward of the zero bound, the first issue we face is that There Is No Yield (TINY). With yields at all-time lows, investors are not earning significant returns at all, while in some cases paying for the privilege of lending. Secondly, it is clear that yields can’t fall forever: the upside of holding duration is limited due to the existence of the zero bound. One way to explore this is to use zero coupon bonds to illustrate the risk and reward profile to which investors are exposed when buying bonds in the TINY world.

Currently, if you agree to buy a 30-year German bund at a negative yield, you essentially agree to make a loss if held to maturity. This is of course different from a positive interest rate environment, where if you hold the bond until maturity you will end up with a positive return. The profit or loss involved is illustrated in the chart below: if you buy a bond with a -2.3% yield, you lock in a halving of your money.

The upside to holding low- or negative-yielding bond securities is therefore very limited and explains the short duration view I express in my funds. When you hit the negative bound, or get near the negative bound, it becomes challenging to invest; upside is limited and losses can quickly accrue (even more so if you hold longer-term debt to maturity).

So while it is possible to get to negative interest rates in principle, it is rarer in practice, and there is a limit: the upside to investors is limited, but the downside could be quite large, and so at a certain point investors won’t accept this. This means it is hard to justify being long duration, from my perspective. As a risk-reward instrument, holding interest rate duration becomes unattractive when you get near the zero-bound. There are also other, wider consequences beyond the risk-reward of owning bonds as yields reach the zero bound.

Consequences of reaching the zero bound

One of the most obvious consequences of reaching the zero bound is that central banks can no longer stimulate the economy in the event of a deterioration in growth and demand. As rates cannot go very negative, the policy tool is effectively removed from their toolkit. This is illustrated by the actions of central banks in regions where rates were already negative or near zero, like Europe and Japan: the policy option has gone. We saw the effect on holders of interest rate duration over the past year: in countries where rates could still be cut (the US and the UK), falling interest rates provide some upside to bond investors; in countries with zero or near-zero rates (German and Japan), they did not provide much upside at all (see charts below).

Another effect of short-term zero or negative interest rates is the extent to which this undermines the banking system’s traditional role in bridging saver and lender. As former Bank of England Governor Mervyn King alluded to in a recent TV interview: “[Negative rates] can’t work with a successful banking sector unless the banks can pass on negative rates to their retail customers. Once that happens, I think you should expect to see a long line of customers seeking to take their cash out of the bank and keep it under the mattress, or at least in a new home safe. I don’t think that is a politically attractive prospect at all”. [2]

It is clear that having zero or negative rates is a threat to the ability of central banks to use monetary policy and to the banking system’s effective functioning.

Unable to cut rates, central banks then pursue other options, resulting mainly in driving rates lower along the yield curve via measures such as forward guidance (i.e. pre-committing policy to a low rate range) and quantitative easing. These actions lower rates along the whole yield curve, flattening it by pushing longer-term rates towards the zero bound too. This can be seen in the chart below of the market 50-year sterling overnight lending rate: it reached the zero bound.

Likewise, the psychology of investors not wanting to lock in a guaranteed loss leads them to extend the maturity of their investment, again pushing the whole curve towards the zero bound. Investors’ purchases of longer-dated bonds result in very flat yield curves as can be seen below. This effect is so powerful that in extremis whole bond curves can exhibit negative yields (see chart below).

As monetary policy reaches its limits, fiscal policy has to take a greater burden in reviving the economy. Consider the recent comments from Federal Reserve chairman Jerome Powell, and European Central Bank President Christine Lagarde. Both central bank chiefs have called on extended fiscal support to boost Covid-hit economies as we approach a tough winter. Powell said that “too little support would lead to a weak recovery, creating unnecessary hardship for households and businesses”, while stating that even if stimulus is above what is needed “it will not go to waste”. Meanwhile, Lagarde emphasised that it is “more important than ever for monetary policy and fiscal policy to keep working hand in hand”.[3]

Interest rates are a pricing mechanism that set a level at which savers and borrowers can interact, and provide an efficient recycling of savings. Between these two economic agents, we have a banking system that recycles that capital. These banks make money on the bid- offer spread between borrowing and lending, but are also heavily dependent on the central bank for help. When the central bank sets a high rate, it is guaranteeing savers and banks a high return for taking no risk – in effect offering a subsidy and a transfer of wealth from the state to the saver. In an environment of negative rates, the central bank is instead taxing the financial system, and savers will be reluctant to lend. In that case, the recycling of capital grinds to a halt.

How to remove the zero bound

The simplest way to remove the zero bound and restore the ability of central banks to cut rates would be to remove the option of holding cash. Electronic money is a solution as, if there were no cash, then your electronic money deposit could decay over time, producing negative rates with no alternative cash to hand. Politically, though, this would be highly unpopular for various, obvious reasons – and individuals may see this as a tax on capital. Other alternatives to money might also be sought, which would undermine this approach: gold, a foreign currency or a different version of electronic money such as Bitcoin are examples.

The second way would be to let the central bank lend money below zero to subsidise the banks. That is the ECB’s approach with its TLTRO (targeted longer-term refinancing operations) programme, designed to stimulate lending and act as a simple subsidy from the central bank to private sector banks. However, this is an intrinsically loss-making transaction by the central banks and ultimately has limited power, because it creates an arbitrage opportunity between negative rates and physical cash.

The third option is to print money. This is perhaps the simplest way to escape the zero bound, but unfortunately raises the difficult question: who do you give the printed money to? Central banks are in the business of lending money, not granting money.  As Federal Reserve Chair Jerome Powell said in his May keynote speech, “the Fed has lending powers, not spending powers”. [4]

The printing of money is a government decision

To escape the zero bound requires a number of key elements. It would require the support of governments through fiscal spending, the printing of money by the central bank and hopefully a pick-up in inflation. But this requires central banks and governments to work together. Fiscal spending is within the remit of government and, if the central bank is printing money, the decision on how that money is distributed is a political one. Central banks and governments have to work together.

No Independent Central (NICe) Banks

The ultimate way to do this, for fiscal and monetary policy to be aligned, would be to remove central bank independence. Arguably we have begun to see signs of this over the past year, with the significant government debt purchases of a number of central banks. Independent central banks were created in the first place to help control inflation and I would argue that, in politicising central banks, we would be allowing the inflation genie back out of the bottle. In order to escape the zero bound we need inflation, and by politicising central banks inflation and inflation expectations would rise.

It would be easier to remove the independence of some central banks than others, of course. The simple delineation here is federal central banks versus state central banks. It would be relatively straightforward to regain full control of the Bank of England, for example – in fact, it is already provided for under existing legislation: according to the Bank of England Act 1998, “the Treasury is given reserve powers to give orders to the Bank in the field of monetary policy, but the Act states that this is only if the Treasury is satisfied that they are required in the public interest and by ‘extreme economic circumstances’.” [5]

In the case of federal central banks it is more complicated. With federal central banks, monetary and fiscal policy are generally harder to carry out in tandem, as typified by the challenges faced by the European Central Bank.

The future of central banks

Central banks are an ever-evolving beast. Their need for independence was born in the high inflation conditions of the 1970s. This regime has worked exceptionally well in reducing inflation to the targets that have been set. If we now have a situation where inflation is permanently anchored around a two percent target then, by definition, central banks will quite likely be faced with the zero bound issue. The tapering of political influence on monetary policy has also helped reduce inflation, and this has been combined with the tailwind of falling inflation from globalisation and progress in technological productivity.

While central banks cherish their independence, they have been exceptionally vocal recently that fiscal measures (that are inherently political) are required. The gap between politics and central banking has been further eroded as central banks are now opining and focusing on what were previously political issues. For example they are now focusing more on income inequality and the global warming conversation — both historically hot political topics and not the remit of unelected central bankers. With these issues in mind, it may be practical for central banks to become less independent, and the political bias to generate inflation may be an appropriate change in economic direction.

Implications for investors

Given the authorities are going to do what they can to exit the zero bound, what are the implications for investors? It would be logical to assume that escaping the zero bound would require extensive monetary and fiscal policy. This would mean short rates being kept low for a number of years, while inflation needs to be re-established as a permanent feature. This points potentially to a very steep yield curve, with short rates pegged, a heavy supply of government debt, and inflation making real bond returns less attractive. It is likely that this high level of monetary and fiscal stimulus will be a strong boost for the global economy. What kind of traction will it provide in 2021 and beyond?

Outlook and concluding thoughts

The world is going through a t-shaped recession: a sharp fall down, with a recovery back towards previous levels. The question is how high up the “t” the crossbar gets. Given that the service sector has been the main victim of the lockdown recession and government action, the ability to reopen quickly may mean at the extreme that we even get close to a T-shaped recession. The lower the bounce, the better for interest rate risk and the worse for credit risk, and vice versa. This is why the economic outlook is so significant in bond investing. However, the risk-reward profile of taking interest rate duration is currently skewed: there is limited upside on profiting from further falls in interest rates if the zero bound persists. This has been demonstrated in the real world of bond investing this year.

There is a need to escape the zero bound for micro and macro policy reasons. This will require central banks to be more “NICe” as they work closely with governments. In such a scenario, fiscal and monetary policy will need to remain loose for some while, potentially aided by central banks printing money to provide the fuel to escape the zero bound. This type of policy generally leads to higher growth and inflation. This bodes well for the economy and for credit risk, but points to a rise in longer-term bond yields.


[1] When looking at total negative rates, one should bear in mind that rates are defined as the rate in a given currency. If we were to hedge global debt into a base currency of euros for example, the negative outstanding debt would be boosted; if it were turned into US dollars, it would be reduced substantially.

[2] Mervyn King, Bloomberg TV, 16/11/20.

[3] https://www.marketwatch.com/story/powell-says-u-s-economy-needs-more-fiscal-support-11601995205, https://uk.finance.yahoo.com/news/lagarde-pledges-forceful-ecb-stimulus-082057866.html

[4] Current Economic Issues: Remarks by Jerome H. Powell, Chair, Board of Governors of the Federal Reserve System at Peterson Institute for International Economics, Washington, D.C., May 13, 2020 https://www.federalreserve.gov/newsevents/speech/powell20200513a.htm

[5] https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1998/the-boe-act.pdf

The 2020 recession is a direct result of global government policy aimed at protecting populations from the virus outbreak. This has curtailed global growth dramatically, though in a very different way to previous recessions. In this blog we will explore the continuing implications of this and look forward to 2021.

This time is different

This recession is primarily a service-led recession: looking at the collapse in services versus manufacturing, it is clear how unique it is in nature (see chart below). This is not surprising. Service consumption requires human interaction, and this is currently discouraged. In economic textbook terms, this would be categorised as a recession caused by trade barriers: service sector trade has been barred or discouraged, and this barrier to trade has caused a recession.

The magnitude and unique nature of this slowdown is evident in total US GDP output: we see a record collapse and now the start of record rebound (see chart below). This bungee-jump economy is something I have touched on before (here and here).

These trade barriers to services are hugely effective in reducing GDP. Fortunately, the response of governments around the world to this recession has been phenomenal. This has resulted in a huge transfer of wealth from the public to the private sector. These two factors make this recession very different from previous episodes. Looking at the following charts, would you be able to identify that we were in a recession?

All of these charts show the effectiveness of the public sector in mitigating the economic impact of the virus policy.  The Fed’s characterisation of the economy has also remained optimistic compared with previous recessions, based on its biquarterly “beige book” commentary (more formally called the Summary of Commentary on Current Economic Conditions).  The chart below plots the relative frequency of negative words (e.g. “slow”, “weak”) in the Fed’s reports, which is much lower than in past downturns.

Recession or depression?

The collapse in GDP this year has been phenomenal.  Its sheer scale means that maybe we should be talking about a depression rather than a recession. A depression is generally accepted to be a collapse in GDP of at least ten percent over two years. We have already seen GDP collapse by more than ten percent on an annualised basis so far this year. Looking over a longer horizon, are we in a depression?

The probability of depression is simple to diagnose: it is a function of the tapering of public policy intervention on the service industry. The timing of this is likely to be driven by vaccine development, hospital care, seasonal effects and the virus’s potency. Progress is being made on the first two while, like other similar events in the past, it is reasonable to assume that the virus will eventually come to a natural end aided by human intervention to mitigate and control it. What kind of economy will we have post virus?

The post-Covid economy

I think it is reasonable to believe that the economy will boom as restricted activities become permitted. Unlike in previous recessions, the general consumer’s balance sheet has not been as damaged as one might expect. In fact it has improved in some cases as a result of government income support (see chart below).  As we enter 2021, not only will the previous year’s GDP collapse work its way out of the numbers but also governments will hopefully remove the trade barriers that they imposed this year. Additionally, with huge debt burdens and little appetite for austerity, it seems unlikely that governments and central banks will seek to tighten financial conditions, or be as concerned with controlling fiscal deficits and inflation as they have been in the past.  This, combined with a surprisingly robust private sector that has large savings and a desire to consume, will result in what looks like a large economic boom in the short term. Therefore a depression is unlikely.

One interesting question is whether actual real GDP will get back to where it was before the recession. I think that in the first six months after the eventual changes in public policy it will. Excess savings, a liberated consumer and governments in no hurry to impose austerity all point to an outcome of high growth and record consumption.

Over the last few years there has been a desire to eradicate the boom and bust economy. This time round, let’s hope the cycle goes from bust to boom: a t-shaped recession.

One common theme in market commentary of late has been the unprecedented use of the word unprecedented! One thing that used to be unprecedented and is now commonplace is central banks buying corporate bonds. Now this seems to have become conventional monetary policy, it is worth asking “why?” and “is this appropriate?”.

We first wrote about corporate bond purchases in 2009. Back then, it was a new and unprecedented tool. Now it is a regular weapon in the central bank armoury (see chart above), and even the Fed has joined in this time around. One of the consequences of the great financial crisis was a change in how the authorities ran the financial system. The main engine of economic liquidity at the time was the banking sector. It borrowed short and lent long, recycling capital; this is an important economic mechanism and was powered by monetary policy. This mismatch of term risk was mitigated by capital regulations, financial supervision and the back stop bid of central banks and governments, respectively as lenders and guarantors of last resort.

The financial crisis showed the vulnerability of this system which we and others have regularly commented on. A new system was required. Banks were discouraged from lending and have adjusted accordingly: their vulnerable function in the cycling and recycling of capital has been supplemented/replaced in part by the development of a term matched funding model. This is clear from the huge explosion of corporate bond debt outstanding, while credit extended to businesses and consumers has plateaued (see chart above). The effects of this transition, replacing short term bank debt with long term capital, are twofold:

  1. There is less liquidity around as it is harder for issuers to borrow money. The corporate bond market is a more laborious, and potentially expensive, route to financing than the established banking market. This results in growth being dampened as the capital markets are less dynamic in nature. A negative.
  2. The economic cycle becomes more stable as it is harder to create the booms and busts that come with a rampant banking market. A positive.

These two effects have been observable since the great financial crisis. Growth has been slow and steady, not high and volatile.

We are now facing a significant economic slowdown in response to public health needs. The governments and central banks of the world needed to respond rapidly in response to this historic event. In any crisis, it is the function of central banks to act as lender of last resort. The more stable financial market structure since the great financial crisis also needs to be part of the traditional crisis backdrop. Therefore, corporate bond quantitative buying programmes to stabilise markets by enabling the corporate bond market to function is appropriate, and a normal policy action.

The new buyer on the block is the Fed. It has been limited in the past in its intervention in the capital markets, but has now become comfortable in supporting the matched funding that the corporate bond market provides. Though new to corporate market purchasing, the Fed has a history of heavily intervening in the private credit markets with previous substantial MBS buying programmes. Its recent actions are an extension of the need to support term-matched funding markets, like is has done historically in the US housing market.

Though the post financial crisis system has evolved into a more stable one, it still needs supporting in times of crisis. Corporate bond buying is a natural function of central banks to support the capital markets functioning as an efficient recycler of capital.

We are currently in the throes of the sharpest and largest economic downturn the modern global economy has ever seen. However, as I wrote in March this is very different from previous recessions.

To recap, a recession has three stages:

Stage 1: into recession

A rapid, record collapse in economic growth as normal economic life is dramatically curtailed for public health reasons.

Stage 2: end of recession

A rapid. record jump in economic growth as we lift public restrictions.

Stage 3: post recession

An economy trying to offset new business practices and a collapse in confidence with strong monetary and fiscal stimulus.

Where are we now?

Economic growth has plunged, unemployment has soared, and we are now at an inflection point, at which growth will now be rebounding and then eventually settling on a relatively (to 2020) stable course: as I wrote in my last blog, a Flash Crash t-shaped recession.

Unlike previous recessions, we can understand and explain the timing of stages 1 and 2, as they are a direct result of a simple government policy. Unlike previous recessions, stage 3 will be outside of normal textbook thinking. Indeed, according to textbook economics, are we actually going to have a recession? Bizarrely, the Flash Crash in economic growth means that, from one point of view, this collapse in economic growth may not even be defined as a recession.

The widely-accepted definition of recession is two successive quarters of negative GDP growth. Based on calendar quarters, we will meet the recession criteria easily in 2020, with negative growth in the first and second quarter. If I were to be especially pedantic however, on a rolling quarterly basis the recession definition will simply not have been met. If we assume that full lockdown started on the 1st of March and ends on the 31st of May, then we will have the first negative quarter of growth we need over this three-month time frame. However, we know that the subsequent quarter, from 1st June till the end of August, will be one of record economic growth. Therefore, on a rolling basis, we will not have generated a recession by the end of August. Given the rapid collapse-and-bounce-back nature of this economic slowdown, should it be defined as a recession at all?

Returning to my original blog, this is why the collapse and recovery looks like a t. It is clear that total economic output will be lower at the end of August than the start of the year, with huge consequences. The question for 2020 and beyond is: how high is the bounce to where we draw the horizontal line of the t?

Governments and fiscal authorities around the world have thrown a record amount of fiscal and monetary response at the problem in an exceptionally short time frame. To modify a famous phrase, the authorities’ job has not been to take the jug of alcohol away from the party, but to facilitate one almighty happy hour. While this hair of the dog policy will not fully cure the hangover, the question is: how much will it cure it? This is where we come back to stage 3.

Fiscal and monetary authorities will understandably want to return the economy to its past glories, which suggests we will see continued fiscal and monetary easing. This will conflict with virus-related changes in business practices, and the extent to which individuals’ behaviour (consumer confidence) is altered by this year’s experience. The authorities will continue providing the stimulus antidote to the lockdown programme, fighting against the progress (or hopefully lack of progress) of the virus, and the damage done by such a short, sharp shock and economic downturn to business, consumers and governments.

Whenever there is the threat or the reality of recession, it usually follows a typical pattern. It is engendered by tight financial conditions, a real or market bubble bursting, a dramatic rise in the price of oil, or a combination of the above. This time it is different: a stay at home recession.

The 2020 economic slowdown isn’t due to any of the usual suspects, namely the US Treasury curve inverting, the US housing market slowing or a high oil price. Rather, it is due to the virus outbreak leading not to a policy error, but a policy-led recession. In response to the virus outbreak, governments around the world have reacted understandably by encouraging their populations to curtail day-to-day activity. For example, I am writing this on my usual journey in and the car park and train are deserted. We will all have our own anecdotes of this dramatic change to daily life. This will result in a collapse in GDP. Credit spreads are closely correlated with economic growth, and spreads have already reacted aggressively to lower GDP expectations.

Fortunately, we enter this recession with already very accommodative monetary policy from central banks. Monetary policy takes about two years before we can see its effect in the economy. For example, we saw a slowdown in 2018 a couple of years after the Fed hiked rates into 2016. Now the economy has a lead, the Fed having stopped hiking rates in early 2019 and then proceeded to cut. While the ECB has limited scope to react due to its already rock bottom policy rate, the Fed and BoE do.

There are three stages to a recession – how is this one going to be different?

Stage 1: into recession

This is the most certain recession we have ever seen: we can all observe the dramatic fall in daily activity around us. Discretionary spending has been curtailed, and the most expensive discretionary spend, travel and tourism, has been hit the most. This is not a slow evolution where individuals gradually discover the new economic reality, this is an in instruction to everyone to stop consuming. This instruction is worldwide and instantaneous, something that has never happened before.

Recessions are usually described as V or U shaped. The first leg of this recession will resemble the U shaped form. It will be vertical and dramatic, and the largest ever collapse in GDP on a weekly and monthly basis in many countries.

Stage 2: end of recession

Given that the recession’s speed and depth is due to the virus and resultant government action to prevent us mingling, we have an unusually strong idea of when and how the recession ends. This virus appears to exhibit seasonal patterns like influenza and, once it has made its way through the population, immunity can build up. At some point therefore, presumably within three months, government policy will be changed and we can potentially return to normal behaviour. This bounce back will be enormous as the population is no longer told to stay at home. Thus, economic data will show a rapid rebound: it will not be a V or a U, rather it will look like an l. It will be the biggest ever jump in GDP on a weekly and monthly basis in many countries.

Stage 3: post recession

This dramatic collapse and recovery will cause some longer term damage to the economic system. Firstly, from an overall business and personal confidence level, and secondly due to the unprecedented nature of the severe short term pain of the recession. Human behaviour may change, and vulnerable companies relying on short term discretionary spending will have been weakened and potentially permanently impaired. While some consumption will just be deferred (buying a car, for example), much will be lost (going to the cinema). On the positive side, unlike most other recessions, developed economies exhibit very low unemployment and considerable numbers of the population will remain employed and many businesses can remain stable. Hopefully there will be fiscal support for those who struggle more.

Therefore, post recession growth will return to normal but initially will be unlikely to regain its previous levels. This makes this type of recession t shaped: a sharp pull down, a sharp rebound and then back to the normal economic cycle, at probably a lower level than before unless the policy response overwhelms the downdraft, in which case we return to where we were before (T not t). For the economies most affected, this t will be a larger downdraft and bounce back, though the permanent damage may be more. For credit investors during this time, it is important as always to differentiate between credit qualities. While high yield defaults can be expected to rise (previous recessions have seen up to 30% of high yield companies defaulting over five years), investment grade companies are so-called because they should survive (with closer to 2% of companies defaulting over five years in times of stress).

This recession is different.  We know why it is happening, have a far clearer idea than usual of its length and can strongly postulate how it comes to an end. Different governments and central banks are therefore working on measures to get us through the short term GDP flash crash. This has allowed the authorities to act in a bold and aggressive manner that is in itself different. This unprecedented stimulation is likely to stay in place post the shock, to ensure that the economy has a chance to get to an economic level as near as possible to its previous level.

When looking at the risk premium embedded in the extra return you receive in owning corporate debt versus “risk free” governments, one of the factors that we have to take into account is the less liquid nature of corporate bonds. This adds to the potential risk premium from a liquidity and transaction cost perspective. A constant theme since the financial crisis has been the belief that the crash removed the abundant liquidity of the corporate bond market, and therefore corporate spreads should now be intrinsically wider.

The first chart below shows the annual moving average of dealer inventory from 2006 to date, this peaked near $200 billion and has collapsed towards $20 billion, a 90 percent drawdown in committed capital. By definition, this does not sound good for liquidity and corporate bond risk premiums.

The second chart shows actual dealer volume over the same period. This has roughly doubled from peak to trough from circa $12.5 billion to $25 billion.

The obvious conclusion is that whilst capital committed has collapsed, real turnover has increased. This is depicted in the final chart below.

Inventory management has significantly improved from 5 percent turnover in the summer of 2008 to 80 percent as of now; that’s a considerable  change. This change is highly understandable though, given the increase in banks cost of capital from a market and a regulatory perspective post the financial crisis. It is fairly clear that the bloated inventory of the past was not designed to facilitate trading, but more indicative of the traditional bank lending nature of these institutions (trading books then were often given an “available for sale”  break not available in traditional lending). These days it appears that inventory is primarily there for trading, not investing. This is a healthy outcome for the market, the weakness in corporate bonds in the financial crisis was exaggerated by banks removing their investment inventory from their bloated balance sheets in the midst of a funding crisis. This technical environment is no longer present, which is good news for the corporate bond asset class.

Commentators constantly point to the collapse in investment bank balance sheets as a Cassandra with regard to corporate bond spreads. These concerns are understandable, but analysis of the numbers show that the bloated balance sheets of the past were not a good guide to probable liquidity, and one could argue these positions actually increased the volatility and the pain of the financial crisis.

The long-end of the US Treasury market has often been described as a giant anaconda: it draws little attention as it sleeps most of the time, but the minute it wakes up, everybody around shakes. US 30-year bonds don’t bite, but their moves can be as poisonous as they basically determine millions of mortgage rates, as well as the price that governments and companies around the world pay for debt. Is this market about to spring higher in yield?

Until now, 30-year Treasury yields have generally made investors smile – a 600 bps rally over the past 30 years has made money relatively cheap, the term premium has collapsed, flattening the yield curve to levels not seen since the 2007-08 financial crisis, as seen on the chart below:

Investors are now watching this flattening with angst, fearing that it may signal a looming recession: when previous flattenings turned into an inversion in 2000 and 2006, a recession surely followed.

I don’t think this is the case now; more so, I believe we may see quite the opposite. This is because:

Technical reasons: 30-year Treasury yields could replicate what we saw in 10-year Treasuries earlier this year, and which I blogged about shortly before the market turned: after four years trying to surpass the 2.64% level, the 10-year yield finally breached through this level in February on the back of strong hourly wage data – finally a sign of inflation after a decade of dormant prices. This was a significant break of both the short and long term trends.

Could we be seeing a similar pattern in 30-year yields, which by nature are a bit slower to move than the more volatile 10-year market? As the chart below shows, 30-year Treasuries have also enjoyed a three decade-long bull run and have traded within a range between 2% to 3.25% over the past four years.

I believe this level could be breached soon: apart from an improving fundamental outlook (see below), the corporate tax changes from earlier this year encouraged underfunded pension funds to acquire long-dated fixed income securities by mid-September. Afterwards, demand for the asset class might drop, lifting yields.

Fundamental reasons: More lasting than potential triggers or technicalities, I believe long US rates may rise as a natural reflection of a robust economy. While not growing at a spectacular pace, the US economy is producing positive data, which may generate more inflation soon – generally a precursor of higher yields. Let’s see what the job market is telling us.

The chart shows that US companies have increased their hiring plans, at the same that it takes them more time to find talent. We all know that a tight job market generally feeds into inflation and ultimately, higher rates. Anecdotally, tech giant Amazon just announced a wage rise for its employees, a clear sign that the market is tight – if anyone knows the outlook for the economy and how tight the labour markets are, then Amazon should. Maybe Amazon provides another clue to the waking Anaconda of rising rates.

The flattening of the yield curve is carefully watched by investors as it is traditionally a good indicator of an economic slowdown. However, we always need to question conventional wisdom, and one thing we can say about the great financial crisis, and the great financial recovery, is that the actions central banks have taken to meet their mandates has been quite different this time.

The Fed has led the central bank policy response to the crisis, cutting rates aggressively, employing quantitative easing (QE), and Operation Twist – the process whereby the Fed simultaneously sold short-dated bonds and bought long-dated bonds to help drive down borrowing costs and boost economic growth. These policies have worked – unemployment has fallen to low levels, and capacity constraints have or are near to being reached. In this type of environment, monetary accommodation – both conventional and unconventional – needs to be removed.

The central banks firstly decided to reverse conventional monetary policy easing, increasing short-term interest rates back to a more “normal” level after being held close to zero since the onset of the financial crisis. The Fed has made good progress towards this level. When this conventional rate approaches the desired level, policy should finally shift to focusing on reversing the unconventional measures they have taken. The Fed has therefore relied on a series of gradual rate hikes to take some of the heat out of the economy – the resulting increase in short-term interest rates has led to a flattening of the yield curve.

In normal economic cycles this flattening implies a higher probability of the yield curve inverting, something that has historically had significant implications. The Fed has pushed rates up regularly and transparently in the first step of normalisation, accompanied by only a minor reduction in the balance sheet. Further reductions of the Fed’s balance sheet holdings are also hard wired into its monetary programme as existing Treasuries mature. However, one thing the Fed has not done is unwind the distortion they caused to the yield curve through Operation Twist.

I think that the next phase of policy will involve less reliance on interest rate hikes. It will feature a more aggressive unwinding of QE, and a reversal of Operation Twist. This unwind can be completed by reorganising the balance sheet of the Fed through buying of shorter dated securities and selling longer dated securities. This would have the benefit of removing duration risk from the Fed’s balance sheet, and would steepen the yield curve.

The market is very concerned about the flatness of the curve and its implications, and the Fed itself is also concerned considering the historical predictive nature of the curve. One presumes the Fed wants to tighten policy, maintain growth, remove the unconventional policy stimulus it has undertaken, and reduce the risk on its balance sheet. By buying short dated assets and selling long dated assets, the Fed will help achieve its policy goals, and re-steepen the curve. This should result in a lower need for short rates to be hiked to counteract the residual unconventional policy operations that hang over the market.

Operation Twist was first deployed by the Fed to distort the yield curve in the early 60s. This time let’s hope for Operation “Perfect”, and the Fed hitting its key objectives for monetary policy of maximising employment, stable prices, and moderate long-term interest rates. I think they can do it.

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I have written in the past

Author: Richard Woolnough

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