Tag Archives: Rates

The normal interest rate

22 Sunday Jan 2023

Posted by in Debt, Monetary Policy

≈ 1 Comment

Tags

,

What determines interest rates and how lower private sector profitability, changes in the institutional infrastructure governing our economies, major geopolitical conflicts, and climate change, could usher in a ‘sea change’ of higher interest rates[i].

The simplest possible explanation of what drives interest rates is the demand and supply of capital and its mirror image debt. I find this to be also the most relevant one.

There are many other variables that matter, which fall under the broad umbrella of economic activity. These factors determine the ability to pay/probability of default and may impose a certain ‘hurdle rate’ (inflation), but it is important to understand that they are a consideration of mostly the supply side of capital.

So, what is a ‘normal’ interest rate? Obviously, when capital is ‘scarce’ (relative to the demand for debt), as indeed for the majority of time of human existence and ‘capital markets’, creditors are ‘in charge’, nominal interest are high and real interest rates are positive. So, that is the norm. But in times of peace and prosperity, as during the time of Pax Britannica (most of the 19th century), and Pax Americana (since the 1980s, and particularly since the end of the Cold war) surplus capital accumulates which gradually pushes interest rates lower as the debtors are ‘in charge’. The norm then could be zero and even negative nominal interest rates.

While indeed the norm is for interest rates to be positive, there is no denying that if one were to fit a trend line of global interest rates in the last 5,000 years[ii], the line would be downward sloping. That should be highly intuitive as human society evolution brings longer lasting periods of peace and prosperity (the spikes higher in interest rates throughout the ages are characterised with times of calamities, like wars or natural disasters, which destroy capital).

What is the function which determines that outcome? The surplus capital inevitably creates a huge amount of debt. This stock of debt eventually rises to a point which makes the addition of more debt an ‘impossibility’. It is important to understand that this happens on the demand side, not on the supply side – it is current debt holders who find it prohibitive to add to their current stock of debt, in some cases, at any positive interest rates.

Richard Koo called this phenomenon a balance sheet recession when he analysed the behaviour of the private corporate sector in Japan after the 1990s collapse. We further saw this after the mortgage crisis in the US in 2008 when US households started deleveraging. Not surprisingly interest rates during that time gravitated towards 0%.

The importance of 0% and particularly negative interest rates is not only that this is where the demand of debt and supply of capital clears, but, more importantly from a ‘fundamental’ point of view, this is the point where the current stock of debt either stops growing (0%) or even starts to decrease (negative interest rates). Positive interest rates, ceteris paribus, on the other hand, have an almost in-built automated function which increases the stock of debt (in the case of refinancing, which happens all the time – rarely is debt repaid).

Because our monetary system is credit based, i.e., money creation is a function of debt origination and intermediation, this balance sheet recession, when the demand for credit from the private sector is low or non-existent, naturally pushes down economic activity, which, ceteris paribus, results in a low, and sometimes negative, rate of inflation.

So, you see, it is low interest rates which, in this case, determine the inflation rate. This comes against all mainstream economic thinking. I am sure, a lot of people, would find this crazy, moreover, because this is also what Turkish President Erdogan has claimed, and it is plain to see that he is ‘wrong’.

However, there is a reason ‘wrong’ above is in quotation marks. You see, this theory of low interest rates determining the rate of inflation, and not the other way around, holds under two very important conditions. First, and I already mentioned this, the monetary mechanism must be credit-based. This ensures that money creation is not interfered by an arbitrary centrally governed institution, like … the government, and is market-based, i.e., there is no excess money creation over and above economic activity.

In light of a long history of money waste, this sounds like a very reasonable set-up, except in the extreme cases when the stock of debt eventually piles up, pushing down the demand for more credit, slowing down money creation and thus economic activity. In times like these, it is the rate of money creation which determines and guides economic activity rather than the other way around (as it should be). Unless there is an artificial mechanism of debt reduction, like a debt jubilee, the market finds its own solution of zero or negative interest rates to resolve the issue.

And the second condition for the above theory to hold is the supply side of the economy must be stable. Don’t forget that inflation is also independently determined by what happens on the supply side: a sudden negative supply shock would push inflation higher. That the balance sheet recessions in Japan, and later on in the rest of the developed world, coincided with a positive supply shock accentuated its disinflationary impact.

To go back to Turkey, Erdogan’s monetary experiment is not working because 1) Turkey’s economy is not in a balance sheet recession (private sector debt is not big, and there is plenty of demand for credit), and 2) Turkey’s economy was hit by a large negative supply shock in the aftermath of the breakdown of global supply chains on the back of Covid/China tariffs, and, more particularly for Turkey being a large energy importer, in the aftermath of the Russian sanctions on global oil prices. A related third reason why low interest rates in Turkey have failed to push inflation lower is the fact that institutional trust is low. In other words, the low interest rates are not market-based, but government-based (market-based interest rates are in fact much higher).

What has happened in the developed world, on the other hand, is, since Covid not only the economies have experienced a massive negative supply shock, but also monetary creation, for a while (well, most of 2020-21) became central-government-based (in the form of huge household transfers). In other words, even though private debt levels remain excessive, their negative effect on economic activity has been offset by other forms of money creation. This not only managed to reverse the disinflationary trend from before, but, when combined with the negative supply shock, it provoked a powerful inflationary trend.

Going forward, unless there is a repeat of the central-government-based money creation experiment under Covid, the demand for credit, and thus the growth of money creation, will remain low, as private sector debt levels remain too high. This does not bide well for economic growth and is disinflationary by default. At the same time, however, the effects of the negative supply shock are likely to be longer lasting given that the reorganization of the global supply chains is still an ongoing process. This is inflationary by default – if that means also lower private sector profits, thus lower capital surpluses, then interest rates should continue to be elevated.

When it comes to the developed world the black swan here is an eventual outright debt reduction (debt jubilee) – the will have a corresponding effect of an artificial capital surplus reduction as well. Maybe this is counterintuitive, but if you have followed my reasoning up to here, that would mean higher interest rates going forward.

An alternative black swan is a direct capital surplus reduction, caused by either lower corporate profitability, lower asset prices, or indeed an artificial or natural calamity, like war or a natural disaster, which have the unfortunate ability to destroy capital. In that sense, it is uncanny that our present circumstances are characterised by a war in Europe, a potential war in Asia and the looming threat of climate change[iii].

Howard Marks certainly did not mean literal ‘sea change’ in his latest missive, but this might ironically be one of the main determinants of higher interest rates in the future.

For more on this topic you might also find these posts interesting:

It would take a ‘revolution’ to wipe out negative rates

Negative interest rates may not be a temporary measure

Inflation in the 21st century is a supply-side phenomenon

‘State’ money creation – this ghost from the past is badly needed for the future

[i] This post was inspired by Howard Mark’s latest, Sea Change, and, more particularly, by his interview on the subject.

[ii] https://www.businessinsider.com/interest-rates-5000-year-history-2017-9?r=US&IR=T

[iii] We live by the sea, literally. When we bought the house in 2007, the sea was about 100 meters from the fence of our garden, in normal times. This has now been reduced at least by half. In the last three years, the sea has often come into our garden, which has prompted us to spend money on reinforcing the fence etc., which has naturally reduced our capital surplus.

Don’t fight Powell

15 Thursday Dec 2022

Posted by in Monetary Policy

≈ Leave a comment

Tags

,

After reading John Authers’ piece this morning, I was not really planning to write a note on yesterday’s FOMC meeting. I think he summed up the Fed’s actions very well and correctly analysed the market’s reactions. And I would say that indeed the mantra “Don’t fight the Fed” should be valid in general. But that holds true only if we understand what the Fed is trying to achieve. Here is a more nuanced view on the matter.

If the Fed had only raised the dot plot in the face of slowing down inflation since the last SEP (and obviously reiterated that there would be no cuts next year, etc.), I would have concluded that the Fed intends to keep hiking, regardless, bound not to repeat the ‘mistakes’ of the late 1970s. Don’t fight the Fed in this case would have been the right strategy.

However, raising the dot plot in the face of slowing inflation but also alluding to a smaller hike than priced in the next FOMC meeting (see Authers’ note above) introduces a decent amount of confusion as to exactly what the Fed’s intentions are. It could be that most Fed members had made up their mind about the dot plot before the surprise slowdown in inflation this week and didn’t bother/didn’t have the time to adjust their view thereafter. The intention for a smaller hike next allows Fed officials to change their mind. So, in this case the market’s reaction (nothing really changed post the meeting[i]) might be justified.

It could also be that Fed officials took the lower-than-expected CPI in stride and concluded that it alone does not warrant a change in view. That also signifies that during the previous SEP, the Fed made a mistake in its projections of the terminal Fed rate (it should have been ‘much’ higher). Does that mean “Don’t fight the Fed” holds in this instance? It appears so, but then again, if the Fed made a mistake in the past and was quick to acknowledge it, then it is also possible that the Fed is again making a mistake. The market’s reaction is thus dubious, neither ‘wrong’, nor ‘right’.

The final possibility is that the Fed has literally and figuratively lost the plot (pun intended) and is planning to stay hawkish (not necessarily continue to hike, but certainly not cut) until the inflation rate crosses back below 2%, regardless of what happens to the economy. It must be clear that in this case “Don’t fight the Fed” firmly holds.

I have no idea what most of the other FOMC members’ intentions are but listening to Fed Chairman Powell’s press conference, I am pretty sure what his are: I think he is firmly in the last camp above. Here is why.

In his opening statement, Powell made several references to the fact that the “labor market remains extremely tight with the unemployment rate near a 50-year low, job vacancies still very high, and wage growth elevated”. In the Q&A session, similar, “I’ve made it clear that right now, the labor market is very, very strong. You’re near a 50 year low: you’re at or above maximum unemployment in 50 years.” I’ve written on this before, i.e., why not only I disagree that the labour market is so tight but that it is actually slowing down.

However here is some additional color, which shows that it is not that straightforward, and we have to give at least some credit to Chairman Powell. So, when it comes to the US labor market statistics the table below provides the basics. Bear these in mind as we go along.

Strictly speaking, Chairman Powell is right that “the labor market continues to be out of balance, with demand substantially exceeding the supply of available workers” (in his opening statement; he goes in more detail on this in the Q&A session particularly in a question from Market Watch). Look at the ratio of Working Population to Civilian Population which is at nearly 50yr low

And within the Working Population the actual Labor Force Size only managed to get just above its pre-Covid level this August and has started to decline again since then, so that the ratio between the two is still below the pre-Covid level (and as a matter of fact still below the high reached at the onset of the 2000 recession).

And here is the now more familiar labor force participation rate (LFPR), still way below the pre-Covid high and substantially below the pre-2000 recession high.

So, when Powell refers to the “labor market is 3.5m people smaller than it should have been based on pre-pandemic levels” this is what he has in mind: strictly speaking, if we adjust the LFPR to its pre-Covid high, the labor force would have been about 3.021m people more. But that is on the supply side, and we are going to go through this more later on.

But let’s look at the demand side as well. As per Powell, again in the answer to the journalist from Market Watch, “you can look at vacancies”. Here they are.

Powell is right to an extent: there are still more that 10m job openings. This is down from nearly 12m from the highs in March, and job openings are never zero, but even the current number puts job openings at about 5.8m additional vacancies over the pre-Covid average.

So, the question really is to square the demand and the supply side of labor. Obviously, it is not that straightforward. It is normal to have people unemployed at the same time as vacancies unfilled, but the state of the labor market post Covid is more unusual, also because the unfilled vacancies are not pushing real wages up. Which is why some people have suggested that rather than a wage issue it is really a skill mismatch issue (plenty of studies done on this post the 2008 recession), or indeed Covid-related issue (even Powell referred to this as a cause in his Q&A).

Chairman Powell lamented yesterday that the LFPR is not going up, “contrary to what we thought”. But if it does go up, does it mean the headline statistics will indicate the labor market is tightening or loosening? I ran some hypothetical numbers regarding this below.

The second column in the table above indicates a hypothetical LFPR per the time period in column one. The third column is the actual labor force as a result (in thousands). The fourth column indicates the additional people coming into the labor market. The fifth column indicates the number of unemployed if all these additional people entered the labor force; the sixth column is the resulting unemployment rate. The seventh column shows the number of unemployed if 50% of the additional labor force actually found jobs; the eight column is the resulting unemployment rate. Finally, the ninth column shows the number of unemployed if all the additional labor force fills the job openings (see Chart above) over and above the average pre-Covid; the tenth column shows the resulting unemployment rate.

There are myriad such scenarios. In the example above, using averages and simple assumptions about additional employment vs unemployment, the unemployment rate is higher than the current one in all but the last three examples (column 10 – the last three entries). Bottom line is that the drop in the labor force participation rate makes relative comparisons about how tight the labor market is (i.e., looking only at the unemployment rate) pretty irrelevant.

It also makes all of the above analysis almost useless (or at best very theoretical) as far as investing is concerned. It really does not matter at the end what the ‘real’ employment situation is. Powell was very clear yesterday. “The largest amount of pain” would not come from people losing their jobs. “The worst pain would come from a failure to raise rates high enough and from us allowing inflation to become entrenched in the economy; the ultimate cost of getting it out of the economy would be very high in terms of  unemployment, meaning very high unemployment for extended periods of time.”

That’s it. Inflation is all that matters. And if there was any hint at all that the Fed might increase its 2% inflation target, Powell was very adamant that it is not happening: “…changing our inflation goal is just something we’re not, we’re not thinking about. It’s not something we’re not going to think about it. We have a 2% inflation goal and we’ll use our tools to get inflation back to 2%. I think this isn’t the time to be thinking about that. I mean there may be a longer run project at some point. But that is not where we are at all at  the committee, we’re not considering that. We’re not going to consider that under any circumstances we’re gonna we’re gonna keep our inflation target at 2%.”

This turned out to be a long note just to conclude that indeed, it is pointless to fight the Fed, assuming that Powell’s view is shared by the majority of Fed voters, or if not, that the majority would still fall under the guidance of the Chairman. However, leaving the possibility of only 25bps hike at the next FOMC meeting is perhaps a sign that there may be some disagreement at the Fed.

[i] During New York hours; the market has subsequently weakened during the European morning session.

The US labour market is slowing down

06 Tuesday Dec 2022

Posted by in Monetary Policy, Questions

≈ 1 Comment

Tags

, , ,

  • Is US employment data hot, ‘goldilocks’, or ‘cold’?
  • Have you been inundated by calls and messages with the question, “But have you seen the details of the Household Survey?”
  • Is the Fed right to keep aggressively hiking?

Summary: The US labour market is slowing down despite headline grabbing low unemployment rate and high wage growth rate. The recent details underlying this data show the total number of people employed growing below trend, fewer hours worked and lower quits rate. As a result, the growth rate of total earnings is also going down, the effect being a lower share of national income going to labour and total consumption as a share of GDP stagnating. All this should make the Fed further re-evaluate its aggressively hawkish interest rate policy.

The Household Employment Survey makes the headlines

After a couple of weeks of ‘SBF’ trending, I, for one, was happy to take my mind off to something much more prescient and important as far as my investments are concerned – the US employment situation. At first glance, the November NFP report came much hotter than expected but because the market did not really react the way one would have expected from such a strong report, we started looking for reasons why that was the case.

Which bought us to the US Household Employment Survey. ‘Us’ here does not mean us literally (for those of you who had followed my writings at 1859, there was plenty of discussion on this topic as soon as I spotted the divergence between the two employment reports in September). And this note is not on why the Household Survey is showing different things from the Establishment Survey.

If you want to, you can read zerohedge on this topic here (I know, think what you want but the folks there were one of the first to spot the issue way back in the summer). If you can’t bear some of the conspiracy language at zerohedge, you can read an inferior version (but still good!) of the same at the more balanced Macro Compass. Finally, there are quite a few respected people on Twitter who have talked about it (see here, here, here).

To give you the full  disclosure, there are some legitimate reasons why the Household Survey produces different results to the Establishment Survey – and they have to do with a methodology issue, see here. BLS is actually well aware of that issue and calculates a time series which reconciles the two surveys and which can be found here (also with a very, very extensive comparison analysis between the methodology of the two). This adjusted data does not look that bad as the stand-alone Household Survey data (the November data was actually very good). But over the last 6 months it still points to a weakening employment market, not a stable or even hot one as per the Establishment Survey.

OK, that’s more than I wanted to write regarding the Household Survey. The rest of the note will show why the US employment situation is actually weakening even taking the Establishment Survey as a base.

The three variables of employment

There are three aspects of employment in general as far as assuaging how hot the economy is doing: wages, people employed, and hours worked, i.e., we need to follow this sequence, purchasing power->consumption->GDP) Basically, one needs to know the full product of Wages X Total Employment X Hours Worked (assuming, of course, that wages are per hour worked; not all jobs pay per hour, but those that do have actually increased at the expense of the others – see some of the links above which discuss the prevalence of part-time jobs and multiple job holders).

The economy can be hot even when wages are flat, or even declining, but there are more people entering the workforce or there are more hours worked – there are multiple combinations among the three variables producing various results. The point is to consider all three variables.

Total number of employed is growing below trend

Let’s take the period in the last three years or so after the Covid crisis. Yes, wage growth has picked up, but more people have exited the labour force and there are fewer hours work.  

The labour force participation rate is still below the pre-Covid levels, and close to a 50-year low:

The total number of people employed has risen but, depending on whether one uses the Establishment Survey or the Household Survey, the number is either just above the pre-Covid levels or indeed below. In any case, regardless of which survey one uses, the number is still below trend (and has not been above trend since the 2008 financial crisis).

Higher wages but lower hours worked

Finally, here are wages and hours worked. I have included below a time series chart for only the last 3 years to be able to see better the divergence between the two: while wages continue to rise, hours worked peaked in January 2021 and have now reversed the spike in 2020.

Let’s focus more on the latest NFP report. Here are the relevant tables below.

  • Generally higher-wage industries, like goods producing, tend to exhibit a smaller increase in hourly wages than lower-wage ones, like services.
  • In some cases, like the Utilities sector, which has the second highest wage per hour but also the highest average weekly earnings (courtesy of more hours worked, more on this later), wages have actually declined.
  • Transportation and warehousing sector has an unusual jump in wages, about 5x the average rise in wages – is there something specific going on there?

The growth rate of total earnings is declining

It is important to look at the last columns in Table B-3 above, ‘Average weekly earnings’, which gives a much better picture of take-home pay as it combines wages with hours worked. So, while indeed the trend of declining 12m-growth rate of weekly wages was reversed with this latest report (back above 5%), which some commentators have warned the Fed should be worried about, the trend of declining total weekly earnings continues to be intact.

Note, average hourly earnings are still elevated, hovering at previous peaks but this is hardly a reason for the Fed to get more worried about, especially after already delivering the fastest interest rate hiking cycle in recent memory.

In fact, quite on the contrary. Despite all the excitement about the rise in wages, the share of national income going to workers has been on a decline, with the post-Covid spike now quickly reversed. We are back to the familiar territory of the low range post the 2008 financial crisis which is also the lows since the mid-1960s. If you were worried about a wage-price spiral issue, ala the late-1970s (I actually do not think there was one even back then as real wage growth even then was negative), you really shouldn’t be. It is a very different dynamic, at least for the moment.

Consumer demand as a share of GDP has been stagnant for more than a decade

And if you are really worried that consumer demand will push inflation higher, again, you shouldn’t be, necessarily: consumption as a share of GDP is elevated relative to historical records but it is not even above the highs reached more than a decade ago. In fact, it seems that consumption has not been an issue for inflation for at least the last two decades.

The quits rate is declining

One final observation, there is another labour data series which has been often cited as an example of a tight labour market: the quits rate.  I would though argue two things: 1) labour tightness explains only part of the elevated quits rate, and 2) the quits rate has already started declining.

A higher quits rate is quite consistent with an increasing share of lower paid jobs and with multiple job holders both of which have been trends seen post the 2008 financial crisis, and especially during and after the Covid crisis. It is possible to decompose the quits rates by industry and sector. For example, retail trade, accommodation, and food services, all of which are lower paid/temp jobs by multiple job holders, have much higher quits rates than the average across all industries. This is corroborated by a Pew Research report according to which most workers who quit their jobs cited low pay.

Finally, the quits rate actually peaked at the end of last year (notice the Household/ Establishment Employment Survey discrepancy started shortly after) at about 3%. This is the highest in the series, but the data officially goes back to only 2000. BLS has actually related quits rate data (but only for the manufacturing sector) prior to 2000 which shows that the quits rate has been above 3% in the past, and yes at above 3%, the quits rate is associated with the peak in economic expansion. You can see the full data set and BLS perspective on it here.

Bottom line: you do not need to believe in conspiracy theories about Household Survey vs Establishment Survey labour data inconsistency to conclude that the US labour market is far from tight. If anything, it has already started to slow down. Do not be confused by headline numbers of high wage growth rate and low unemployment rate, look at the overall employment picture taking into account trends in overall total compensation.  

Fed Funds peaks and UST yield curve inversions

02 Friday Dec 2022

Posted by in Debt, Monetary Policy

≈ Leave a comment

Tags

,

  • Either the peak in the Fed Funds rate is much higher, or the UST yield curve, 2×10, is too inverted. Whatever the case is, it’s extremely unlikely that the Fed eventually ends up cutting just the 150bps priced in at the moment.
  • Or to be more precise, unless there is a modern debt jubilee (a central bank/Treasury debt moratorium) or a drastic capital destruction caused by a total collapse in the global supply chains, continuation of war in Europe/Asia or a natural disaster (climate change, etc.), the Fed is more likely to pause the hikes next year, wait, and eventually cut by more than the 150bps priced in the market but less than in the past.
  • In other words, the shape of the current Eurodollar curve is totally ‘wrong’, just like it had been wrong in the previous three interest rate cycles but for different reasons.    

The current UST 2×10 curve inversion is pretty extreme for the absolute level of the Fed Funds rate. At -70bps, it is the largest inversion since October 1981 but back then the Fed Funds rate was around 15%. The maximum inversion of the UST 2×10 curve was -200bps in March 1980 when the Fed Funds rate was around 17%. The Fed Funds rate reached an absolute high of almost 20% in early 1981.

Back then the Fed was targeting the money supply, not interest rates, so you can see the curve was all over the place and thus comparisons are not exactly applicable. But still there were plenty of instances thereafter when the Fed moved to targeting the Fed Funds, and the Fed Funds rate was much higher than now, but the curve was much less inverted before the cycle turned.

Take 1989 when the 2×10 UST curve was around -45bps but the Fed Funds rate at the peak was around 10% (almost double the projected peak for the current cycle). The Fed ended up cutting rates to almost 3% in the following 3 years. Or take the peak in Fed Funds rate in 2000 at 6.5% and a UST 2×10 yield curve inversion of also around 45bps. The Fed proceeded to cut rates to 1% in the following 4 years.

Finally, take the peak in Fed Funds rate at 5.25% in 2006-7 and a UST 2×10 yield curve inversion of around -15bps. The Fed ended cutting rates to pretty much 0% in the following 2 years. In the 2016-18 rate hiking cycle, when the Fed Funds rate peaked at 2.5%, the UST 2×10 yield curve never inverted.

So, today we have a peak in the Fed Funds rate of around 5%, so comparable to the 2007 and 2000 cycles, but a much deeper curve inversion, more comparable to the 1980s. If we go by the 2000 and 2007 scenarios, the Fed cut rates by around 500bps; in the 1980s the Fed cut much more, obviously, from a higher base. In this cycle, if the peak is indeed around 5%, 500bps is the maximum anyway the Fed can cut. That is also the minimum which is “priced in” by the current curve inversion. But the actual market currently and literally prices only 150bps of cuts.

Again, neither of the past interest rate cycles are exactly the same as the current, so straight comparisons are misleading, but somehow, it seems that the peak Fed Funds rate today plus the current pricing of cuts in the forward curve do not quite match the current UST 2×10 curve inversion – either the peak is too low, or the curve is too inverted.

What I think is more likely to happen is the Fed hikes to more or less the peak which is priced in currently around 5% but it does not end up cutting rates immediately. The market is currently pricing peak in May-June next year and cuts to start pretty much immediately after; by the end of 2023 there are 50bps of cuts priced in.

In the last three rate cycles (2000, 2008, 2019) there was quite a bit of time after rates peaked and before the Fed started cutting. The longest was in 2007 – 13 months, then in 2019 it was 8 months and in 2000 it was 6 months. Before 2000 the Fed started cutting rates pretty much immediately after the end of each rate hiking cycle, so very different dynamics.

Here are how the Eurodollar curves looked about six months before the peak in rates in each of these cycles. The curve today somewhat resembles the curve in 2006, in a sense that the market correctly priced the peak in rates in 2007 followed by a cut and then a resumption of hikes. But unlike today, the market priced pretty much only one cut and then a resumption of hikes thereafter.  In the interest rate cycles in either 2000 or 2018 the market continued to price hikes, no cuts at all, and a peak in the Fed Funds rate not determined.

Source: Bloomberg Finance, L.P.

And here are how the curves looked after the first cut in each of these cycles (the colours do not correspond – please refer to the legend in the top left corner, but the sequence is the same – sorry about that). The market didn’t expect at all the size of cuts that happened in either of these cycles. Notice that the curve in the current cycle still does not look at all like any of the curves in the previous cycles (noted that in six months’ time, the current Eurodollar curve is also likely to look different from now, but nevertheless, there are much more cuts priced now than in any of the other three cycles).

Source: Bloomberg Finance, L.P.

The point is that the market has been pretty lousy in the past in predicting the trajectory of the Fed Funds rate.

  1. It is strange that the market never priced the pause in any of the actual past three interest rate cycles, and it is even stranger that it is not pricing it now either, given that there has been consistently a pause in the past.
  2. In none of the past three cycles did the market price any substantial cuts; in fact, we had to wait for the first actual cut for any subsequent cuts to be priced – that is also weird given that the Fed ended up cutting a lot.
  3. This time around, the market is pricing more cuts and well in advance but not even as close to that many as in the previous cycles.

However, I do not think we go back to the zero low bound as in the past three cycles. To summarize, the current UST 2×10 yield curve is too much inverted and the Fed would eventually cut rates more than what is currently priced in, but much less than in other interest rate cycles and after taking a more prolonged pause.   

USTs are expensive to foreigners

23 Wednesday Nov 2022

Posted by in Debt

≈ Leave a comment

Tags

,

Foreigners have bought record amount of USTs this year: if we look at the nine-month cumulative flow in USTs (YTD as per TIC data), it is at a record high, marginally beating 2009. This is actually in stark contrast to what they have done with US equities: the nine-month cumulative flow in stocks is at a record low, easily beating the previous low in 2018.

While it is more difficult to compare stocks across countries, as there are a lot more idiosyncratic factors at play, with bonds it is a little bit more straightforward, once we take hedging costs into consideration. And by that measure, USTs are the most expensive they have been at least in the last 10 years.


Here at the USD hedging costs for foreign based investors based in these jurisdictions (the calculation is done using 3m FX forward points and – so, an investor buys USD and immediately sells it 3m forward – converted into a ‘yield’/carry, annualized). I have chosen here the largest foreign buyers of USTs: Japan, China, the United Kingdom, and Europe (I have excluded the Cayman Islands which is another large buyer of US assets because even though classified as a foreigner in the TIC data, the hedge funds there are almost all USD-based).

Hedging costs in Japan and China are the highest in the last 10 years; hedging costs for EUR-based investors are close to the highs; hedging costs for GBP-based investors are substantially off their highs. This is what a foreign investor is getting in yield if he or she invests in UST 10yr.

This is in nominal terms – do not be confused by the fact that a JPY-based investor will receive a negative 1.2% yield if he or she invests in UST10yr hedged into JPY for one year. A European would do slightly better, and a Brit would do even better than a European; in fact, until recently a Brit buying USTs hedged in GBP could have picked the highest yield in the last 10 years!


But USTs are really not that attractive anymore to a CNH-based investor – even though he or she still picks up a decent 1% hedged, which is more than a European would gain, this is the second lowest yield in the last 10 years. In fact, this is the same for a Japanese investor – the only other time UST10yr fully hedged yield has been lower was during the height of the Covid crisis in 2020.


Foreigners are much better off buying their own government bonds than UST10yr, if they do indeed hedge the currency risk. In almost all these four cases (GBP is the exception but only recently) foreign bonds offer a record pick up to fully hedged USTs.

So, how do we reconcile the record buying of USTs YTD by foreigners with these findings? First, the hedge funds in the Cayman Islands have been large buyers of USTs but, as mentioned above, they are USD-based. Once we exclude them (and they have bought 40% of the USTs from ‘abroad’ YTD), foreign buying of USTs is not that high. UK-based accounts have actually been the largest buyers of USTs from abroad (pretty much bought the other 60% of the USTs). I think some of those accounts in the UK are actually USD-based. There is also the peculiarity of the UK Gilts market this year – about 40% of the total YTD buying of USTs by UK-based accounts happened in the two months before the LDI crisis.


As to the two behemoths in the UST market, Japan, and China, yes, they have been net sellers of USTs this year, in line with what the relative valuation above would have predicted. Where does that leave USTs? Looking at the sectoral balances in the US, the private sector still has a sizable $1.4Tn of surplus (as of Q2 this year), and as we have seen above, USD-based investors have not been shy to pick up these relatively high yields in the UST market.

Record liquidity leads to record net issuance of financial assets

06 Monday Jul 2020

Posted by in Asset Allocation, Debt, Equity, Monetary Policy

≈ Leave a comment

Tags

, ,

At $3.2Tn, US Treasury (UST) net issuance YTD (end of June) is running at more than 3x the whole of 2019 and is more than 2x the largest annual UST issuance ever (2010). At $1.4Tn, US corporate bond issuance YTD is double the equivalent last year, and at this pace would easily surpass the largest annual issuance in 2017. According to Renaissance Capital, US IPO proceeds YTD are running at about 25% below last year’s equivalent. But taking into consideration share buybacks, which despite a decent Q1, are expected to fall by 90% going forward, according to Bank of America, net IPOs are still going to be negative this year but much less than in previous years.

Net issuance of financial assets this year is thus likely to reach record levels but so is net liquidity creation by the Fed. The two go together, hand by hand, it is almost as if, one is not possible without the other. In addition, the above trend of positive Fixed Income (FI) issuance (both rates and credit) and negative equity issuance has been a feature since the early 1980s.

For example, cumulative US equity issuance since 1946 is a ($0.5)Tn. Compare this to total liquidity added as well as issuance in USTs and corporate bonds.*

The equity issuance above includes also financial and foreign ADRs. If you strip these two out, the cumulative non-financial US equity issuance is a staggering ($7.4)Tn!

And all of this happened after 1982. Can you guess why? SEC Rule 10b-18 providing ‘safe harbor’ for share buybacks. No net buybacks before that rule, lots of buybacks after-> share count massively down. Cumulative non-financial US equity issuance peaked in 1983 and collapsed after. Here is chart for 1946-1983.

Equity issuance still lower than debt issuance but nothing like what happened after SEC Rule10B-18, 1984-2019.

Buybacks have had an enormous effect on US equity prices on an index basis. It’s not as if all other factors (fundamentals et all) don’t matter, but when the supply of a financial asset massively decreases while the demand (overall liquidity – first chart) massively increases, the price of an asset will go up regardless of what anyone thinks ‘fundamentals’ might be. People will create a narrative to justify that price increase ex post. The only objective data is demand/supply balance.

*Liquidity is measured as Shadow Banking + Traditional Banking Deposits. Issuance does not include other debt instruments (loans, mortgages) + miscellaneous financial assets. Source: Z1 Flow of Funds

We can’t ignore SOFR (continued)

23 Friday Mar 2018

Posted by in Monetary Policy

≈ Leave a comment

Tags

  • People have been proposing a variety of reasons for the LIBOR-OIS spread continued widening. And majority of them make sense. My view is that we cannot discard the fact that the gradual replacement of Libor with the Secured Overnight Financing Rate (SOFR) is also playing a major role.
  • Unless you are actually directly involved in the Libor market, and there are only a ‘handful’ people left in it now, the larger investment community is not paying enough attention to these changes.
  • At the moment there are four eligible benchmark interest rates which can be used for hedge accounting purposes, as per FASB: UST, LIBOR, OIS (based on FFER), SIFMA Municipal Swap Rate. The Fed has requested that the OIS based on SFOR to be added to the list.
  • This is a big deal. There are $350Tn of worth of loan/bonds, etc. tied to Libor. And by 2021 Libor will be gone. From April 3, 2018, the Fed will start publishing Libor’s replacement, SOFR. Anyone involved in the Fixed Income markets better start to get ready.

Of course, LIBOR may remain viable well past 2021, but we do not think that market participants can safely assume that it will.  Users of LIBOR must now take in to account the risk that it may not always be published.

Jerome H. Powell, Roundtable of the Alternative Reference Rates Committee, November 2, 2017

  • The meaning of Libor may still be the same, but the significance of the way it is derived, has massively changed since the scandals of 2012, and now its relevance is about to fade: Libor is no longer reliable.

In our view, it would not be feasible to produce a robust, transaction-based rate constructed from the activity in wholesale unsecured funding markets.  A transactions-based rate from this market would be fairly easy to manipulate given such a thin level of activity, and the rate itself would likely be quite volatile.  Thus, LIBOR seems consigned to rely primarily on some form of expert judgment rather than direct transactions.  

Jerome H. Powell, Roundtable of the Alternative Reference Rates Committee, November 2, 2017

  • Today, there are 17 banks that submit quotes in support of Libor. Look at the distribution of daily aggregate wholesale dollar funding volumes for the 30 global systemically important banks: the median is less than $1 billion per day. On some days, there are less than $100 million.

  • SOFR is very different. To begin with, it is secured (UST collateral), it is only O/N and it is only transactional but volumes are massive (see below). Libor is unsecured, term and it is both transactional and ‘estimated’ (increasingly more the latter). SOFR is kind of a ‘pure’ GC rate.

  • SOFR is a good proxy for a risk-free rate. It could offer the broadest measure of dealers’ cost of financing Treasury securities O/N and, therefore, it could provide useful information regarding O/N demand and supply for funding in the UST repo market.
  • So, the market has three years or so to start converting $trillions worth of contracts which point now to Libor, to SOFR (some of them will just expire before that date). The problem is, because Libor is much higher than SFOR, the receiver of Libor on a legacy contract will require compensation in order to agree to the conversion.

  • There are just too many issues with this conversion. For example, how do you deal with current Libor contract which requires payments based on 3m Libor after the introduction of SFOR which is only O/N (CME will start trading future on SOFR in May)?

 

Now, however, market participants have realized that they may need to more seriously consider transitioning other products away from LIBOR, and the ARRC has expanded its work to help ensure that this can be done in a coordinated way that avoids unnecessary disruptions.

Jerome H. Powell, Roundtable of the Alternative Reference Rates Committee, November 2, 2017

  • When you need to settle floating rate coupons then you need to use OIS (based on SOFR), but there may not be that much (term) liquidity there at the beginning. You don’t want to be relying on this then if you are going to be converting trillion of $ of Libor.
  • Darrell Duffie proposes instead an auction and protocol based approach. Bottom line is that the LIBOR->SFOR conversion is a big thing in the markets and unless you dig in regulatory/compliance documents, very few people are discussing it.

The story of the year is not soaring Libor but emerging SOFR

22 Thursday Mar 2018

Posted by in Monetary Policy

≈ 1 Comment

Tags

  • So, apparently Morgan Stanley thinks “soaring Libor is the story of the year…”  I believe the story of the year is Secured Overnight Financing Rate (SOFR) which the Fed will start publishing April 3; LIBOR is going into the history books. I am not saying the widening of the Libor-OIS spread is related to this, however, I suspect so.
  • The widening of the Libor-OIS curiously coincided with the Fed’s initial announcement on SOFR in June’18, then again in towards the end of 2017 when it said it plans to start publishing SOFR in Q1’2018. It blew up finally, when it became clear that that date will be April 3.

  • Libor setting was always partially subjective even in the good old days pre-2008, especially longer-dated tenors; after 2008, with many banks withdrawing, it has become increasing less transaction-based.
  • According to the Fed, SOFR will be entirely transaction-based and it will be purely spot (O/N). This is a big divergence with the Libor-based structure. Has the market started to transition already?
  • For example, custodians need to move to new systems for calculating compound term coupons from spot because even though market makers will start to build systems to trade futures and forwards, that will take time as it also needs regulatory approval.
  • New debt products will reference SOFR, but existing ones must also have some reference to SOFR, especially longer-dated ones when Libor really becomes extinct in 2021. All this takes time as well, and, I suspect, it is not going to be that straightforward given the large legacy of Libor products out there.