The importance of the Fed's change of heart in January
Last autumn we were confidently predicting that US 10-year yields would go above 3% and, for a short while, they did. Today they are at 2.5% and we are equally confident they are going lower. What has changed?
The short answer is the facts. The US Federal Reserve’s change of heart in January was in our view much more than a simple move from a tightening pathway to a more neutral position. We think it was an admission that QE is here to stay for the long-term and that interest rates are in today’s world not able to perform their traditional function as a policy tool. If so, that means investors have to think radically differently going forwards.
Perhaps, we should first ask why? Our friends at CrossBorder Capital think the catalyst is the frailty of corporate bond markets and particularly at the bottom end of the investment grade credits – BBB. Institutions and corporates have been looking for safer, and perhaps higher, returns for their cash than they can receive from banks. One response has been to invest in money market-like funds, which in turn lend to different corporates via repurchase agreements (“repos”) in order to minimise risk.
However, these repos depend on the availability of collateral in the form of ‘safe’ assets such as short-term government bonds. Quantitative tightening means the latter are in scarce supply, accentuated by demand from some central banks (eg. Bank of Japan) for their own QE programmes. CrossBorder’s data suggests that the average net supply of ‘safe’ assets’ over the last six years has been roughly one third of the 2010-2012 period and it is increasingly concentrated in the United States.
The implications are numerous. In the bigger picture, the Fed will use its balance sheet rather than interest rates to steer the economy. We call that QE4. While it may not inflate asset prices in the way that QE1, 2 and 3 did, it does provide the equivalent of a Greenspan ‘put’ for investors. The US bond curve is likely to fall, possibly in an extreme case to levels similar to Japan, though in practice we doubt that. In turn that may propel equity valuations higher as investors seek return.
Inflation is a tougher question. The history of QEs 1, 2 and 3 was that consumer inflation did not take off. Today the employment background is tighter and society is less cohesive. Governments may decide that inflation is the lesser of various evils and be prepared to accommodate some. Far be it from us to suggest that that would also help them inflate their indebtedness away.
If we are wrong, the brunt is likely to be borne by those lower down the debt hierarchy – BBB grade, non-investment grade debt and equity holders. It’s no secret that not all BBB rated credit is worthy of its rating but if collateral for repos becomes scarce or unavailable even companies with unimpaired credit could find themselves struggling to refinance their existing corporate debt. That could trigger a much sharper funding crisis as (shades of 2008 GFC) rating agencies find themselves re-evaluating their ratings.
We see the path of the next few months as critical. It all depends on whether the central banks are watching the right balls. If you’d like to discuss this in further depth, please give us a call on +44 20 3637 6341.