There are Six Pillars of low rates in the long end. You’ve heard me discuss these in the past, but not presented in this way. We have the Big 3 QE central banks (ECB, BOJ and the Fed), plus three other factors (the neutral rate, inflation, and demographics). I thought we should do an inventory of where we stand on these various drivers to gauge the potential long-end selloff:
• The ECB’s QE. The ECB was a little late to the QE party. But they had been buying €60B per month since March 2015 (with the exception of this 12 month period where they bought €80B), so I think of it more as €60B being their “base amount.” They stepped on the gas for a year, and now they feel like they can go back to their base amount. It seems a little premature to call this a “taper.” If they go to €40B, we can have a conversation about a taper. At the end of 2017, they will have surpassed the Fed’s balance sheet usage. It will be interesting to see how far the ECB is willing to go. But they have many problems to deal with – political, economic and cultural. The betting odds of Brexit next year have increased from 1/3 to 1/5. The EU may have some other problems keeping the Fellowship together, with their current #2 and #3 members (France and Italy) possibly joining the UK in leaving. To expect a taper is saying that you think everything will be fine by the end of next year. That does not seem like a high probability tail. Bottom line: €60B per month is a little disappointing for bulls, but there is no reason to think ECB QE is not here to stay.
• The BOJ’s QE. Since the BOJ went to “unlimited QE” and pegged the 10 year JGB to zero, JGBs haven’t deviated more than 10bps from 0 (mostly on the negative yield side). We get an interesting test next week – global fixed income puked some more on Friday. It will be interesting to see how high ten year JGB yields will get. Is this going to be a “bend but not break” defense, or a cement wall? This has been keeping a lid on yields in the ten year sector in other currencies. Bottom line: Japan is in a demographic sinkhole, so there is no reason to think BOJ QE is not here to stay in some form.
• The Fed’s repurchases. People generally don’t talk about this as QE, but in effect it is… they are buying QE-like billions a month in securities per month. They will continue to do so until the “normalization of the level of the federal funds rate is well under way.” I don’t consider one hike per year as “well under way.” But Mester said earlier in the year that she thinks they could be ready after some more hikes. Since she is a hawk, it seems reasonable based on what we know now to think this would be a year away (at least). Bottom line: Barring some massive growth or inflation prospects in 2017, a near-term termination of Fed repurchases seems unlikely.
• The neutral rate. This one is the one we have the least information on, but could potentially be the most important. In effect, we are asking, where longer term rates will be in equilibrium. A change in the long term neutral rate would also affect the valuation of equities, from a cash flow valuation perspective. A year ago, everyone was spouting “new normal” theories. It’s not clear to me if the narrative of lower neutral rates was fundamentally sound, or if it was just economists trying to back-fit the lower rate observations. There’s probably some of both. Bottom line: TBD.
• Inflation. We now have a few reasons to think inflation could pick up: oil prices are higher, there seems to be some global growth, commodity prices have recovered, and trade barriers could be inflation-friendly (if they don’t cause a recession). Draghi mentioned the risk of deflation has largely disappeared in the EU. This is true in the US, and not true in Japan. We had been pricing in some risk of deflation and that has diminished. However, there are some structural reasons for lower inflation, like better pricing discovery, technology, and demographic shifts, to name some factors. The Fed is currently in a “gradual” mode, which should see increased inflation risks priced further out (bear steepening). Deflation risks have subsided and the inflation risks have risen, but is this enough to get inflation noticeably above 2%? Bottom line: As per the Fed, the risks to inflation are balanced.
• Demographics. The first of the baby boomers turned 70 this year. The last of the baby boomers is only 52. So for some time, pension funds and insurance companies may have need to buy the long end of the curve. People are also living longer over time. These factors will keep some bid to the long end. Bottom line: the demographic demand for longer term fixed income won’t change in the near future.
A few prominent investors (Gundlach and Druckenmiller) have suggested bond yields could hit 6%. This is highly unlikely in the current environment. Of course the environment could change going forward. That is why doing a regular assessment of these Six Pillars could be valuable. For now, we see some cracks in some of the Pillars, but others are very sound. The other issue I see is that extremely high yields in a vacuum could crush many sectors of the economy – housing, equities, high debt companies, etc. A few economists (including Goldman) had been forecasting a drop in equities if 10yr Treasuries rise another 13-28bps. I can only imagine the carnage with 6% yields. Any type of correction should cause rates to go lower, all other things being equal.