As rates have risen, investors have, once again, started asking the perennial question: Is the bond bull market over and are rates normalizing? In thinking about bond yields, it is important to keep longer-term factors in mind that have nothing to do with central bank policy. Low yields have correlated with two, related longer-term trends: low nominal GDP (NGDP) and an aging population. The reason they’re related is that an aging population means slower growth in the workforce, and in turn, slower economic growth.
An aging population impacts rates through a second mechanism. As consumers age, their borrowing and investing patterns shift. Older households tend to borrow less and demonstrate a preference for income, in the process raising the demand and lowering the supply of bonds. The net result is that older populations tend to be associated with lower real, or inflation-adjused interest rates. This dynamic has been at work for decades and helps explain why low yields predated the financial crisis.
Because the population will not get younger any time soon, what would need to change to push rates back to “normal”? In terms of the real economy, the simple answer is faster nominal growth. Looking back over the past 60 years, the level of nominal growth has been the key to understanding the level of rates. During this period, a smoothed average of nominal growth explains almost 60% of the variation in long-term rates (see the chart below).
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Bill Gross: “The expansion of central bank balance sheets from perhaps $2 trillion in 2003 to a now gargantuan $12 trillion at the end of 2016 is remarkable. Not only did central banks buy $10 trillion of bonds, but they lowered policy rates to near 0% and in some cases, negative yields.
Withdrawal of stimulus, as has happened with the Fed in the past few years, seemingly must be replaced by an increased flow of asset purchases (bonds and stocks) from other central banks, as shown in Chart below. A client asked me recently when the Fed or other central banks would ever be able to sell their assets back into the market. My answer was “NEVER”. A $12 trillion global central bank balance sheet is PERMANENT – and growing at over $1 trillion a year, thanks to the ECB and the BOJ.
An investor must know that it is this money that now keeps the system functioning. Without it, even 0% policy rates are like methadone – cancelling the craving but not overcoming the addiction. The relevant point of all this for today’s financial markets? A 2.45%, 10-year U.S.Treasury rests at 2.45% because the ECB and BOJ are buying $150 billion a month of their own bonds and much of that money then flows from 10 basis points JGB’s and 45 basis point Bunds into 2.45% U.S. Treasuries. Read more »
The Fed (and every other Fed commentator) uses the word “normalization” to describe the upcoming next phase of monetary policy. While the debate focuses on when that might be — as in, exactly how long is a “considerable period?” — we’ll simply say sooner than the markets expect. Now we can answer this question recently posed to me by a financial advisor: “What does normal mean?” “Normalization” refers to the two main components of the policy response to the 2008 financial crisis: quantitative easing (QE) and zero interest rate policy (ZIRP).
By “normalization” the Fed means returning its balance sheet to its pre-crisis size by exiting quantitative easing. That was last year’s story (the “taper tantrum”), and in the September Federal Open Market Committee meeting the Fed outlined its plans for how it intends to normalize its balance sheet. Leaving aside the many “inside baseball” details, the key implication of QE was that this policy was fundamentally directed towards reducing longer maturity interest rates. The Fed supported the housing recovery by targeting the QE programs at subsidizing mortgage borrowing costs. Hence, the exit from QE debated last year led to increases mainly in longer maturity interest rates.
“Normalization” means the end of ZIRP. This second part is more “normal” in that we can compare policy rates historically over past periods of Fed policy accommodation. Importantly, when considering the degree of policy accommodation historically, we need to look at the “real” fed funds rate (the nominal fed funds rate less the rate of inflation). Today, with inflation around 2%, current policy places rates at minus 2%.
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Fascinating chart from Jerry Khachoyan at The Armo Trader blog. Below (click to enlarge), Jerry shows how almost every market top and bottom has coincided with an action or announcement from the Federal Reserve or its FOMC
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“When the market is going up, there is a tendency for investors to become more risk averse. Research shows that people tend to be risk-seeking when dealing with losses and risk averse when dealing with gains. As a result, with the market hitting all-time highs, individuals surprisingly are starting to become a little more nervous with regards to the future direction of the market. It is important to remember that market movements are time independent events. The fact the market is hitting new highs has no statistical bearing on what is going to happen next. The market is no more likely to go up or go down given it has appreciated in the past. If anything, there is some data that shows if a market is exhibiting long-term momentum that momentum tends to persist for a few months. The odds of investing in the equity market, over long periods of time, are in an investor’s favor.
Generally speaking the market tends to appreciate at a rate that is roughly 600 basis points, or 6%, above the risk-free rate. The risk-free rate is the rate of return on 3-month treasuries. This rate of growth is surprisingly stable over time and is likely to persist in the future. As a result, on average, an equity investor should plan on having an investment in the market double every eight to ten years. This means if you perform as well as the market has historically, a $1 million investment should grow to roughly $2 million over a ten year period when factoring in the reinvestment of dividends. Read more »
There’s been an awful lot of belly-aching about the Federal Reserve possibly beginning to taper, or gradually reduce, its stimulative bond-buying program. Some have attributed the risk of the taper to the return of volatility in the stock markets. But this volatility may be explained more directly by a larger, more theoretically sound reason: deteriorating earnings expectations. “The Street had become a bit too happy of late and then got upended by the Fed and the likely tapering of QE amidst some prior hopes of a delay in ending such accommodative policy, almost without spending any time looking at earnings estimates or trends less than a month before second quarter results are released. Such a thought process seems ill-founded since earnings matter the most for equities, in our opinion, and there is relatively robust statistical evidence to back up that contention. In this respect, we have been a tad shocked by the surge in negative-to-positive preannouncement trends that make 2009’s surge appear less worrisome in retrospect (see Figure 1). Upward earnings guidance has dipped as well (see Figure 2) and there has been little consternation or discussion about it,” said Citi’s Tobias Levkovich in a note to clients last week. Read more »
“Over the past several years, U.S. farmland prices have soared as grain prices rose and the Fed drove interest rates to historic lows. What happens now is that grain prices are falling as global output surges, yet U.S. farmers are suffering from a swing from a drought last year to too much rain this year, limiting their production as they lose global market share to foreign competition. Furthermore, the Fed is contemplating ending its bond-buying program later this year, which is already pushing up borrowing rates. These trends could lead to a reversal in land prices that could in turn be felt well beyond the farm. The U.S. Farm Credit System is a government-sponsored enterprise that provides federal guarantees for bad loans—much like Fannie Mae and Freddie Mac helped to fuel the U.S. housing boom. While a much smaller potential financial fiasco than the housing bust, financial companies with exposure may suffer. Also, investors around the world have poured billions into farmland as a “real asset” in recent years and may see losses”.
By Mitch Zacks, Senior Portfolio Manager at Zacks Investment Management, Inc.
“The market is always looking out six to eight months. For this reason, investing using macro-economic data is not necessarily a winning strategy. Macro-economic data tends to be backward looking. The unemployment numbers tell you what has happened in the past; however, they don’t give a good read as to what might happen in the future. The S&P 500 does not care what the GDP numbers were last quarter. Instead, it is looking at what GDP growth is going to be in the coming quarter and, most importantly, whether that growth will come in stronger or weaker than current expectations. For this reason, I almost always prefer to follow an investment strategy that focuses on forward looking metrics, like changes in analysts’ earnings estimates, rather than trying to decipher what the latest CPI number is telling us about the market.
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