By sometimes overanalysing rates on our screens, we tend to forget to look a little further in front of us... Yes, we could rewind and say that rate steepening was obviously going to happen: a US economy that was bound to accelerate with the pace of vaccination, the USD 1.9 trillion fiscal stimulus plan, job creation accelerating, and all this in front of a Fed that struggles to convince markets of its ability and willingness to control the yield curve. But in reality, the truth is that most investors were positioned in the opposite direction until recently, hence the violent adjustment underway… Here is our understanding of the current situation in a few Q&A’s.
1. How should we understand this rise in rates?
There are five explanations for this sudden rise in US long rates:
- Inflation expectations - fuelled among other things by base effects - which have progressively recovered since summer 2020.
- The US fiscal stimulus plan, which should bolster the recovery this year and is already generating a debate on the risk of overheating among leading economists.
- The asset/liability management of banks that has led to hedging against a rise in rates, and a prudential issue in the United States (equity vs. total assets ratios) which could lead to the sale of US Treasuries.
- The uncertainty around the Fed. The nature of the debate has changed; the question is no longer knowing if the Fed is doing enough to support the economy, but whether it is willing and has the ability to control the rise in long term interest rates by adapting its asset purchase program (which is still not visible to date).
- Hence the last explanation: investors have hedged against this risk by selling the US curve, which has amplified the February steepening movement.
Certain aspects (such as technical effects on inflation and the tendency of markets to overreact) suggest that stabilisation can be achieved in the short term. However, other medium term factors (the impact of the US stimulus plan, the fall in unemployment and the reopening of the economy) can lead to renewed steepening after this stabilisation phase.
2. Is this rise in long-term rates a really problem? What are the implications?
The answer depends on whose perspective we take.
From the point of view of the real economy, this steepening of the yield curve is still relatively insignificant in terms of impact on the cycle. The immediate benefits of the recovery plan on domestic demand are much greater than the effects of tightening on investment caused by the rise in long-term rates in the medium term. However, if this boom in demand is limited to 2021, and anticipated demand stops growing and financing conditions become less attractive, the risk would be that the premature rise in long-term interest rates would break the recovery in investment. Nevertheless, we can consider that today we are far from this latter point with 10-year yields at 1.5% in the US and close to zero on average in Europe. In fine, everything is a question of real interest rates.
From a market point of view, the observed speed of the recovery is more problematic in the short-term, but this will of course depend on the allocation of one’s equity portfolio. If we were to maintain corporate earnings growth constant, the relationship between stock prices and interest rates is inversed. It is all the more so as the earnings generation is a long distance call. This explains why "growth" stocks (which have been the main driver of equity markets over the past 10 years) are vulnerable to the rise in long-term rates. As long as earnings growth is there, these values can hold their own, but the cumulative risk of a deceleration in the growth outlook and a rise in interest rates could be severely damaging. Conversely, this trend is very favourable to "value" shares (i.e. discounted values), which benefit from both a recovery of the real economy and a rise in interest rates and commodity prices (ex: banking and energy). The latter is therefore an important factor for redistribution, and a source of repositioning and volatility.
Finally from a public sector point of view, this is where things get more complicated in the medium term. If central banks were to exit zero/negative rates and stop increasing their balance sheets, the cost of public sector refinancing would go up.
Generally, the assumption that the recent sharp rise in public debt is sustainable is based on several hypotheses, mainly three:
- Debt held by central banks can de facto be considered monetised as central banks will not reduce their balance sheets;
- Rates will stay low for long due to low inflation;
- Investor demand for government debt will not stop.
The example of the last few weeks shows that we must be cautious about the last hypothesis. Surprisingly weak demand for government bond issuances and the factors mentioned above (bank asset / liability policies) are of significant importance.
Bottom line: the rise in long-term rates is relatively benign for the economy and governments for the time being, but is already worrying for markets and generating significant repositioning.
3. Could the problem be that central banks are pursuing too many goals and that equilibrium interest rates are not the same for all players?
Another way to summarise the problem: each of these spheres does not necessarily have the same equilibrium interest rate and it is this tension or divergence that drives the uncertainty on how central banks must manage the situation:
- For the economic cycle: it is traditionally believed that a negative real interest rate is required when GDP growth is below its potential (and vice versa). With GDP growth possibly exceeding 6 or 7% in the US this year and surpassing its growth threshold, a rise in real rates seems bearable and even justified;
- For equity investors: we must both think of the neutral nominal rate (which could be equal to the progression of the growth and value styles) and the threshold rate from which the market is adjusting as a whole (probably ~2%);
- For bond investors: when annual returns can be lost from only a rise of a couple basis points in long-term interest rates, the logic is to hedge, which in turn drives up long rates;
- For central banks, Keynes and Hicks summed up the problem a long time ago: you have to find the right nominal rate (which determines the demand for money) and the right real rate (which balances savings and investment). Too low of an interest rate leads to a liquidity trap, while too high interest rates will discourage investment. Central banks are therefore limited to a very narrow path;
- For governments: sustainability constraints and the stabilisation of the debt-to-GDP ratio implies that the interest rate on sovereign debt should be lower than nominal GDP growth in medium term (for example: if we take potential growth and core inflation in the medium term, we can say that the limit rate is rather between 3% and 4% in the US).
4. What to make of the risk in rising inflation in the short term?
We recently wrote that the structural fundamentals for a sustainable rise in inflation were not met as of yet, or at least that they were not yet visible. Nevertheless, it must be noted that the fear of rising inflation is a typical reaction during a phase of economic recovery and/or in the context of the implementation of a very accommodative policy-mix. Just think back to the (unjustified) fears on the inflationary effects of the Fed's policy after 2008.
This rationale still seems apparent in 2021, even if, in the medium to long term, the new balance in policy-mix that is being set up (and which we had already described in our Global Outlook in Q2 2020) could ultimately lead to a more sustained inflation regime.
In the short term: a temporary rise in inflation
- There will be many types of base effects on the H1-2021 inflation in mature economies: mainly due to the low oil prices in spring 2020, but also the end of certain VAT reductions (notably in Germany);
- If we look past these effects and remain focused on rising core inflation, it is clear that US inflation is not really accelerating for the moment (1.3% in February 2021, down 0.1 basis point vs. January);
- It is therefore more an issue of managing expectations of what may occur in the second half of the year and thereafter.
Structural inflationary pressures remain limited at this stage
- Beyond recent statistics reflecting temporary factors, wage inflation still seems measured: recent US employment surveys displayed monthly growth of 0.2%, i.e. an annualised increase of 2.5%. In February, core inflation remained very moderate in the US (1.3%);
- There is a strong desire to reduce inequalities and raise the minimum wage to the US, but this proposal did not appear in the final legislation of the fiscal stimulus plan;
- Regarding commodities, we know that the surge in metals is partly due to significant rebuilding of inventories and that the price of oil has been propped up by supply cuts that aim to stabilise prices around $ 60 a barrel in the medium term. The Energy Information Administration expects prices to stabilise between 2021 and 2022.
How could inflation reach and exceed 2% before 2023?
- First, through the US recovery plan which creates a real risk of overheating through a surge in private consumption in second half of the year bringing about pressures on the supply of manufacturing goods and commodities (the Energy Information Administration has raised its price forecasts per barrel in early March to USD 61 for 2021 for the Brent).
- At the same time, European countries will most likely have vaccinated a significant part of their population, translating into a reopening of services and transport (currently still confined). All in all, this could snowball into a stronger recovery.
5. Are we moving towards a structurally higher inflation regime in the long term?
In the medium to long-term, there is a real risk that the inflation rate will be persistently higher.
- The moderate inflation regime of the past decade was based on the following equilibrium: downward pressures on unskilled labour due to globalisation, global supply-chains and technology, cheap energy prices as well as tax and spending policy that were more favourable to capital. This phase is known as "great moderation" which led to very flat Philips curves (inflation / unemployment relationship) until the very end of the cycle (US wages do not really increase until 2017-2019);
- Several elements seem able to reverse this paradigm: a convergence in global living standards for the middle class, energy (and food) transition which will involve paying more for our energy (with or without a carbon tax), a gradual relocation of production capacities (also made possible by robotisation) and political willingness in the US to reduce inequalities (minimum wages);
- Finally, inflation has historically been the solution to get out of excessive debt and/or an unsustainable political and social value-added sharing equation;
- Economically, a change in the inflation regime is a manner to redistribute the cards: between corporates and employees, between savers and debtors, but also between sectors of activity and between countries.
6. What impact for our basket of currencies in the long term?
There is a link between an inflation regime and an exchange rate regime. The strength of the US dollar, the need for dollars and the attractiveness of the US rate curve made it neither necessary for the US Treasury to pay higher rates nor to resort to inflation to depreciate the debt burden in real terms or in debt-to-GDP terms. Finally, the strength of the dollar tends to reduce imported inflation.
If the dollar were to lose its reserve currency status and the US suddenly accept financing at a higher level, the exit through slightly higher inflation would be an option. This apparently attractive idea which seems to suggest a consensus for inflation is, however, dangerous in several ways: on the one hand, because the past shows that it is difficult to stabilise inflation beyond a moderate level ; on the other hand in a country with double structural deficits, inflation could increase the downward pressure on the greenback in the long term.
Historically, each change in economic regime has resulted in a new equilibrium for exchange rates. But let's not go too fast… Nothing points to the US dollar being dethroned very quickly and nothing says that a multipolar exchange rate regime would be a guarantee for stability. Finally, the rise of the yuan will not necessarily beneficial to Europe.
In the shorter term, the US dollar will be supported by the macro divergence of GDP growth rates and yields with the Euro Area, but the weakening of the dollar could resume as of this summer.
7. What implications for central bank policies?
In the short term, there is no fundamental reason to anticipate a hardening of Fed policies. Unemployment is still much higher than its pre-COVID level (over 6% with a historically low labour market participation rate), core inflation remains very moderate (beyond short-term effects) and the Fed considers that the uncertainties linked to the pandemic are still too important. Therefore, no change is anticipated before the start of 2023, even if the US stimulus plan could lead to a return to full employment and targeted inflation a year ahead of schedule.
In the medium term, a normalisation of conditions seems inevitable in the case of a return to full employment and inflation around (or above) 2%. But outside pressures created government financing needs (and energy transition) could lead to a different balance and to a reshuffling of priorities, which is already noticeable in the change in the Fed's inflation strategy. Closer coordination in policy-mix between monetary and budgetary components also suggests a higher tolerance for inflation (which can be either chosen or imposed).
In the Euro zone, the situation is very different even if the long-term interest rates partially carry the stigmas of US steepening. Inflation remains very low and cyclical recovery risks are still high, while the ECB has reinforced its capacity to step up asset purchases.
8. What are the short-term and long-term impacts for asset allocation?
Even if the uncertainties are great in this terra incognita of reflation, several investor strategies can emerge in the short-term and the long-term:
- During this equity rotation, it is favourable to remain positioned on Value with a good exposure to values correlated with the cycle, steepening and reflation, even if this rotation is not immune to sudden hiccups over the next few months;
- We believe that, unlike in previous cycles, government bonds are of limited help in a portfolio and a short duration policy remains of the essence;
- In geographic terms, this trend is favourable to European equities;
- If this trend were to lead to a stronger rise in the dollar, emerging assets would be vulnerable both in terms of bonds and in terms of their equity markets;
- It is favourable to maintain an exposure to the US dollar in this phase of macro divergence, which will be a source of resilience for portfolios in the event of stress in emerging countries;
- In terms of risk exposure, there are many supporting factors to make 2021 a positive year while remaining vigilant on the speed of the rise in the US 10-year rate.
In the medium term, at the strategic level, it will be necessary to keep a good balance between secular growth themes and cyclical / value assets. After all, the rise in rates will not stop digitisation, climate transition and investment needs in healthcare...
March 12, 2021