Mission Accomplished (Update September 2016)
This week the Bank of Japan (BOJ) is expected to update its rate policy (a “comprehensive review of its negative-interest-rate policy”) as global central bank officials are starting to question the efficacy of negative interest rates to spur economic growth. As of the time of this writing, the BOJ chose to leave short-term rates unchanged but is committed to expanding its balance sheet “indefinitely” until inflation “overshoots” the 2% target as well as a long-term interest rate of 0% for the 10-year bond. Prior to the announcement in a quasi-reversal of current policy, BOJ officials were floating the idea of engineering a steepening of the yield curve where future balance sheet purchases would be concentrated on the front end of the curve (short-term rates) causing the back end (long-term rates) to rise which would improve the economics of long-term lending. These ‘trial balloons’ followed BOJ Governor Haruhiko Kuroda “acknowledging the downsides of his negative-interest-rate policy.” I had to do a double take when I pulled in the latest balance sheet data on the Federal Reserve and the BOJ (Exhibit 1). The size of the BOJ’s balance sheet is right at the level of the Fed despite Japan’s economy being 1/3 the size of the U.S.
Exhibit 1 – BOJ Balance Sheet the Size of the U.S. Fed Despite Japan Having 1/3 the Size of the U.S. Economy
A growing debate about the effects of negative interest rates emerged in early August, with those skeptical of negative rate policies pointing to rising household savings rates in Europe and companies hoarding more cash. Up to this point, fixed income investing amounted to a front-ending of central bank purchases as investors drove down European and Japanese rates further into negative territory. The 10-Year U.S. Treasury yield dropped in sympathy with global rates from 2.27% at the beginning of the year to 1.45% at the end of July. The chase for ‘safe’ income also took off as bond proxy sectors such as utilities, telecom and REITs generated 2016 YTD returns of 22.6%, 26.1%, and 14.8%, respectively (through July 2016). The punchbowl turned out to be in fixed income rather than equities.
However, following the August cautious comments, we are now witnessing a sell-off (albeit moderate) in fixed income across duration (interest rate risk) and credit as investors acknowledge the possibility that the theoretical low in long-term interest rates has been achieved, at least in this current cycle. The 10-Year Treasury yield has risen to ~1.70% from a depth of 1.37% post-Brexit vote while the 10-Year Japanese Government Bond yield has risen from -0.28% to -0.04% (Exhibit 2).
Exhibit 2: 10-Year Sovereign Yields Rise in September – U.S. Treasuries versus Japanese Government Bonds (through 9/15/2016)
If the intent was to steepen the yield curve, then ‘Mission Accomplished.’ At least in the U.S., the Treasury yield curve (2-10 Year Treasury Term Spread) has steepened (Exhibit 3) to levels not seen since the first half of 2015. Banks are the primary beneficiaries of a steepening yield curve as the spread between long-term lending versus short-term borrowing contributes to net interest margins. This quarter, we’ve seen a reversal of sector leadership with financials outperforming telecom and utilities, largely in response to ‘Mission Accomplished.’
Exhibit 3: Mission Accomplished – U.S. Yield Curve Steepens at a Rate Not Seen Since Early 2015 (through 9/15/2016)
Corporate credit spreads have widened a bit in response to the back up in rates but seem contained so far (Exhibit 4). Spreads have narrowed quite a bit from the February sell-off but remain well above the 2013-2014 lows.
Exhibit 4: Credit Spreads Widen in Response to the Back Up in Rates (through 9/15/2016)
Mission Accomplished – Updated September 2016
We initially intended to write this piece as a preview of the upcoming rate policy updates from both the BOJ and the Fed, but we also thought a one-year retrospective would be in order to help set the context for what the markets are grappling with in a quasi-policy shift of sorts.
We’ve mentioned several times this year going back to our 2016 Market Outlook published in January how central bank policies, especially the Fed, would remain ‘central’ to market volatility. In early December 2015, we published “Mission Accomplished”. We noted at the time that the Fed had built into their ‘dot-plot’ forecasts of four rate hikes in 2016 as they expected economic conditions to normalize, justifying a rate hike cycle (albeit gradual). However, the markets weren’t buying it as Fed Funds futures were only pricing in one possible rate hike in 2016 sometime around June (Exhibit 5).
Exhibit 5 – 12/8/2015: Fed Funds Futures Only Priced in One Rate Hike in 2016
Source: Bloomberg (originally published on 12/8/2015 in ‘Mission Accomplished’)
It turns out Fed Funds futures were more correct than the Fed (something that has been consistent post the 2008 financial crisis) as it seems the Fed’s desire for rate normalization keeps getting pushed off (paraphrasing Wharton Professor Jeremy Siegel’s comments mentioned in the January 2016 Market Commentary). As we approach year-end, it appears that the Fed will choose to raise rates in December barring a major market disruption or collapse in macro data, although the Fed remains deeply divided on the timing between September and December. Exhibit 6 presents the current Fed rate outlook heading into December. The red line below shows the probability of a 0.50-0.75% Fed rate by December hovering around 40% throughout much of the year apart from the January/February sell-off and post-Brexit in early July despite repeated attempts by the Fed to signal rate hikes earlier in the year.
Exhibit 6 – Fed Funds Futures Pricing in one rate hike in 2016 (December Meeting)
Source: Bloomberg as of 9/20/2016
Fed funds futures have been more reliable forecasting the near-term path of Fed funds rates than even Fed officials themselves. Indeed, I was confident enough to post this comment on Seeking Alpha as a participant in their Fed Watch Market Challenge back in April based on what the Fed Funds futures were pricing in:
However, the ink used for those inflation tattoos is starting to warm up. Goldman Sachs now expects to see wage increases make their way through the price channels and with the declining tailwinds of lower commodity prices and a strong dollar, we may start to see bond markets price in a higher inflation premium. A 1) gradual Fed, which keeps overestimating the pace of the current rate hike cycle versus what markets expect, combined with 2) higher inflation premiums and 3) reduced appetites for central-bank driven negative rate policies can start to show up in further steepening of global yield curves. Yet, the longer-term demographic challenges of low nominal growth and high debt levels should keep a lid on the pace of steepening (although we wouldn’t rule out another ‘taper tantrum’ like we saw in 2013). Investors continuing to chase ‘yield’ should be cautious as higher rate volatility can show up in ugly ways (i.e. negative convexity where callable features of a bond can turn a short-duration instrument into a long-duration instrument overnight).
Ultimately, long-term inflation expectations will help determine the pace and level of future rate hikes. The 5-Year/5-Year Forward Breakeven (TIPs versus Nominal Treasuries) Rate is indicating higher inflation (Exhibit 7), but if expectations remain range-bound below the 2% level, then we may see fixed income markets settle down as Fed policy and market expectations of Fed policy finally align with one another.
Exhibit 7: Market Implied Inflation Expectations Remain Range Bound (through 9/15/2016).
It’s been approximately seven months since we launched Targeted Fixed Income (Hold-to-Maturity ETF portfolios) as part of a plan for ‘stockpiling income’ five to 10 years out. For investors concerned about future rate volatility, a hold-to-maturity portfolio doesn’t sound too bad. The investor’s mindset should shift from ‘trading’ to ‘planning’ when building out a fixed income program. At 3D, we have developed a comprehensive retirement income planning tool built on time segmentation with ‘planning’ the core emphasis. Contact us if you’re interested in learning more about what we offer in the way of retirement income planning solutions.
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By: Benjamin Lavine