Updated: May 19, 2022
The 10 year US Treasury yield has fallen from 2.5% on 27 June to 2.1% currently (as at 25.08.2015), a very substantial change. Normally, changes in nominal yields are due to changes in the expected inflation rate over the life of a bond as well as changes in the real yield (in the corporate bond sector yields are also a function of credit spreads). However , it is interesting to note that the recent fall is due entirely to a fall in the expected rate of inflation. The 10 year breakeven inflation rate, as it is known, has fallen from 1.9% to 1.5% over the period in question, while the real yield has stayed around +0.5%.
My point is that I find it hard to understand how the Federal Reserve could now justify a rise in interest rates any time soon. As I wrote recently:
“I’m angry with Fed chair Janet Yellen and Bank of England Governor Mark Carney. Why did they have to be so eager to raise interest rates, talking them up in the way they did? Yellen’s trigger happiness has caused the Dollar to rise, oil prices to fall, China to devalue its currency, other emerging markets to devalue theirs, inflation pressures (to the extent there were any) to subside and, guess what, the case for raising rates to be booted into touch.
Actually, it’s worse than that. By calling for rates to be raised too soon, Yellen has lost a lot of credibility. Central banks have been virtually single-handedly propping up the global financial system, so their credibility is paramount. I remember five years ago wondering which would come first; a global economy returning to “normal” or loss of faith in central banks. The last few days and weeks have seen me shifting my views firmly in favour of the latter.
My main bone of contention is that the end of QE in both the UK and the US constituted an effective tightening of monetary policy. As I noted in my last investment letter, it is estimated that the tapering of asset purchases in the US was the equivalent of an interest rate rise of 4 percentage points. This is the same as the entire tightening cycle of 2003 to 2006, which saw the Fed Funds rate go from 1% to 5%, and which arguably triggered the financial crisis. Why oh why couldn’t Yellen or Carney communicate the message that having had a substantial effective tightening, they would leave interest rates where they were for at least 2 years in order to gauge its effects? It’s not as if we were coming out of a normal recession in which inflation pressures were going to rebound quickly. Far from it. Inflation still needs propping up not suppressing.
I’m not an economist – thankfully! – but it seems to me that the world is prone to deflation not inflation. We humans seem to be able to find cheaper ways each year of making something or providing a service. Furthermore, while credit creation is inflationary, the reverse is deflationary. Throw in other sources of deflation like the internet or China and you have a world in need of central bankers not competing to be the first out of the blocks.”
Published in Investment Letter, September 2015
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.