A Special Report: Changing US Interest Rate Expectations Changes Everything: Explanation, Ramifications, How To Profit, Effects on FX in general, EURUSD in particular.
One of the biggest stories in global financial markets this year, particularly in currency markets, is the shift in US interest rate expectations. This is huge, because as we'll describe below, it affects almost all major global markets and asset classes.
First, look what's been happening to yields on the benchmark 10 year US Treasury Notes.
Yield On 10 Year US Treasury Note From January 1 2014 To Present
(Source: Yahoo finance)
Despite the presumed recovery that is supposed to bring higher rates, they've been falling, especially recently. Why, and why the recent sudden dive?
1. Leaks From Bernanke "Private" Dinners
On March 5th, Reuters reported that former Fed Chairman Bernanke, who retired from the Fed at the end of January, had begun hitting the speaking circuit and cashing in on his experience. On March 4th he earned $250,000 for giving a talk at a banking conference in Abu Dhabi. That's more than his entire $199,700 annual salary as Fed Chairman.
In the months since then he's earned that fee many times over from various other speaking engagements, and can be expected to continue doing so as long as he's seen as an insider with unique insights into current Fed policy. That could last a while.
In addition to being as close to the process and fellow Fed governors as one can be, he is known to be close with the new Fed Chair Janet Yellen, and believed to share her views. All of which supports the belief that he should continue to be the premier Fed insider who is legally allowed to say what he thinks about the likely direction of Fed policy. Given that Ms. Yellen is trailblazing the gradual transition back to historically normalized interest rates after the biggest monetary stimulus experiment ever, investors have advanced insight into how the Fed is going to proceed could have a huge advantage over those who don't.
Obviously the attendees who can afford to split his fee are mostly those who can justify the expense both for its hard information and prestige, those responsible for managing huge investment portfolios and hedge funds.
Looking at the above chart on 10 year Treasury note yields, it appears that in April word began to leak out about Bernanke's key message, with technical traders and computer driven traders probably noting the price action and adding to the selling. As recently as September, the Eurodollar futures markets suggested they didn't expect the fed funds rate to be back at 4% until 2018, however now they've pushed that off until 2022.
So it's not surprising that on May 16, Reuters came out with a follow up piece allegedly revealing to the masses what Wall Street's elites had been paying a substantial share of that $250,000 (before travel expenses) fee to hear in small round table discussions at some pricey restaurants where they were free to ask questions. The key points:
…that easy-money policies and below-normal interest rates are here for a long time to come, according to some of those in attendance.
Bernanke, who retired from the U.S. central bank in January, has predicted the Fed will only very slowly move to raise rates, and probably do so later than many forecast because the labor market still has a lot more room to recover from the financial crisis and recession.
In one dinner-table exchange with investors, Bernanke argued that fiscal tightening, constrained financial markets and lower U.S. productivity all point to lower real rates than would be considered normal for a long time to come.
Anonymous guests or those claimed to have spoken to them were quoted as believing that Bernanke
…does not expect the federal funds rate, the Fed's main benchmark interest rate, to rise back to its long-term average of around 4 percent in Bernanke's lifetime
…the Fed aims to hit its 2 percent inflation target at all times, and that it is not necessarily a ceiling.
In sum, the word is now out that Bernanke believes the Fed will continue to reflect his views that rates stay low until US economic data confirms that the current excess capacity in the economy is about to disappear and the recovery is strong enough to continue even with rising interest rates. Eurodollar futures traders don't expect to see even 4% on the 10 year T-note until 2022
How Far Can We Trust This Growing Consensus?
Call me cynical, but before you start placing big bets on the above, consider:
- If you had just paid anywhere from $25,000 or more (assuming a maximum of 10 guests in order to facilitate a chance to have a meaningful exchange with Bernanke), I'd be awfully reluctant to share insights with anyone other than those who are both close and can be trusted to keep their silence. Yet Reuters seems to have been able to find multiple sources willing to speak. Could it be, just maybe, that the low interest trades from the smart money are already in?
- Not to accuse the former Fed Chairman or his fellow governors of anything but the purest motives, but if he wants to keep collecting anything close to those tempting $250k fees, he'll need to come up with some new insights to keep the high rollers coming back for more. Could it be that a few months of strong data could have us hearing once again about the possibility sooner rate hikes?
Not only would just a few hints that Bernanke (or from one of the FOMC's voting governors) suddenly sees greater than expected improvement and/or inflation risks keep those $250k speaking fees rolling in, they'd fit with the Fed's perceived (if not official) role in maintaining stable markets.
After all, a market complacently overloaded on interest rate sensitive stocks, EU periphery debt, emerging market stocks and bonds, and other low interest rate bets will only make reinforce that liquidity trap and complicate the transition to normal policy. Any hint of coming rate hikes would bring a bigger selloff with bigger "taper tantrums" than those of the past. "Adjusting" rate expectations away from extremely low rates for an extremely long time risk the very recovery that the Fed seeks to promote. It would also risk another sudden outflow of cash from higher yielding emerging markets as we saw in early 2014, with similar risks to the global economy that could ultimately hurt the US too.
So unless US growth and inflation weaken over the rest of 2014 (in which case rate hike speculation goes into hibernation anyway) we wouldn't be surprised if Bernanke and Fed officials attempt to reduce verbally reduce complacency on the low rates for a longer time theme.
As we note below, another reason behind the current drop is a simple short squeeze on bonds, after too many positions were placed based on the certainty of rising rates within the coming year. As the new low rates for a long time consensus takes hold, beware of the same danger, as crowds are usually wrong.
That said, over the coming years the odds remain in favor of continued low rates for years to come, for example:
· Risk of crisis in the EU, which remains fundamentally broken. Few disagree that to survive as a currency union it needs to become more of a political union, yet it can't even come up with a decent banking union pact. Meanwhile, EU parliamentary elections are expected to increase the power of those opposing further integration.
· Risks of economic crises in China or Japan are very real
· The ballooning of total outstanding US debt provides a huge incentive for the US to keep rates low so that debt service payments remain manageable. Governments of most other major economies face the situation. Even if the US could handle higher rates, there's a real risk that rising US rates would still undermine enough of the world's economies to cause a global slowdown that hits the US too.
2. FOMC's Incoming New Governors: Strengthening Yellen's Hand
Former Bank of Israel Governor Stanley Fischer and former U.S. Treasury official Lael Brainard are expected to back Fed Chair Yellin's push for a new set of tools to allow for an expanded Fed role in managing the U.S. economy. These tools would touch on how the Fed controls interest rates, holds and disposes of assets on its balance sheet, and how directly it can intervene in financial markets to prevent crises.
The new Fed Governors are also believed to agree with her on the need for continued loose monetary policy and low rates until the US jobs market recovers.
3. An Unwinding of Short Positions That Forces Bond Prices Up And Yields Down
First, let's be clear that part of the current move lower, as well as further yield declines in the near term, is at least partially due to the temporary effects of a short squeeze, an unwinding of short positions that forces buying 10 year treasuries and thus lower yields.
As the above chart reminds us, at the start of 2014 the 10-year yield was around 3.0% and Wall Street said it would climb to 3.4%, because of course, everyone "knew" the taper meant that higher rates were coming soon. That trade got crowded (as well may the new low rates trade). As the new perception of continued low yields takes hold, there will be more bond buying as short sellers need to close their positions and buy back 10 year notes and other shorted debt.
Indeed, at least a few bond market heavyweights have warned for months this could happen.
In a public webcast on Jan. 14, when the 10-year yield was at around 3.0% and Wall Street said it would climb to 3.4%, DoubleLine Funds' Jeffrey Gundlach predicted that it could fall as low as 2.5% in the near-term.
Currently the 10-year yield is around that level already.
Gundlach isn't the only one warning of a short squeeze in the bond market.
Stifel Nicolaus' Dave Lutz has also pointed out that there's a short squeeze on.
"10y short interest futures (CFTC) data showing a very crowded short… The crowd is rarely right, and now the squeeze is on."
Gundlach warns yields could fall further still.
"If for some reason someone has to cover these shorts, you could actually see the low yields of 2012 get taken out," said Gundlach.
Take a bow, Jeff Gundlach.
(via Business Insider)
Ramifications: General And Especially For The EU
The environment thus remains supportive for risk assets, as low rates mean lower borrowing costs and thus higher profits in general. Particular risk asset beneficiaries include:
· Stocks in general
o Low rates mean lower borrowing costs and better earnings and dividends
o Continued cash inflows from yield seekers
· Higher yielding stocks, which have been punished in times of rate hike fears, both because they're seen as competitors with bonds for income investor cash, and also because many of the higher yielding stocks tend to be capital intensive and thus to get hurt by higher borrowing costs that come from funding their high cost expansion projects. Such stocks include mid-stream MLPs, utilities, telecoms, REITs, housing sector plays, etc. The belief in continued low yields has the opposite effect.
· Commodities, as debt funded capex spending is supported, as is the demand for the materials needed to build them.
· Assets Of Emerging Markets: For example, remember how emerging market assets and currencies get sold off in times of US rate hike fears? That's because they typically offer higher yields to compensate for their perceived added risk. When that yield advantage is believed to be disappearing, they get sold off, or their central banks raise interest rates to maintain that yield advantage, but do so at the cost of making local credit more expensive, thus hurting their economies and interest rate sensitive assets.
· USD Effects Mixed: As the most widely traded currency, changes in USD interest policy profoundly affect currency markets. In general lower rates mean the USD weakens against its counterparts. However it's possible that the EUR will actually weaken more, which means the USD could actually strengthen against other currencies despite shrinking rate hike expectations. Here's why.
· ECB Stimulus Plans Depend On EUR Weakening Against The USD: Continued low rates are obviously a huge headache for the ECB, which is trying to drive the EUR lower with its own rate cutting in order to give the EU's struggling economy some stimulus and fight of looming deflation threats. It can't do that unless it can get the EUR to depreciate against the USD (see here for why), and that will be hard to achieve unless the EUR's rates are lower than those of the USD. That means the ECB will need more radical easing than it wants to do, or may be able to do because:
o Germany or other more hawkish EU members oppose it.
o A full blown US-style bond-buying program is more complicated for the EU than for the US, so the ECB has been trying to avoid that option.
Like everyone else, until recently the ECB had been expecting higher US rates and thus a stronger USD. That would have driven the EUR lower (see here for why) without the ECB needing to take strong easing measures, if any at all.
The ECB is expected to announce new easing measures at its June 5th meeting. This past week the EUR continues to fall, as lower US rates feed speculation that the ECB needs to announce stronger rate cuts or other stimulus than it had previously planned. See here for further details.
Our Take On How To Profit
In addition to the ways alluded to above:
As noted above, for longer term investors, there are many more reasons beyond the above why not just the Fed, but all of the central banks of the biggest currency areas will desperately want low rates for many years to come, and thus to expect them to do all they can to make that happen. To recap:
There are real risks of financial crises in the EU, as well as China and Japan
All of these currency zones, in addition to the US, are coping with lower than desired growth, and low rates are a tool to help fix that problem.
We would not bet against the Fed, never mind the combined efforts of the Fed, ECB, BoJ, PBoC and BoE, short term fluctuations in and minor tightening moves aside.
As for the EURUSD, the US's greater economic strength (see our weekly preview for details) continues to suggest the USD will eventually rise against the EUR and thus drive the pair lower. However it's becoming less clear when, if ever, that rate advantage will materialize.
Over the next 6 months to a year, speculation on rates and related market reactions all depend on the data and the Fed's record at long term forecasting isn't any better than anyone else with their resources (not amazing) as it's hard to model an entire economy. A bet on a rates bouncing is tempting.
What We Think The Fed Plans To Do
Assuming that the current slow but steady growth continues and inflation remains at current levels (big assumptions, yes), here's how we see the Fed behaving.
Rates on the benchmark 10-year note are around 2.5%. If rates stay stable, the Fed could raise rates, while minimizing the risks of taper tantrums or rate shocks that rock global markets and threaten to boomerang back to hurt the US, as follows.
If US growth continues to improve or inflation becomes a threat, the Fed could announce a 25 bp hike, accompanied with forward guidance that
This hike was intended as a one-time adjustment based on the current situation and that
There are no further plans to raise rates in the foreseeable future based on the information they have, but that markets should understand that over time rates will be rising as data permits (read: don't get too complacent with your long term low rate bets)
Repeat the above process about once a year. At the rate of 25 bps per year, the increase is gradual enough for markets to adjust without long term economic damage or volatility that might endanger the recovery. The 10 year T note rates wouldn't hit 4% until about 2021.
Disclosure/disclaimer: No positions. The above is for informational purposes only. All trade decisions are solely the responsibility of the reader.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.