There has been much hand-wringing of late about the US interest rate markets. How could it be that the 10yr is 2.5% when we started the year at 3%? Sure, we had some bad weather, but jobless claims just came in at their lowest level in 7 years! Non farm payrolls were almost 300k! The Fed taper will be done in just a few months! Even the soft housing data rebounded strongly in April!?
Oh but how we worry.
Various explanations have been put forward for the rally in US bonds.
1. Central Bank holdings as FX reserves go up
2. Equities wobbling (near all-time highs?!)
3. G4 central banks leaning back towards dovishness
4. Yellen winning the dovish argument on the FOMC
5. Bernanke telling people rates won’t go back to their long term average of 4% ‘in my lifetime’ http://reut.rs/TkXoy1
The final point makes it very clear just how much of a colossal loss of nerve is going on. Since when did we listen to the guy no longer in charge? Sure, he’s close to Yellen, but is it surprising that the man who sanctioned the biggest money drop in US history is somewhat dovish? The detail in that article says it all… some big fund managers are quoted as cursing themselves for not listening to his comments more carefully. No, they’re just frustrated that the market is moving against them, even now the weather effects are out of the way.
At the heart of this lies the expectations for the US economy. It’s not surprising that it is so hard to call. With the patient having spent 7 years on life support, just how will it manage on its own? After all that time can we really believe it will skip out of the hospital? Particularly when housing and banking, the implosion in which brought the world economy to its knees, is so sensitive to interest rates. Let’s not forget that at the same time a new chairman is in charge of the biggest central bank in the world – and only the 3rd in 30 years.
This chart is the key. It’s consensus expectations for US economic growth this year. We’ve run from one side of the boat to the other, starting the year expecting almost 3%, now down to 2.5%.
Janet Yellen is wrong. The Fed’s “dots” do matter, but only because they give us confidence in our view of the US economy. Central bankers have been performing an excellent jedi mind-trick since Lehman went under – “trust us, we will keep pumping the drugs until we’re confident you can leave the hospital”. But markets should have their own confidence now.
The response to the Bank of England Inflation Report gives the clearest signal that the market is capitulating. Every time previously that Carney has signalled on forward guidance, the market has brought forward rate hikes. This time his dovishness saw it pushed back. The guy is in place to ensure that any spike in yields is contained, which means using sterling to weigh on inflation, and macroprudential rules to weigh on the housing market. But it doesn’t mean that there isn’t underlying strength in the UK economy.
What will make the market regain its confidence? It will need something so obvious that it can be grasped with both hands and thrown in the face of the world’s central banks. The key to watch is inflation – and specifically wage inflation. Go back to the Reuters article on Bernanke, where one attendee says they’re “shocked” that 2% inflation was not considered a ceiling. How can anyone be shocked when central bankers will pat themselves on the back for averting another deflationary Great Depression! Even the ECB appear to be putting some kind of asset purchases on the table. For Central Bankers, inflation is a massive result. It’s like (pre Moyes era) Manchester Utd: having good players on the bench makes the team selection a headache you want to have -> employment, wage inflation and growth makes getting behind the curve worthwhile. Raising rates into a recovery will be accompanied by a sigh of relief.
If the central banks have told us anything, it’s that they want to be behind the curve. Markets need to recognise that this means the yield curve is ours for the taking. Courage, mon brave…