"Progress is impossible without change, and those who cannot change their minds cannot change anything."
- George Bernard Shaw
Watching with interest the significant compression in credit spreads, thanks to "Le Chiffre", aka Mario Draghi going "all in" - which, to some extent, is putting pressure on Haruhiko Kuroda and the Bank of Japan, to raise the stakes once more in this global game of liar's poker, given their respective ability in reaching their inflation targets and both their repeated failures - we reminded ourselves for our chosen title analogy of "Unobtainium", being any fictional, extremely rare, very costly, or impossible material, or (less commonly) device needed to fulfill a given design (inflation) for a given application (QE+NIRP). The word "Unobtainium" derives humorously from unobtainable (inflation), followed by the suffix -ium, the conventional designation for a chemical element.
What we also find of interest in our chosen title is that there is a cryptocurrency named Unobtainium, which uses Bitcoin's source code with some modifications to the monetary policy. UNO, aka Unobtainium, is a SHA256 proof-of-work cryptocurrency unique for low inflation, scarcity, a fair launch and distribution. Just 250,000 Uno will ever be mined over 300 years. Unobtanium is merged mined with Bitcoin, resulting in a secure high-difficulty blockchain that is 3x faster than Bitcoin. Uno is rare not only in the number coins issued, but also in its fair launch and distribution. Uno was not pre-mined. There is no POS inflation. On that matter, we find it very amusing to read about the proto-currency known as RSCoin in recent column by Ambrose Evans-Pritchard on the 13th of March in the Telegraph, in his article entitled "Central banks beat Bitcoin at own game with rival supercurrency", as a better alternative to Bitcoin and its smaller rival, "Unobtainium":
"The RSCoin is deemed more likely to gain to mass acceptance than Bitcoin since the ledger would remain exclusively in the hands of the central bank, with the 'trust' factor of state authority. It would have the incumbency benefits of an established currency behind it... RSCoin may be irresistible for central banks. Dr Danezis said it is allows them to turn the money tap on and off with calibrated precision, and lets them track the sort of counterparty liabilities that nearly blew up the financial system during the Lehman crisis. "There would be instant visibility. They could react very quickly in an emergency, " he said.
Ultimately it could achieve some of the objectives of 'narrowing banking' proposed by Adam Smith, or the Chicago Plan put forward by US economists in the 1930s - but never enacted - to transfer control of money creation from private banks to the state. Arguably, this would make the financial system safer and less prone to boom-bust cycles."
- Source: The Telegraph, Ambrose Evans Pritchard, 13th of March, 2016
We find it particularly hilarious that RSCoin is deemed more likely to "mass acceptance", thanks to the "trust factor of state authority". To paraphrase Hayek's 1988 book, one could argue that RSCoin will not likely be more successful than Bitcoin, because having the "trust factor" of the central bank would be a "fatal conceit", but we ramble again...
On a side note, before we move on our weekly musing, we find as well very entertaining that China and its People's Bank of China (PBOC) are thinking about the implementation of a "Tobin tax", given one of our latest musing was the "reverse Tobin tax". This was reported by Bloomberg on the 15th of March in their article, "China Tobin Tax Riles Analysts as Citi Warns of Foreign Exodus":
"China's central bank has drafted rules for a tax on foreign-exchange transactions, a plan that still needs central government approval, people with knowledge of the matter said on Tuesday. The initial rate may be kept at zero to allow authorities time to refine the rules and to deter speculators by letting them know that there is a system in place, said the people, who asked not to be identified as the discussions are private.
The People's Bank of China has been fighting to drive out traders who take advantage of the difference in the yuan's rates at home and abroad. The PBOC drove the currency's offshore borrowing costs to records in January, increasing short-selling costs, and instructed banks on the mainland to restrict sending yuan overseas.
Among the biggest Tobin tax concerns cited by analysts is that the levy would sap market liquidity. One gauge of the ease of trading the yuan - the currency's bid-ask spread against the dollar - was about 0.05 percent on average in March, versus 0.01 percent for the dollar-yen rate, according to data compiled by Bloomberg Intelligence."
- Source: Bloomberg
As a reminder from our conversation, the Tobin tax suggested by Nobel Memorial Prize in Economic Sciences Laureate economist James Tobin, was originally defined as a tax on all spot conversions of one currency into another. This tax intended to put a penalty on short-term financial round-trip excursions from the speculative crowd and was suggested in 1972, shortly after the fall of the Bretton Woods system, which ended on August 15, 1971. Also we would like to point out that this additional precautionary measure from the PBOC does seem to us overstretched, as we indicated in our "The disappearance of MS München" conversation, the fate of the attack of the yuan and, in effect, the attack of the HKD peg can be analyzed through the lens of the Nash Equilibrium Concept:
"It seems to us that speculators, so far has not been able to gather together or at least one of them, did not believe enough in the success of the attack. It all depends on the willingness of the speculators rather than the fundamentals."
- Source: Macronomics, 1st March 2016.
For us, this announcement from the PBOC is posturing, and ambitions to deter further speculation and prevent speculators to gather together, ensuring in effect that renewed attacks will be postponed and inflict sufficient damage to the "short crowd". It seems to us that shorting the yuan is indeed a very costly "Unobtainium" for now. End of our side note.
In this week's conversation, we would like to look at inflation expectations and what it means in terms of allocation and credit, given the significant tightening move seen in recent weeks.
- Macro and Credit - Is inflation really rearing its ugly head?
- Macro and Credit - The bond yield curves are now fully inelastic
- Final chart: Demography is destiny
Macro and Credit - Is inflation really rearing its ugly head?
Back in October 2015, in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective, given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:
"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor"
- Source: Macronomics, October 2015
We hinted a "put-call parity" strategy early 2014, e.g. long Gold/long US Treasuries, as we argued in our conversation "The Departed", and of course, it has worked again like a charm in 2016:
"If the policy compass is spinning and there's no way to predict how central banks will react, you don't know whether to hedge for inflation or deflation, so you hedge for both. Buy put-call parity, if there is huge volatility in the policy responses of central banks, the option-value of both gold and bonds goes up."
Given it seems that US inflation expectations jumped after a renewed dovish Fed, one could argue that the compass in the US has somewhat stopped spinning, hence the move in US breakevens and TIPS, in conjunction with the continuous support for gold miners (yes we are still long...).
We continue to like US TIPS, particularly if pundits started claiming inflation in the US is rearing its ugly head, particularly for the specific deflation floor embedded in US TIPS. It works both ways, so what's not to like about them in the current "reflationary" environment?
What we also find of interest is that some have argued that with inflation supposedly "rearing its ugly head", US Treasuries are vulnerable in this situation. No doubt, the dovish stance of the Fed is going to wreak havoc on the short end of the curve, but we do think the very long-dated part of the curve (30 years) still offers some good carry and roll-down in a growing NIRP world (yes, we are still long, very long US duration as well, if you'd like to ask).
But when it comes to "inflation" and "Unobtainium", we still think as per our conversation, "Perpetual Motion" from July 2014, that real wage growth is indeed the "Unobtainium" piece of the puzzle the Fed has so far been struggling to "mine":
"Unless there is an acceleration in real wage growth we cannot yet conclude that the US economy has indeed reached the escape velocity level given the economic "recovery" much vaunted has so far been much slower than expected. But if the economy accelerates and wages finally grow in real terms, the Fed would be forced to tighten more aggressively."
- Source: Macronomics, July 2014
A very interesting 2015 paper by the Bank of Israel (Sussman, N and O Zohar 2015, "Oil prices, inflation expectations, and monetary policy", Bank of Israel DP092015) indicates that since the Great Financial Crisis (GFC) of 2008, a 10% change in oil prices moves 5-year expected inflation by nearly 0.1% in the US and 0.05% in the euro area. Therefore, given the recent significant surge in oil prices towards the $40 mark, we do not think it is such a surprise to see a rise in inflation expectations in that context. This latest rise in inflation expectations could, after all, be transitory, as well as the sudden rise in oil prices, particularly in the light of the tight relationship between the US dollar and oil prices. We think the latest dovish stance of the Fed all has to do with their concerns relating to the "velocity" of the US dollar and the "unintended consequences" a too rapid rise of the "Greenback" could have on emerging markets (EM).
When it comes to the assessing the transitory nature of the rise in inflation expectations, we read with interest Bank of America Merrill Lynch's take from their Liquid Insight note from the 18th of March entitled, "Yellen: The lady doth protest too much", where they disagree with the impact of the change in oil prices moves on inflation expectations we mentioned above:
• The Fed's dovish commentary on inflation is getting stale very fast.
• The evidence for a pick-up in wage and core price inflation is not just a couple data points, but is broad based.
• Markets are only beginning to come to terms with the reality of a steady upward move in inflation.
Our core disagreement with the Fed
Once every year or two a significant gap develops between our thinking relative to the Fed. For example, early last year, we were struck by the Fed's apparent complacency about the strong dollar. Fed officials seemed to dismiss the dollar, arguing that the US is a relatively closed economy and a strong dollar could be viewed as a vote of confidence in US growth rather than as a shock to US growth. That view seemed increasingly out of touch given both the size of the dollar move and the fact it continued to strengthen in the face of very weak US data. The Fed did not capitulate until March when they acknowledged the weaker outlook and moved out the expected timing of the first hike.
Today, a similar sized gap in thinking has emerged; this time around the outlook for core inflation. Despite stronger data, the FOMC continues to question whether core inflation is really picking up. "Inflation is expected to remain low in the near term ... but to rise to 2% over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further." Asked about the pick-up in core inflation during the press conference, Chair Yellen vaguely talked of volatile components. The forecasts were similarly dovish: even though year-over-year core has already jumped from 1.3 to 1.7% YoY, the median forecaster continued to look for 1.6% inflation this year and the median forecast for next year actually dropped from 1.9% to 1.8%.
Here we take a closer look at the gap between the FOMC and our own thinking. We think the Fed's views are stale in several respects. We also argue that the FOMC is more willing to allow inflation to overshoot the 2% target than they are suggesting. Looking ahead, we think this meeting outcome will be the high point for Fed dovishness this year and we reiterate our long-standing call for hikes in June and December.
It was a new day yesterday
A key Fed concern is that weakness in oil prices will pass through to the core over time. However, most studies find very weak or nonexistent pass through. The worst of the oil price drop now appears behind us: prices seem to be finding a floor, with Brent up about 40% from its 20 January low. As base effects fall out of the data, headline inflation should continue to converge to the core (Chart of the day above).
The Fed is concerned that the strong dollar will continue to drive import prices lower as the lags play out. Presumably they are also concerned that if they are too hawkish the dollar could surge again. In our view, the period of rapid dollar appreciation is fading into history (Chart 1).
As a result, consumer import price deflation has already slowed sharply. For much of last year, consumer import prices were falling at 1.3% YoY, but the rate of decline has now dropped to just 0.2%. In our view, this is a major factor in the recent pickup in core goods price inflation.
Yellen and company seem skeptical about any pick in wage growth: "in the aggregate data, one doesn't yet see any convincing evidence of a pickup in wage growth. It's mainly isolated to certain sectors and occupations." She also pointed to the pickup in the participation rate as a hopeful sign. In our view, the evidence of a pickup in wages is compelling. The growth in average hourly earnings in the last 12 months is higher than the prior 12 months for seven out of 10 major industries. Overall compensation growth has accelerated relative to a year ago for all the major compensation gauges except the employment cost index. A lot of second-tier measures, such as surveys from the Fed, have also picked up modestly.
At her press conference Chair Yellen was asked why she was skeptical about the recent inflation numbers. She said, "I see some of that as having to do with unusually high inflation readings in categories that tend to be quite volatile without very much significance for inflation over time." We agree that there are a few special factors in the numbers, but not enough to cancel out the inflation signal. The Fed has developed "trimmed mean" measures of core inflation that strip out all volatile items rather than somewhat arbitrarily eliminating all food and energy items (Chart 2).
The trimmed CPI measure is still up at a solid 2.5% annual pace in the last two months and on a year-over-year basis has been accelerating since May 2015. A similar story applies for the trimmed PCE: it is rising at a 2% annual pace in the last two months and has been drifting higher since last January. In our view, these are trends, not noise.
The one dovish aspect of the Fed view we agree with is the risk of inflation expectations unhinging to the downside. Measuring inflation expectations is difficult. Survey measures have an upward bias and market-based measures can be heavily distorted by technical factors. Nonetheless, after six years of weakness in wage and price inflation it would be surprising if inflation expectations for real people had not fallen. We believe confidence in the Fed's inflation-creating ability surely is under pressure and is already impacting wage and price setting. Despite this headwind, however, wage and price inflation is already starting to pick-up. This suggests the economy is already at full capacity.
Living in the past
This brings us to our final point. Chair Yellen has been adamant that the Fed has not changed its inflation target: it is still 2% and it is still symmetric; they are just as concerned about above-target inflation as below-target inflation. We are skeptical. In our view, there is a very strong economic case for "really risking" overshooting the target. Recall that the reason the Fed's target is 2% rather than zero is that the Fed wants to minimize the risk of deflation and avoid hitting the zero lower bound for the funds rate when fighting recessions. Recent experience argues strongly for a higher inflation target:
• the Fed and other central banks have been stuck at zero for many years,
• inflation has been chronically low
• inflation expectations have fallen below the Fed's target
• and the equilibrium real rate has probably dropped.
With the benefit of 20-20 hindsight we think the Fed would have adopted a higher target: say 3%, instead of 2%. The problem is that resetting the goal would require a very complicated debate at the Fed, raise concerns about a slippery slope (if 3%, why not 4%?) and would likely subject the Fed to even bigger political attacks. In our view, the politically correct answer is to keep the target, but err on the side of overshooting and then wait for the inevitable recession to knock inflation back down to target.
The bottom-line of all of this, in our view, is ongoing upside risks to inflation breakevens as the markets recognize the Fed can create inflation after all."
- Source: Bank of America Merrill Lynch
It seems to us that Bank of America Merrill Lynch is focusing on the content, and like any good behavioral psychologist, we prefer to focus on the process. If, indeed, the Fed has recently preferred a slowdown in the "velocity" of the surge in the US dollar for obvious external EM concerns, hence its dovish tone, what has also been a concern has been the overall global tightening of financial conditions. What is also of interest is that the surging dollar in recent years and falling US Treasury yields have happened in conjunction with falling commodity prices, and particularly, a sharp drop in energy prices. This has therefore reinforced the possibility of coordinate actions from central banks, which could have happened given the US dollar has dropped as much as 3 percent since the G-20 meeting held in Shanghai, which ended on February 27. Whereas the Fed's latest dovish tone aims to somewhat lessen the impact of a rapidly surging US dollar, clearly to us, the ECB's ambition of purchasing corporate bonds is a clear demonstration of its willingness in suppressing a surge in credit spreads and a flattening of the credit curves - which would, in effect, trigger a rise in the cost of capital and funding for banks and other players, and trigger a renewed credit crunch in Europe in the process. Not only has the US dollar fallen relative to other currencies, but in Europe, credit spreads have fallen very rapidly to much lower levels, thanks to the ECB "credit put".
When it comes to wage inflation, which would entice us to validate the "recovery" mantra, we believe wage inflation remains "Unobtainium" - an impossible material as posited by Zero Hedge in their article from the 18th of March, entitled "Feeling Underpaid? This Is What Wage Inflation Around The World Looks Like", which is pointing to the similar Deutsche Bank report we read with interest, "Inflation Sensation - a global inflation monitor", from the 16th of March. If US inflation is indeed rearing its ugly head, then the jury is still out there when it comes to monitoring wage inflation in the US:
"Wage developments are striking across the G10. While there are tentative signs of producer and consumer price disinflation bottoming in some countries, wage growth remains particularly weak. This may be because wages are a backward looking indicator of inflation pressure, but it may also be a sign of second-round effects influencing price-setting behaviour."
- Source: Deutsche Bank
What seems so evident to us is that central banks such as the ECB are pouring oil on the fire, as they have been trying to push long-term rates down after having succeeded in pushing short-term rates to zero.
In Europe, it is clear that the ECB's policy is having no lasting effect on prices and inflation. It is because the ECB can create all the money it wants, but it cannot command it to flow "uphill" in wages, hence the "Unobtainium" situation. The new money flows downhill where the fun is: to the bond market. Bond speculators are having a field day, and now credit speculators are joining the party with both hands:
- Graph source: Deutsche Bank
As we pointed out in our recent conversation, "The Monkey And Banana Problem":
"Lower rates then end up raising, rather than lowering the demand for bonds as the saving rate goes up. This negative feedback-loop, doesn't stop the frenzy for bonds and the "over-allocation process. On the contrary, as the "yield frenzy" gather pace thanks to NIRP. This push yields lower and bond prices even higher"
- Source: Macronomics, February 2016
The results of the "Unobtainium" process is that money flows into Wall Street, and less so into Main Street as a result. The latest decision by the ECB is putting the demand for credit products into "overdrive", while in no way is the most recent TLTRO altering the credit profile of ailing Italian banks and their balance sheets bloated by nonperforming loans (NPLs). "Liquidity" via funding at zero cost doesn't resolve "Solvency". But yes, the rally in credit has legs for the time being.
The "Unobtainium" process followed by our generous gamblers have not only enticed even more speculation downhill in the government bond markets, but now in the credit markets, where we still favor quality, and in particular, US Investment Grade (for carry purposes...). All of this brings us to our next point, namely that bond yield curves behavior have changed dramatically.
Macro and Credit - The bond yield curves are now fully inelastic
Whereas the rise in US inflation is raising some concerns relative to the US yield curve, we do not have such a sanguine approach for the long end of the curve, particularly because we agree with Louis Capital Markets' latest points made in their most recent cross-asset note from the 16th of March, entitled "How does it end?":
"Last week there was also a huge move on long term Japanese rates. The 10 year Government bond yield appears now to be well anchored in negative territory. How is this possible? In what world do we live?
Below, we show the average 10-year bond yield for developed countries and it stands at an all-time low, below 1%. We live in a world in which the public sector has never been so indebted. However, it can borrow money at a rate that has never been so low.
Economic textbooks are filled with details of the term structure of interest rates and the message of the bond yield curve. Below right we show that these academic books should be used now for lighting fires because the historical relationships have fully broken down. Since 2009, we have faced a long lasting capitulation towards the idea that one day long term bond yields will recover their pre-crisis levels. Thus, while the slope of the bond yield curve was negatively correlated to short term rates, it is now fully inelastic: short term rates have been stuck to 0% since 2009 and long term bond yields have moved from 3% to 1%.
The fact that long term bond yields confirm that even in the long term the situation will never normalise poses two questions. Firstly, do bond markets fundamentally misunderstand the economic situation or are they correct in their expectations? The problem is that central banks, who decide the level of short term rates, have remained unclear about what will be the next "normal situation"? The case of Sweden, one of the first countries having experienced deeply negative rates, is worth mentioning. We show below the dynamic of the core CPI, of wages, of Employment and we add the main refinancing rate into the mix as well. The first chart below shows absolute data and the second one, it is a z-score (in standard deviations around the mean).
Sweden: Key Economic Data
Click to enlarge
We see that in Sweden, the employment situation has normalised, the core inflation rate has normalised, the wage dynamic is a bit weak but interest rates have never been so low in economic history. Why has the Swedish central bank decided on such a policy? Or to put it in another way, what is required to put rates back above 0%?
The Fed will meet in two days. We believe Fed Board members remain very uncomfortable with the current situation. We will not repeat what we have said for many months now, that slacks in the economy no longer exist and that inflation is back to trend. The problem is not the US economy, the problem is the US$ leverage in the emerging world and the declining EM currencies. The question for Fed members is clearly subjective. Should they grant more time to EM countries to make their adjustments or should they reload their monetary policy tool because the US economic cycle is reaching maturity? These are two different questions and up to now, Fed members have refused to choose, leaning however a little towards the first solution.
Our stance remains the same, because we are bullish on the US economy, we do not understand how 5y×5y forward USD rates can trade below 3%."
- Source: Louis Capital Markets
Apparently, the Fed has chosen to throw a lifeline to EM countries and to give them more respite by tampering their "normalization" process, but as far as our "inflation expectations are concerned and in relation to "Unobtainium", when it comes to the US, we remain "data dependent", and it remains to be seen if the US has indeed reached "escape velocity" when it comes to "wage inflation". We do not share the same optimism as LCM on that matter, and believe the rise in "inflation expectations" to be for the time being a temporary phenomenon. Yet, if indeed the slope of the bond yield curve, which was negatively correlated to short-term rates, is now fully inelastic from a strategy perspective, we believe being long US TIPS (given their embedded deflation floor), long gold miners and long US long bonds still represents a relatively attractive "allocation". What is as well interesting is that the short end of the US yield curve is prone to more volatility in similar fashion than long-dated Japanese, and German government bonds have become as well significantly volatile, thanks to NIRP.
The volatility of the US yield curve is clearly in the front-end of the curve, as indicated by Bank of America Merrill Lynch in their Situation Room note from the 16th of March, entitled "Marking the Fed toward the market":
"Marking the Fed toward the market
The main story at the conclusion to the March FOMC meeting was that, by lowering the dot plot to two rate hikes this year, the Fed chose to mark their view on the near term path for the Fed funds toward market expectations. In other words, the Fed acknowledged, what the market has suspected for a long time, that it will be difficult for the Fed to hike rates in an environment of global weakness and deflationary pressures. Hence the big bull steepening move in the Treasury curve with 2-year yields 10.9bps lower while 30-year yields were comparatively little changed (-2.0bps).
As a result the likelihood of a hawkish monetary policy mistake derailing the US economy declined significantly and VIX dropped 11.0% as stocks rose 0.6%. Less economic uncertainty in turn is positive for credit spreads, while the decline in interest rates is negative. However, with longer term interest rates holding up well the net effect is positive and supportive of our bullish outlook for HG credit as well as the Treasury curve steepening move supports our view that the 5s/10s spread curve flattens. Sector wise today's Fed moves are more positive for industrials than banks, although relative valuations and last weeks's ECB moves mitigate that."
- Source: Bank of America Merrill Lynch
Whereas the rally in the US Investment Grade has been significant, the ECB's latest "generosity" package has lead to a rush towards credit spread products, enticing investors to renew the "beta" game in the process, namely reaching for yield and credit risk in the process. If indeed the short end of the European government bond market has become irresponsive, thanks to NIRP, and has plunged most of European short-term bonds into negative territory, the consequences of yield curves becoming "inelastic" is pushing punters towards the only "less perceived risky"decent game in town namely investment grade credit. This is validated by the flows seen in Europe as shown in Bank of America Merrill Lynch chart below from their Follow the Flow note from the 18th of March, entitled "Front-running" the ECB...":
"... as investors rush to buy corporate bonds
We have seen it in the past. When the ECB announced the government bond buying program, inflows accelerated into the asset class. With the help of the ECB, credit flows broke free from a long period of outflows. Last week's positive inflow into high-grade and high-yield funds was the third consecutive and the biggest in 53 weeks.
This considerable shift in momentum was mainly thanks to a decisive shift in high grade. The asset class recorded its first inflow in ten weeks and the biggest for more than a year. High yield funds enjoyed another - the fourth in a row - week of inflows.
Elsewhere in fixed income, government bond funds recorded another outflow during the previous week.
Money market fund flows were also in the negative territory, recording a fourth consecutive outflow - the longest streak since March '15.
To the contrary outflows continued from equity funds. The asset class has suffered outflows for the last six weeks, which now sum up to $15bn. This is the longest period of outflows seen in equities since October '14."
- Source: Bank of America Merrill Lynch
The outflows from equity funds do not surprise us. This what we pointed out in "The Monkey and banana problem":
"The sell-off this year has set up the stage for an operant conditioning chamber (also known as the Skinner box): When the central bank monkey correctly performs the "central bank put" behavior, the chamber mechanism delivers positive investment returns to the community and a buying behavior. In some cases of the Skinner box investment experience, the mechanism delivers a punishment for an incorrect or missing responses (central bankers). Due to the lack of appropriate response or incorrect response (Bank of Japan with NIRP) from central bankers in 2016, the investor monkey community has been delivered a punishment in the form of a violent sell-off, leaving the investor monkey community less inclined in going again for the "equity banana" for fear of another "electric shock" hence the reach for bonds."
- Source: Macronomics, February 2016
No doubt that the "European investor monkey community" is fearful of another "electric shock", so for now they'd rather play the "reach for bonds", ditching equities in the process. The beauty of the Skinner box... or from "Unobtainium" (Main Street) to "Obtainium" (Wall Street), but, we are ranting again...
This leads to our final point and final chart - that no matter how hard central bankers try to generate "Unobtainium", demography matters, end of the day, no matter how big your "printing press" is.
Final chart: Demography is destiny
As we have pointed out, like many others before us, when it comes to the trajectory of bond yields and inflation expectations, demography matters. This is the point we made in our February 2015 conversation, "The Pigou Effect", relating to our long-term deflationary stance.
You probably better understand now much better our long standing deflationary stance and lack of "appetite" for European banks stocks (we are more credit guys anyway...). It's the demography stupid! Beside's that we have pointed out in our conversation "Stimulant psychosis:
Both the master Pigou and the student Keynes have inadvertently grant unprecedented capital gains to rentiers in the form of exorbitant bond price!
"Rentiers seek and prefer deflation - European QE to benefit US Investment Grade credit investors. Rentiers seek and prefer deflation. They prefer conservative government policies of balanced budgets and deflationary conditions, even at the expense of economic growth, capital accumulation and high levels of employment."
The problems facing Europe and Japan are driven by a demographic cycle, not a financial cycle. This once again illustrated in our final chart and table from Bank of America Merrill Lynch from their latest Securitization Weekly note from the 18th of March:
"Demography is destiny
The big picture
We borrow this week's title from Dr. Joseph Coughlin of the MIT AgeLab, who was a featured speaker at this week's BofAML Residential Mortgage and Housing Finance Conference. For financial markets, the key demographic reality is that populations across the globe are aging, some more rapidly than others. BofAML Chief Investment Strategist Michael Hartnett noted this in the recent piece, BofAML's Transforming World Atlas: Investment themes illustrated by maps.Table 1 shows, by country, the percentage of populations that are 65 years old or over, as of 2015 and projected for 2050.
Japan is seen as the world's leader in age, both now (26%) and in 2050 (37%). Europe (Germany, Italy, Spain) is not too far behind. The US, currently at 15%, is next, although countries such as China and Brazil will age more rapidly over the next 35 years and overtake the US in terms of the percentage of people above 65 years old. Not surprisingly, as populations age, productivity and consumption patterns change, with deflation conceivably an associated phenomenon. The bond market experiences of Japan and Germany relative to the younger US are perhaps illustrative. Chart 1 shows the history of 30yr bond yields in Japan, Germany, and the United States over the past 15 years. Japan has led the way lower while Germany has followed suit and narrowed the gap to JGB yields. US yields have moved lower but not to the same degree.
The question arises: will the US inevitably follow and see 30yr bond yields head below 1%? So far, US yields have proven to be somewhat more resilient than in Japan and Germany, and the different demographic outlook (less aging) argues for less downward pressure on yields than in Europe and Asia. Nonetheless, we should note that one of our conference presenters, Scott Minerd of Guggenheim Partners, made the case for a 1% 10yr treasury yield at some point in the not too distant future; currently, we are simply at the middle of the downward trend channel in rates of the past 30 years (Chart 2).
At a minimum, the aging of the global population suggests it is not unreasonable to think this is at least reasonably likely outcome at some point in the future."
- Source: Bank of America Merrill Lynch.
No offense to Bank of America Merrill Lynch, but the title they used has not been authored by Dr. Joseph Coughlin of the MIT AgeLab, but by August Comte, a French sociologist (1798-1857).
You probably understand by now, our inclination towards long-dated US Treasuries. At the end of the day, if central banks cannot generate "Unobtainium" in the form of "renewed" inflations, what is not to like in the "carry play" offered in the long part of the US Treasury curve? We wonder.
"Low interest rates are usually attributed to low inflation, weak economic growth and super easy monetary policy. But there's another deep-seated factor that doesn't get much attention: demographics."
- Greg Ip, Canadian journalist