- Global interest rates have continued to decline throughout the summer as global growth remains sluggish and inflation pressures remain muted.
- As real yields continue to fall in the Eurozone in anticipation of ECB QE, the US Treasury bond market will become even more attractive.
- The new regulatory framework implementation will continue to nominally pull interest rates lower.
- The end of the Fed's QE program will not lead to a massive interest rate sell off in long dated US bonds due to mortgage hedging dynamics.
Over the past several months, many investors and market commentators incorrectly believed US interest rates were set to rise as the Fed's massive bond buying stimulus program was winding down and set to conclude in October 2014. Investors and speculators who went short US Treasury bonds have been frustrated and puzzled by the seemingly endless rally in US interest rates. There are several undercurrents within the US bond market that have outweighed the impact of reduced Fed bond buying. In fact, in this article I will argue that some of these undercurrents are structural in nature and likely to continue to hold interest rates at low levels for quite some time.
During the summer months we have seen global growth trends decelerate noticeably in both the developed and developing world. Over the past two quarters we have even witnessed economic contraction in significant economic countries such as Italy and Brazil. Indeed, there are also many European countries such as France, that are not in technical recession, but whose economies are merely treading water. This is the main reason global central banks have continued to maintain aggressively loose monetary policy for fear economic growth will suffer via a domino effect if easy money policies are withdrawn. Therefore, slower global growth over the past several months has translated into lower nominal interest rates.
However, the most notable development of the past several months is the clear deceleration in European inflation rates. Here is a time series chart of the Harmonized Inflation Index (HICP) from inflation.eu
The HICP is the main inflation metric used in Europe, which is somewhat similar in nature to the US CPI inflation measure. Many people expect the current trend lower to continue in the HICP if the European Central Bank (ECB) doesn't soon take drastic steps to stimulate the Eurozone (EZ) economies. Low EZ inflation along with ECB support led European banks to reach for yield in the peripheral government bond markets, thereby greatly reducing yields in countries such as Ireland, Spain and Italy. In fact, even as those countries each experienced financial crises over the past few years which led to skyrocketing interest rates, the ECB's pledge to do 'whatever it takes' has sent interest rates on debt from all three countries below US interest rates! In fact, most countries using the Euro are now able to borrow more cheaply than the US out to 10 years with the exception of only Portugal and Greece.
As yields on peripheral EZ debt continue to decline due to ECB programs such as LTRO and TLTRO, European investors will look to the US Treasury market to pick up yield. Corporations and asset managers often hedge out currency risk when investing in foreign bonds as they prefer targeted exposure to rates and not currency risk, but under this scenario where European banks buy US Treasury bonds, many will likely keep their US bonds without hedging the currency risk as a disintegration of the EU would lead to gains in US dollars for European investors in US government bonds. Indeed, the euro is likely to fall further as the ECB implements QE. This will drive real yields on Eurozone sovereign debt down relative to US Treasury bonds making the US dollar and US Treasury bonds more attractive. I believe this will be very beneficial for the US Treasury ETF TLT as European investors realize high quality AAA government bonds in the EU offer much lower yields than comparable Treasury securities.
In my previous article, Why Interest Rates Won't Rise, I mentioned the Fed's QE program effectively reduced term premia on longer dated US bonds, which had the effect of lowering longer dated interest rates. However, I think the reverse effect of rising term premia due to less Fed bond buying will be swamped by the reach for yield from both European and other foreign investors.
Moreover, the post crisis regulatory framework will likely continue to affect the US interest rate market as well. US banks were forced to hold more capital given the new Basel capital requirements. This led to a dramatic rethinking of bank balance sheets. It became much more expensive in terms of capital charges for banks to hold non government, high yielding bonds and loans on their balance sheets. Implicit in the new Basel capital standards is a favorable capital charge for sovereign debt. Therefore, developed economy sovereigns now borrow at subsidized rates as government bonds are more attractive for bank balance sheets given the relatively favorable capital treatment. It's the same rationale one uses in thinking about exempting interest payments from Federal tax on municipal bonds. It effectively allows municipalities and local governments to borrow cheaper than they otherwise could. It follows that the new favorable Basel capital treatment allows governments to issue debt at lower interest rates due to higher demand from banks for sovereign debt.
Additionally, I don't believe the end of QE will lead to a significant sell off in long dated interest rates. Above, I mentioned further stimulus from the Eurozone, along with the regulatory framework, both of which are likely to be in place for several years and therefore, should keep US Treasury bonds in demand and yields low. Historically, previous big sell-offs in interest rates such as the one experienced in 1994 seen in the chart below, were driven by mortgage hedging.
As home buyers previously tried to call the bottom in interest rates, once they felt interest rates were going to begin a rising trend, they would run to the bank en masse to refinance their mortgages or to buy new homes. The banks would anticipate the surge in refi's and start selling mortgages forward into the market, which put pressure on interest rates to rise as there was now a sudden spike in duration hitting the market.
Furthermore, mortgage originators, asset managers and other investors would seek to hedge against future rises in interest rates, which led to further rate increases as the hedgers jumped into the market and demanded interest rate swaps and swaptions that would gain in value as interest rates rose pushing rates up further. It effectively creates a self reinforcing cycle of increasing interest rates that can greatly overshoot depending on market positioning at the time (if the market were caught by surprise), or amount of hedging needed.
For the current cycle, it doesn't appear the Fed will aggressively begin hiking rates anytime soon. In addition, the Federal Reserve and the GSEs (Fannie Mae and Freddie Mac) combined hold the vast majority of mortgages outstanding; the private mortgage market is mostly only active now in jumbo mortgages. So there isn't as much hedging happening today as in previous cycles. For example, the Fed does not hedge the mortgages they hold on their balance sheet. In addition, the GSEs are now effectively part of the US government and if GSE mortgage hedging started adversely impacting rates in a significant way, the US government would stop their hedging activities as higher rates could put the economy at risk. In short, the interest rate volatility markets are not pricing in a lot of volatility going forward and I would not expect there to be for the reasons described above. As volatility remains low, term premia should stay muted, weighing on long term interest rates.
The long bond US Treasury ETF is likely to continue to perform well over the coming months. Growth in Europe is likely to remain sluggish even as the ECB embarks on additional stimulus. Europe suffers from a lack of aggregate demand, and current monetary policy proposals are unlikely to change that in a significant way over the next few years. As seen in this chart from a recent WSJ article by Enda Curran, European banks are lending; just not to European businesses.
This further supports the claim that it's not that European banks are refusing to lend, rather it's more driven by a lack of aggregate demand in Europe. Therefore, ECB QE is unlikely to have a meaningful impact on underlying economic growth in the Eurozone. If Europe unveiled a Fed style QE program, it would likely drive real interest rates lower in Europe and juice European equities, similar to how the Fed program lowered US real interest rates and juiced US equities.
European countries should implement a massive fiscal stimulus package given nearly every country can currently borrow at record low interest rates. That would generate greater levels of aggregate demand, which would raise European growth and lead to higher interest rates. Unfortunately, given the political climate, that seems unlikely to happen. Therefore, this huge effort by the ECB to lower interest rates to stimulate aggregate demand is somewhat ineffective since nobody wants to borrow. The governments are contracting their balance sheets just like the private sector. Similar arguments could be made for the US, only not to such a strong degree.
In conclusion, until governments find a politically palatable way to implement a fiscal stimulus and increase aggregate demand, we are unlikely to see strong economic growth, higher inflation or rising wages. Therefore, without an increase in aggregate demand coming from somewhere, interest rates are likely to remain low. Under those conditions, I think the ETF is likely to continue performing well. However, investors should note the risk to investing in the long dated US Treasury ETF is that interest rates rapidly rise and begin to trend higher. Basically, the capital losses due to rising interest rates would need to more than offset the interest payments and positive roll down. For reasons described above I do not anticipate a rapid rise in interest rates, which is the biggest risk for holders of TLT. In fact, I believe interest rates will continue to trend lower due to the Fed withdrawing market support (QE) and the inability of political leaders around the globe to understand the problem of low aggregate demand. Eventually, the US and Europeans will roll out large fiscal stimulus packages to stimulate demand, but we are still a few years away from that scenario. In the meantime, growth trends will remain sub-par and long dated US Treasury bonds will be an excellent investment.