One is the inevitability that policy rates will have to settle at a higher future rate than in the recent past (see my column in the FT on 26th June, Investors still need to adjust to a world of higher interest rates) and the other is that the focus of markets is likely to shift from inflation to growth and then onto debt, with elements of this being evident in recent market moves. Let me highlight three issues that current developments bring to the fore: uncertainty about the term premium and about policy rates, and the increased debate about what constitutes a safe haven.
One: the term premium
The adjustment in future interest rate expectations helps explain the continued rise in bond yields, although it is not the only factor, particularly recently. Effectively, the long-term bond yield can be split into two parts: the rolling-over of shorter-dated bonds (this reflects what is expected in terms of expected central bank policy such as the US Fed funds rate), and the additional component that cannot be explained by that, which is the term premium. This is seen as the compensation that needs to be paid to investors for holding longer-dated debt.
In fact, the term premium has been more of a focus since last summer when it started to increase and this has been an important recent part of the rise in yields. It is the US term premium that markets are focused on. In the aftermath of the global financial crisis, easy money and an expectation that low inflation was predictable and here to stay contributed to a low-term premium.
At various times over the last eight years, the US term premium turned negative, particularly when the pandemic hit, helping to suppress bond yields, and it has been negative in the last two years, until now. Increased uncertainty helps explain this latest change. Given that there is considerable future uncertainty about debt, and not just about inflation or growth, it would be no surprise if the term premium rises further. The point is, it is premature to say bond yields have peaked.
Two: policy rates
Markets are worried about the relationship between monetary policy and growth. At turning points in economies, it is not uncommon to see mixed and at times conflicting economic data, before a clear and uniform trend becomes clear. Moving from high inflation to slower growth is one such time, as now. The current data shows that inflation has peaked, but it is still unclear where inflation will settle. Core inflation has been stubborn in many countries. Here in the UK, inflation could bottom next summer, perhaps below 2%, but as I have outlined before it would be no surprise if inflation settles then at a higher level than pre-pandemic, at 3% or slighter higher.
It’s a similar story in the US, and thus markets are unsure as to what this means for policy rates and growth. Previously there had been an expectation that a soft landing would materialise, with modest growth in the US and more generally in the west, and that lower inflation and slower growth would allow central banks to ease policy rates next year. Now, the market perception is that central banks could hike further, and not ease as quickly or by as much as the markets previously expected. I think that is right.
Markets are increasingly uncertain about whether expectations of a soft landing in the US and western economies should be replaced by the factoring in of a hard landing, which means recession. The narrative is similar whether it is the UK, US or euro area, although the US economy is in a stronger position helped by a relaxed fiscal policy. The UK currently looks likely to avoid recession next year, growing at a modest pace, as decelerating inflation boosts spending power and consumer confidence. But because monetary conditions are already so tight, a recession is possible.
Ideally, the Bank of England (BOE) should not tighten further but their poor reading of the economy means another rate hike is possible. And even when rates peak, they are planning increased quantitative tightening, which is a policy error. Despite the lagged impact of monetary policy, they are focused on current economic indicators. The more they hike, the more likely it is that growth will be weaker. And the more they hike the more likely it is that rates may have to be cut sooner, but even then, they will still settle at a higher level than previously.
The uncertainty about the profile of rates is also compounded by the lack of clarity about where rates may eventually settle. If for instance, UK growth settles at a future trend from 2025 onwards of 1.5% and inflation at 3% that means nominal GDP growth is 4.5%. In that environment, I think that policy rates should settle at 4.5%, in line with the growth of nominal GDP. But if the thinking of central banks is that policy should return to where it was before the pandemic then that means that r* (which is policy rates after allowing for inflation) is zero. When r* is zero policy rates are then in line with inflation so if inflation is 3% then policy rates would be 3%.
Markets would like to think an r* of zero is where we are returning to, led by the US. But just as markets in recent months have had to get used to the idea that policy rates may stay higher for longer, markets may need to factor in that rates will normalise at higher levels, too. This is critical in determining when it is appropriate to buy government bonds.
Three: what is safe?
What constitutes a risk-free asset? Government bonds? The yen? Perhaps not now. During the pandemic, two-fifths of government bonds globally yielded less than zero. Investors seemed more concerned about a return of their capital rather than a return on it. Governments lucky enough to be able to sell bonds at negative yields were being paid to borrow. Many others may not have enjoyed negative yields, but they were still able to borrow at close to zero. Government bonds were seen as safe. One might be tempted to say, as safe as houses, but property prices are falling now, too, in some countries including the UK.
Then there's the yen. Once the ultimate safe haven. Over the last week, it breached 150 versus the dollar, and then a sudden, temporary, small bounce suggested Bank of Japan (BOJ) intervention. Even if there was, it was more likely aimed at smoothing, rather than reversing the yen’s depreciation, although the markets believe it may signal the BOJ is keen to defend that level. If so, that is foolhardy.
History shows that when a currency is depreciating, defending specific levels do not work. It would not be a surprise if the yen becomes much weaker. Even with the BOJ in a staged exit from its cheap money policy and from yield curve control, and thus raising rates slightly, the yield differential versus the US is great and Japanese funds and investors continue to buy overseas assets outside of Japan.
Not too long ago, at times of uncertainty, the common refrain would have been that bonds and the yen would have been seen as safe havens. And one could have added in the Swiss franc and at times of real stress, gold, too. The Swiss franc retains its appeal. Of course, when it comes to discussing safe havens or risk-free assets there are other factors such as the depth and breadth of the market, so issues like liquidity and volatility and not only price moves matter. But even allowing for this, the recent sharp falls in government bond prices reflect the need for mindsets to change regarding viewing a particular asset as safe versus another. Macroeconomic and financial conditions matter.
We continue to be concerned about how this plays out. Recently, I noted that half of global financial assets of $486.6 trillion at the end of 2021 were accounted for by non-bank financial institutions (NBFIs) and the opaqueness around some of these NBFIs. These are collectively referred to as shadow banks, although they cover a vast array, including far from opaque pension funds and insurance companies.
Strictly speaking, the narrow definition of shadow banks covers assets of $68.7 trillion. And three-quarters of this group are (according to the Financial Stability Board), “collective investment vehicles with features that make them susceptible to runs” such as money market funds, fixed-income funds, mixed funds, credit hedge funds, real estate funds.
It would not be a surprise if government bonds play an important role in the underpinnings of these institutions and so the recent rise in bond yields may feed further market unrest. Thus, as we saw with the pension fund crisis a year ago in the UK, and the regional banking problems earlier this year in the US, further volatility is inevitable as a consequence of the normalisation of policy rates and the upward move in bond yields.
Please note, the value of your investments can go down as well as up.
