One of the features of the credit crunch era has been the falls in first world interest-rates and bond yields. The first phase saw the slashing of official short-term interest-rates and once that was seen to be inadequate, central banks directly purchased bonds to reduce yields further. It is seldom put like this but there was already an implied failure as according to the models back then the interest-rate cuts should have done the trick. Back then I was already looking ahead to when there would have to be ch-ch-changes and posted the view that central banks would delay what has become called policy normalisation.

For example back on the 24th of February 2011 I pointed out this about a speech from David Miles of the Bank of England.

 My problem with this is that when you act as they have and you have in effect used what weapons the Bank of England has virtually to the maximum by cutting interest-rates by 4.75%% and spending some £200 billion on asset purchases then you have been extraordinarily interventionist. Accordingly it is then hard for you to blame events because some of them are the consequence of your own actions……

What that illustrates is that already the truth was being manipulated and also I am glad I wrote “virtually to the maximum” as of course the amount of asset purchases has more than doubled. In addition we have seen credit easing in the UK via such policies as the Term Funding Scheme and the start of full-scale QE from the European Central Bank as well as negative interest-rates.

But the point about delaying proved to be very accurate as the Euro area is still actively pursuing QE and in net terms the UK has managed to raise interest-rates by a measly 0.25%. The opportunity in 2014/15 was meant with promises via Forward Guidance but no action.

The US

This is the one country which has taken clear action on the path to normalisation. Here is the current state of play.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 2 to 2-1/4 percent.

That is currently working out be be around 2.2% and more rises are promised. Also there is some reversing of the QE or Qualitative Tightening.

The Committee directs the Desk to continue
rolling over at auction the amount of principal
payments from the Federal Reserve’s holdings
of Treasury securities maturing during each
calendar month that exceeds $30 billion, and to
continue reinvesting in agency mortgage-backed
securities the amount of principal
payments from the Federal Reserve’s holdings
of agency debt and agency mortgage-backed
securities received during each calendar month
that exceeds $20 billion.

That combined with forecasts of another interest-rate rise in a fortnight and at least a couple next year seemed to put pressure on bond markets. However this sentence in a speech from Federal Reserve Chair Jerome Powell shook things up on the 28th of last month and the emphasis is mine.

We therefore began to raise our policy rate gradually toward levels that are more normal in a healthy economy. Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy‑‑that is, neither speeding up nor slowing down growth.

You may note we seem to have travelled from “policy normalisation” to neutral. But what the neutral interest-rate represents is an attempt to figure out what interest-rate would neither stimulate or contract the economy. Or a sort of measure of what we might aim for as a new normal. When they are trying to put a pseudo scientific gloss on things economist and central bankers call it r-squared.

However the “just below” dropped the expected path for US interest-rates by 0.5%.

Bond Markets

Let me take you to the Wall Street Journal on Tuesday.

This quarter, yields on longer-dated bonds have dropped and those on two-year Treasurys are flat. The gap between two and 10-year Treasury yields is now around 0.11 percentage point, compared with around 0.55 percentage point at the beginning of the year.

This is attracting a lot of attention in the financial media but the change of 0.44% is pretty much my 0.5% suggestion above. Now let us look at the US ten-year yield which is 2.9% as I type this and we see that in basic terms it is predicting a couple more 0.25% interest-rate rises. This will come in the next year or so if true so it is not very different to the two-year yield of 2.76%.

If we look beyond Federal Reserve policy we have seen a fall in the price of oil over the past month or two. If we look at it in Brent Crude terms then just above US $86 of early October has been replaced by below US $59 this morning as oil follows equity markets lower. The exact amount of the change varies but the path for inflation now seems set to be lower as it has been rare in 2018 for the oil price to be below where it was this time last year. That is another reason for lower bond yields.

Is this a signal of a recession? Here is the St.Louis Fed from last week.

Does the recent flattening of the yield curve portend recession? Not necessarily. The flattening of the real yield curve may simply reflect the fact that real consumption growth is not expected to accelerate or decelerate from the present growth rate of about 1 percent year over year. On the other hand, a 1 percent growth rate is substantially lower than the U.S. historical average of 2 percent. Because of this, the risk that a negative shock (of comparable magnitude to past shocks) sends the economy into technical recession is increased.

That is a fascinating way of looking at it and in my experience precisely zero bond market participants will look at it like that. It is also revealing that we seem to just assume growth will now be lower. Didn’t they save us?

Comment

I wanted to look at this subject today because of the clear changes which are happening. Now it looks much less likely that US interest-rates will pass 3% and if they do not by much. So “normalisation” will be at best about two-thirds of what it might have been considered to be pre credit crunch ( 4.5%). Some of you have suggested that we can no longer afford interest-rates and yields above 3% so well done at least if we stay where we are! If Italy folds you may get a second tick in that box.

But as we look wider we see even more extraordinary developments. Let me take a look at my own country the UK which is in political disarray yet the ten-year Gilt yield is below 1.3%. So those predicting a surge in Gilt yields are slipping back into the bushes whilst I note the extraordinary absolute level and the persistence of negative real yields which bust past metrics. Germany has a ten-year yield of 0.26% and a five-year one of -0.3% as we note again more metrics which are busted.

So my view is that we cannot rely on old recession metrics because another cause of all of this is that QE4 from the US Fed has got closer. I have worried all along that interest-rate rises might run into more QE and if they do we will be singing along to Coldplay.

Oh no I see
A spider web and it’s me in the middle
So I twist and turn
Here am I in my little bubble