Low Short-Term Rates for a Long Time?
November 4, 2015
We are likely to have worldwide near-zero short-term interest rates for at least another two years, maybe three or four. The implications for stocks, bonds, and currency exchange rates are huge, as we will explain below.
Let’s define worldwide short-term rates as a weighted average (by size of capital markets in advanced economies, not by GDP). Remember, as an investor you buy securities in capital markets; you do not buy GDP. Remember that the United States is about 23% of global GDP. But about 60% of the world’s population and economic output are within a US dollar zone where currencies are either pegged or floated with dollar sympathy. (Source: The Economist) The US dollar short-term, riskless, central bank policy rate is a band from 0.0% to 0.25%
Today, in all of the so-called advanced economies, the short-term rate is well under 1%. We thank Barclays for data. Let’s take a partial inventory.
For American stock and bond markets, Federal Reserve policy is still the big issue and is still an unknown. Many market agents remain puzzled and uncertain. Market agents suffer fatigue from all the guessing and analysis about the Fed. We do, too.
Yet, as investment advisors and managers of separate accounts, we still have to deal with this ongoing saga in the annals of central banking. Fatigue cannot be permitted to alter the importance of the “longest Fed drum roll in history.” (Credit for that monetary moniker goes to Nariman Behravesh, Chief Economist at IHS. He is a colleague of Bob Eisenbeis and mine at NBEIC. We thank Nariman for permission to cite him.)
Fed policy has been made even more complex since the Fed revealed that eight of the Reserve Banks have asked for discount rate hikes. That information from the meetings of the Board of Governors reveals division within the Fed. While this complexity is difficult for many unskilled observers to fathom, it adds substance for those willing to dig deeply into the details.
A careful reading of Reserve Bank forecasts and requests for discount rate action allows us to make educated guesses about which voting members of the FOMC favor such action and which are willing to defer. We know that an FOMC member can make a “soft statement” of policy bias by encouraging a Reserve Bank board to call for a discount rate change. My colleague Bob Eisenbeis has written in detail about this process. See the archives at www.cumber.com.
Tallying the views and forecasts of the Reserve Bank presidents is more easily done now that their views are more clearly identified. They are either in favor of tightening (eight) or waiting for more data and then tightening (three). For only one president can we surmise a view in favor of easing. A tightening action is thought to be defined as a ¼ point hike in the policy interest rate. That action now carries the moniker of “liftoff.”
Meanwhile, the governors (five sitting, with two vacancies) seem to be divided. Their debate is now more public, which only adds to confusion. It also places an ongoing burden on Chair Yellen since she has to speak for the FOMC and try to maintain a clear and coalesced view after each meeting. Yellen is the spokesperson for a divided group. If all presidents voted at every meeting, it is conceivable that the majority would favor a rate hike now. The combined vote would certainly be a close call. Remember that only four of eleven presidents vote at any time. The exception is the president of the Federal Reserve Bank of New York, who votes permanently. Given the diverse views of the group, Chair Yellen now has the problem of “herding cats.”
A few FOMC voting members still predict a liftoff in December at the last meeting of the year on the 16th. But that is not a clear forecast. January and, more likely, March are also in play. Some forecasts now go to June, 2016. Even with a liftoff, it appears that the path away from zero will be slow and will extend for several years once it starts. Market-based indicators suggest an implied rate of around 1% in early 2018. The FOMC dot plot gets you to about 2.5% in 2018 – but few market agents believe it.
Think about the dot plot in terms of future currency exchange rates. If the FOMC dots are correct and the US policy rate is 2.5% in 2018 while inflation is low and the federal deficit is down and stable at about $500 billion, where is the dollar? The yen is expected to still be at a near-zero short-term rate in 2018. The euro will still be in a negative rate regime. A suggested exchange rate would be dollar/yen at 135 and dollar/euro at 100 or even 90.
Let’s segue to the euro.
The European Central Bank is likely to continue negative rates, extend and enlarge QE, and acquire more balance sheet assets over time. ECB policy influences other nearby non-euro jurisdictions, as we just saw with Sweden’s additional easing. Essentially, all short-term interest rates of higher-credit-grade and mid-grade countries in Europe are negative, and the policy of negative rates is spreading as the rates go even lower (more negative).
The negative rates originate in the euro area but are not restricted to that geography. Remember the European Union is a trade and commerce union. So non-euro currencies are heavily influenced by the European Central Bank. The use of negative rates in an open commercial union means an adjustment process for non-currency zone members who are part of the union. That requires each of those countries to take their national policy rate below the ECB. That is why Denmark, Sweden, Switzerland are lower and why other neighbors are headed lower. In the case of Europe this has now spread beyond just the short-term rate. About $1.9 trillion value of intermediate-term bonds are now trading at negative rates. (Source: Bloomberg) We expect that number to increase.
Japan is now an enigma. The BOJ is not adding to its stimulus path with additional incremental easing, but it faces economic headwinds that call for additional stimulus. We expect market forces of zero inflation and possible recession to push the Japanese central bank into an enlargement of its easing policy. Japan has an election cycle for the upper house of its National Diet in the middle of 2016. The political pressure is building for further QE and enlarged deficits growing from expansive budget actions. Financing needs for higher defense expenditures are unknown, but the path for them seems to be up as well. We expect Japanese short-term rates to be near zero in 2018.
Among other advanced economies, the UK is easing (market expectations are pricing in a short-term rate of a little over 1% in 2018, according to Oxford Economics). Australia and New Zealand are easing, too. Among the emerging economies, China, the world’s second largest economy, may be down to 3% in 2018. Indonesia, India, Korea, Hungary, Poland, Russia, Turkey, and Mexico are all easing.
Hence we reach the easiest of conclusions. First: monetary stimulus continues worldwide and is actually expanding. Secondly, very low short-term interest rates are likely to extend for longer periods than many market agents expect.
Zero and negative interest-rate policies have profound implications for asset pricing. In a theoretical model, the price of a long-term asset is infinity if the discounting rate is zero. In a theoretical model the long-term interest rate reflects an expectation that short-term rates will persist over time, with a risk adjustment for being wrong. Markets never expect zero forever.
But markets have been expecting rising rates for years and not getting them. In fact, the expectation of higher rates in the future may have kept longer-term rates higher than they otherwise would have been. As long as this circumstance persists, shorter rates will remain very low, and asset prices will have an upward bias. That is why we remain nearly fully invested in the US stock market. We also like foreign markets but believe some of them require that currency-hedged positions be in the portfolios. Not all, but some.
For bonds, spread product is desirable, not Treasury notes and bonds. TIPS may be an exception in some portfolios. Mechanical ladders are not desirable. They trap the investor in sections of the yield curve that deliver punishing performance. Remember, mathematically a ladder is nothing more than a mixed stream of payments about which a duration calculation may capture 95% of the price sensitivity with a single bullet computation. The bullet is the duration reference, except that the ladder carries with it a cost of maintenance that the bullet avoids.
Only when the bullet happens to be the best choice of term on the yield curve does a mechanical ladder add any value. If that happens, it is pure coincidence. At Cumberland, we rarely use a ladder; we compete against them.
David R. Kotok, Chairman and Chief Investment Officer