The fourth quarter of 2014 was dominated by deflationary concerns, fueled by the fall in commodity prices, especially oil, and the announcement of a European quantitative easing (QE) programme that would include buying sovereign debt. In 2015, markets will be looking for any pick up in European and Japanese inflation as a result of their QE programmes. With growth picking up, we may start to see signs of a rise in US inflation although much depends on the stronger US dollar, which is currently keeping a lid on it.
Strong growth in US economy but keep an eye on the dollar
The US economy saw strong growth in the second half of 2014, with Q3 GDP having been revised up to 5.0%. The labour market has proved to be resilient, with unemployment falling from 6.7% in 2012/2013 to 5.6% by the end of 2014. Broader measures of unemployment remain elevated but are falling. The fall in the participation rate has helped to lower the unemployment rate so a debate has arisen over how much slack there really is. If the fall in the participation rate was not just structural due to an aging population but was in fact cyclical, then the unemployment rate would be underestimating the amount of slack in the economy. The fact that wages seem to be remaining controlled despite strong employment growth suggests that this hypothesis could be correct. Nevertheless, based on 2014 data for the US economy, we might have expected the Federal Reserve (Fed) to be closer to raising interest rates and not be cautiously talking about "patience".
A major reason for the Fed’s caution is the strength in the US dollar. Ever since the European Central Bank (ECB) started to seriously discuss a sovereign QE programme that would raise its balance sheet to 2012 levels, the US dollar has been on the increase. The effect of this is to lower US inflation and compound the fall in commodity prices. Since inflation remains below the Fed’s target, it is an issue that the bank will be taking seriously. The impact on inflation pricing in the US bond market has been dramatic, with the 10-year bond falling by 50 basis points (bps) in the second half of 2014, driven mainly by the pricing of inflation. Real rates have remained unchanged.
The chart below shows that US 10-year breakeven inflation pricing has fallen significantly since July 2014. The Morgan Stanley USD Trade Weighted Index (TWI), which shows the strength of the US dollar vs. a basket of other currencies, has been inverted to show how the strengthening US dollar has kept pace with falling inflation expectations.
US dollar trade index inverted vs. US 10-year breakeven inflation pricing
Source: Bloomberg. As of 16 February 2015
US dollar strength is particularly concerning for the Fed as it may start to cause a slowdown in growth. With QE in Europe and Japan, the pressure on the US dollar is likely to continue and could worsen if the Fed tries to raise rates, particularly if it is seen as politically-driven given the current Congressional pressure on the Fed. With anemic growth in the rest of the world as well as many countries attempting to drive their currencies lower, there is probably one way for the US dollar to go and that’s up. The less responsive the US economy is to the currency, the higher it will go, and any signs that the Fed is about to raise short-term rates could place further upward pressure on the US dollar.
European and Japanese QE could push investors into US bonds
The Bank of Japan (BoJ) and the ECB have announced two open-ended QE programmes in an aim to raise inflation expectations. We have concerns about the efficiency of QE in the European system, which relies on bank financing rather the bond market as in the US. In addition, with European bond yields currently extremely low, we aren’t convinced that ECB bond buying will have the level of impact that’s intended.
In our view, the major effect will be on the yen and euro, as has already been seen. With lower currencies, they should begin to export low inflation/deflation and import growth. This would have a negative impact on countries, such as the US, whose currencies are rising as well as countries that have currencies pegged to the euro. Those countries will either have to cut interest rates to negative as Denmark has done or unwind the currency peg as Switzerland has done.
These programmes will also have ramifications for European and Japanese bond markets. The BoJ already holds 60% of Japanese government bonds (JGBs) and buys 100% of new issuance. With lack of new supply, the ECB will have problems in sourcing Eurozone bonds, particularly ones with strong credit ratings. Market commentators have estimated that privately-held Eurozone bonds will have to fall by around EUR 300 billion to satisfy ECB demand and some of these holders could move out of Eurozone bond holdings entirely. This investor outflow could be reinforced by the fact that maturities out to 5 years in the German bund curve and 3 years in the French bond curve are trading at negative interest rates. With added ECB buying, Eurozone yields are likely to continue to fall, reducing their attractiveness to investors searching for yield.
The table below shows the yields in seven major markets and the rate of return that could be expected from buying that bond and hedging it back over a 30-day period. The best performer on a hedged basis is the US market given it has the steepest yield curve, followed by the UK and Canada. On an unhedged basis, Australia and New Zealand’s bonds look the most attractive, but their high official cash rates mean a flatter yield curve, which counts against these bonds on a hedged basis. As a result, we think it is likely that the US bond market will be a major beneficiary of these Eurozone outflows, as will AAA rated countries with high yields.
Bond yields and currencies
Source: Bloomberg. As of 11 February 2015
Commodity prices having a deflationary effect
The commodity sector had a poor fourth quarter generally. It had already been suffering from the effect of increased supply due to heavy investment into the sector in response to the high commodity prices that have prevailed for much of the past decade. Commodities such as dairy, iron ore and energy have seen large investment as a result of previous high prices. However, Chinese demand has been the major contributor to high prices and, with its rate of growth slowing, they have come under pressure.
A particular casualty during the quarter was the energy sector as Saudi Arabia failed to restrict supply and instead looked to increase market share as oil prices slid under pressure from supply disruptions, increased supply from the US and falling demand.
The decline in commodity prices had been taking place over much of 2014, but the strengthening US dollar in the second half of 2014 and particularly the fourth quarter, added further downwards pressure. Many investors had large positions in commodities as a result of low interest rates and high liquidity. As it became increasing likely that US liquidity would reduce with the end of the Fed’s QE programme, the unwinding of these positions contributed to the price declines. This was especially true in oil, but the reduction in Chinese liquidity had a similar impact on iron ore prices as the commodity had been used as collateral for Chinese loans.
The fact that prices fell so far also created concerns around the health of the global economy since falling demand may have been a contributor to the price declines. Although commodity price declines are generally seen as positive in terms of consumer demand, with many countries fighting low inflation or even deflation, these lower prices can reduce inflation levels further and de-stabilise longer-term inflation expectations. In addition, although 2014 saw a major drop in commodity prices, tighter US liquidity is likely to exert further downward pressure on US prices of commodities.
The US economy closed 2014 at a strong pace, which should allow the Fed to start normalising rates, as they have indicated they wish to, later this year. However, monetary policy overseas is leading to an appreciating US dollar, which is lowering US inflation expectations and tightening monetary conditions. Lower long-term rates will be positive for the US housing market, but a stronger currency cannot be ignored. It is unlikely to prevent the Fed from tightening monetary policy this year, but may delay rate rises to Q3 2015 and reduce the pace and magnitude of further hikes. Signs of inflation of picking up in Europe will be more important for US bonds and bonds globally as this should reduce the downward pressure that low bond yields in Europe are placing on global yields.
In our view, Eurozone QE is likely to be a positive for the US bond market in particular. With US Treasury/German Bund spreads at all-time historical highs, we see a sell-off in the long end of the US yield curve as unlikely and believe yields will be constrained more by developments in Europe than the US. We don’t as yet know what the psychological impact of negative interest rates will be on investors, but there are already reports of investors withdrawing money from bank deposits and hoarding cash in an extreme form of the Keynesian liquidity trap. With 35% of European bonds returning negative rates, we may well see increasing flows out of Europe as investors escape negative rates.