Harbour commentary: Spiking the Punchbowl

The US Federal Reserve's unprecedented monetary policy moves have left markets torn between short-term growth risks and longer-term inflation risks, with low yields making global bonds unattractive.

Wednesday, October 3rd 2012, 12:10PM

by Harbour Asset Management

• US Federal Reserve follows the ECB with more aggressive policy action. QE3 kicks off with purchases of mortgage-backed securities, in an attempt to lower mortgage rates.
• The FOMC “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens…and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.”
• US long-term bond yields rose to the highest levels since May on the announcement, but subsequently fell as markets remained focussed on the more immediate prospect of subdued growth and ongoing Eurozone malaise.
• Alan Bollard delivered his final Monetary Policy Statement, leaving new Governor Graeme Wheeler with some flexibility, yet no apparent urgency to adjust the Official Cash Rate (OCR).
• In New Zealand, interest rates were barely changed, despite some modest intra-month volatility.
• Once again, the NZ and Australian corporate bond markets have remained surprisingly resilient throughout the volatility in global markets. Retail demand for securities has led to strong performance from subordinate and perpetual securities.
• While long-term bonds appear expensive, and face medium-term risks, for now we anticipate yields to remain low as investors focus on the more immediate challenges faced in the global economy.

Central banks up the ante

In 1955, the then Governor of the US Federal Reserve launched the phrase that captured the essence of monetary policymaking in saying the Fed’s role was to “take away the punch bowl just when the party is getting good.” Nearly 60 years later Ben Bernanke has arguably done the opposite and spiked the punch bowl with a bottle of proof alcohol. The trouble is, right now hardly anyone is drinking.

At the US FOMC meeting on 13th September, the Fed announced a fresh package of quantitative easing (QE3) and monetary policy signalling. This included four elements:-
• Extending the guidance that the Fed Funds rate would stay near zero until 2015, from 2014;
• Going down the credit spectrum into mortgage-backed securities (MBS);
• Buying MBS in unlimited size;
• A signal that the aggressive monetary policy stance will continue until well into a recovery.

The Fed’s mandate covers both inflation and employment, but of the two it is clear the sluggishness of the recovery in the jobs market is their primary concern at present. While the Fed stated the initiatives are being introduced ‘in the context of price stability’ objectives, they have clearly made the judgement inflation is not an issue at present.

However, the intention to stay with super easy policy well into a recovery, effectively abandoning forward-looking monetary policy, takes monetary policy into a zone that had historically been unthinkable in the pre-GFC world.

To understand the implications of the Fed’s action we need to consider the economic possibilities that might evolve. Ignoring a swathe of unintended consequences, quantitative easing aims to (by printing money) stimulate nominal economic growth by making money more readily available. To date the Fed has injected US$ 2 trillion into the economy since 2009 and is prepared to continue in an unlimited volume far into the economic recovery.

In normal economic conditions, two economic possibilities exist from this action. Either growth will be stimulated as money is put to work, or if capacity constraints exist, the abundance of money will bid up prices and inflation rises. However since the GFC, the QE unleashed so far has done neither. In practice, the Fed has found it easier to reflate markets than reflate economic activity, although it is very likely that economies would be in even worse shape had QE not been implemented. The inability to positively stimulate the economy has been because in the environment of household deleveraging and corporate wariness, the demand for money has been absent. In economic terms, the velocity of money has plummeted. Hence the analogy of a punchbowl that no one is drinking from.

Consequently, financial markets are fighting two offsetting forces. Long-term bond yields remaining low makes sense on a judgement that deleveraging isn’t yet over, that fiscal constraint in Europe and America will hold back growth, and that political and financial risks are abound. In this environment it’s hard to see inflation rising. However we can’t be sure for how long this will continue. In the context of a ten year bond, can we envisage an eventual return to growth? And if the Fed does keep policy super-easy what risk do they run that inflation picks up, potentially aggressively?

It seems highly plausible that if it were not for the fact that the Fed is actively bidding down long-term US Treasury yields, longer-term rates would have more inflation risk premium priced in. In fact we did see this when comparing fixed rate Treasuries with TIPS (Treasury Inflation Protection Securities). Immediately after the FOMC meeting the yield margin between the two (known as the inflation breakeven) spiked higher. This is in stark contrast to before QE1 and QE2, when these inflation breakevens pointed to deflation as a genuine threat. The Fed has moved from fighting deflation to tempting inflation.

Source: Bloomberg.
Note: Nominal bonds yields less yields on TIPS (Treasury Inflation Protection Securities).

It appeared we might be on the cusp of a shift in market sentiment, where medium term inflation sentiment increased. However, the bond market quickly rejected this shift, with yields not sustaining the initial surge higher, and long-term rates fell back into the very low ranges we have seen lately. This is a rather sobering outcome. The market has effectively said the Fed’s actions will not be sufficient to turn the economy around in the immediate future. By the end of the month focus had moved back to the familiar European themes. Core bond markets have reverted to the pattern of providing a safe haven for the multitude of investors that remain concerned about risky assets and are prepared to own bonds despite very low real yields. It almost went unnoticed that economic data in United States surprised to the upside in September.

Source: Citigroup and Bloomberg.

To our thinking, this leaves global bond yields looking rather unattractive on a medium-to-long-term view. Low real yields, driven by explicit central bank action and investor preference are not providing a sufficient premium for the uncertainty we face given the radical nature of the changes adopted by the Fed. This is especially so, given the upside inflation risks that may build over the medium term. However, while Europe still faces considerable risk, there is certainly scope for bond yields to fall further, before inflation fears might emerge.

Source: Bloomberg.
Note: Nominal 10 year bonds yields less actual inflation.

As always, the global developments flowed through into the New Zealand market. The NZ 10 year bond yield rose from 3.46% to 3.73% then fell back down, closing the month at 3.44%. Dr Alan Bollard delivered his final Monetary Policy Statement, leaving a signal that any change, up or down in the Official Cash Rate, would be some time away. This leaves the incoming Governor, Graeme Wheeler, under no time pressure to act and also free to signal his areas of emphasis.

The Governor’s Policy Target Agreement, signed with the Minister of Finance, continues to focus on inflation targeting. Indeed a new reference to the mid-point of the 1% to 3% target range has been included. The contrast with the US Federal Reserve’s approach could not be more stark. Investors with a preference for inflation fighters are likely to continue to favour NZ Government Bonds as well as the New Zealand Dollar. Indeed New Zealand is one of the few countries with adequate real yields.

Amongst these numerous pressures, we see corporate bonds faring relatively well. More resilient balance sheets and stronger funding positions leave companies well placed to cope with what may continue to be challenging economic times.

Mark Brown & Christian Hawkesby
Harbour Asset Management, Fixed Income

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