Updated: May 22, 2022
From Seneca Investment Managers' public marketing material. Seneca is now part of Momentum Global Investment Management.
The very rapid decline in safe haven bond yields in recent months has taken me somewhat by surprise. Although we at Seneca have been preparing for a downturn in 2020 for some time, I had been expecting economies and thus bond yields to remain firm for a little while longer, and therefore to be able to buy safe haven bonds on what I had hoped would be decent valuations ahead of the end of the cycle. As it is, the bond rally started in November when real yields globally were at -0.4%, which hardly represented good value; they are now at -1.0%.
"Will the cycle be extended or have we entered the end game?"
The decline in yields can be attributed to changing expectations for future monetary policy. Equity markets across the globe fell sharply in the fourth quarter, sending the clear message that monetary policy was too tight and thus threatening growth. In January, the Fed and other central banks began to reverse their collectively hawkish stance and have not looked back since. This has resulted not only in plummeting bond yields – an indicator of expectations of looser monetary policy ahead – but also rampant equity markets.
The question is, will a bit of loosening prolong the cycle further, or is economic growth now in an unstoppable downward spiral as usually happens when a cycle ends?
Equity markets certainly seem to believe that a dose of central bank tonic will do the trick. But then equities often respond well to prospects of looser monetary policy. It is only when it becomes clearer that the looser monetary policy is simply ‘pushing on a string’ that they wake up to the reality of an inevitable recession. So, which is it? Will the cycle be extended or have we entered the end game?
There are I think four factors that complicate investigation of this question more than might otherwise be the case.
First, we live in a world that is experiencing strong deflationary forces, so expecting policy rates during this cycle to peak where they did in previous cycles may be wrong. The term ‘secular stagnation’ has been making a comeback of late, and so-called ‘stagnationists’, to support their thesis, point to the natural rate of interest – the rate that supports the economy at full employment and maximum output while keeping inflation constant – having fallen over the last ten years as well as the last four decades.
Second, quantitative easing has clouded measurement of the extent to which monetary policy was loosened during the years following the Great Financial Crisis, and therefore the extent to which it has since been tightened. Leo Krippner at the Reserve Bank of New Zealand has sought to address this problem by using some clever maths to represent a certain amount of quantitative easing at a particular time in terms of an effective policy rate – the greater the amount of quantitative easing, the more negative the effective rate (see charts).
Third, major developed economies are out of sync with respect to their economic cycles, evident from differences in prevailing monetary policy. The US is most advanced and has been able to increase its policy rate nine times this cycle. The UK is second, but a distant second, having increased rates only twice. As for the Euro Area and Japan, they are fighting over last place, with neither having been able to push through a rate hike this cycle.
Fourth, China is no longer supporting global growth in the way it has been doing for most of the last three or so decades. It is only to be expected that growth slows as an economy matures, but China may be particularly vulnerable given that it has grown so quickly and that its growth has been both credit driven and somewhat one dimensional, based as it has been around fixed capital investment.
On balance, I think these four factors have the scope to cause global growth to be weaker than expected, not stronger. The problem for central banks, however, is that core inflation across the developed world is not showing the signs of softness that would warrant some loosening of monetary policy. If anything, accelerating wages and rising trade tariffs argue for the opposite.
Published in Investment Letter, July 2019
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.