February Rates Update

Monthly Commentary

March 01, 2016

The Bank of Japan (BoJ)’s adoption of a negative interest rate policy framework to close out January proved to be the kindling U.S. Treasuries needed for another break lower in yields in February as 10y yields traded as low as 1.53%. This move back lower in yield may not have been driven as much by the impact of the rate cut on valuation as much as it was by realization that negative interest rate policy may have more staying power than initially thought. While there are 13 countries with 2y rates trading at richer levels than 2y Japanese Government Bond (JGB)’s, the move to Negative Interest Rate Policy (NIRP) by Japan may have been the most meaningful move since the Swiss National Bank (SNB) was the first major central bank to breach the zero bound in early 2015. By showing financial markets globally they are willing to punish their own population of savers to increase the velocity of money, which has fallen to a 50-year low, yield seekers will have to look elsewhere, similar to the message sent by the SNB. As global yield curves rally into negative territory it is worthwhile to remember that U.S. debt makes up 47% of all outstanding developed market debt that still trades with a positive yield, which makes U.S. Treasuries among the most attractive safe haven debt instruments globally.

As their global counterparts seek to find the limits of expansionary monetary policy, the FOMC spent February backing away from their own tightening bias for the near term. For her part, Chair Janet Yellen gave her Semiannual Monetary Policy Report before both Congress and the Senate early in the month. Though the Chair was noncommittal on the future path of interest rates, she had clearly taken notice of the tightening in financial conditions that had taken place in 2016. Despite her acknowledgement of tighter financial conditions, she explained that she doesn’t see tighter conditions as being persistent but would adjust her growth and inflation outlook if that was indeed the case. Ultimately, the tone and text of the testimony did not show a Fed Chair who was ready to continue on a path to tighter policy; instead she appeared content to wait on economic data to paint a more complete picture.

Notwithstanding Chair Yellen’s lack of clarity regarding the future path of monetary policy, other Fed speakers were more willing to share their views on economic developments of early 2016. The loudest voice came from St. Louis Fed President Bullard, who stated that he regarded it as unwise to continue a normalization strategy in the face of falling inflation expectations. In the past, Bullard has been the FOMC’s resident pragmatist, frequently recognizing the need to adapt his own views to changes in the macro landscape before his FOMC colleagues. Most notably, President Bullard was the first Fed member to utter the phrase QE2, well in advance of the implementation of the policy in the fourth quarter of 2010. Similarly, Vice Chairman Stanley Fischer voiced similar albeit less forceful concerns about potential drags of financial conditions on global growth and inflation in a speech at an energy conference in Houston. To round out the central bank’s market communication for the month, FOMC Governor Brainard spoke on international monetary policy synchronization at a U.S. monetary policy forum in New York. Governor Brainard also broke away from the FOMC’s four hike in 2016 consensus saying, “Although the U.S. real economy has traditionally been seen as more insulated from foreign trade shocks than many smaller economies, the combination of the highly global role of the dollar and U.S. financial markets and the proximity to the zero lower bound may be amplifying spillovers from foreign financial conditions.” This recognition that measures of U.S. economic health do not just manifest themselves in the real economy but in global financial markets is an important development for the Fed who may have been too myopic in their prior assessments of U.S. health. While a strict framework of purely economic indicators may have been sufficient in the past; the relatively newfound connectivity between global central banks and asset markets throughout the risk curve has changed the necessary calculus for setting monetary policy. If the ability to further tighten policy continues to come at the cost of falling asset prices that may push growth and inflation expectations down further still, it seems some FOMC members are now willing to back away from the table.

The FOMC may be backing away from their easing bias at just the right time as the U.S. is now the only G-10 country with a futures curve implying hikes, and not cuts. The unintended consequences of even a mild hiking bias from the FOMC under current conditions could have an outsized impact on the dollar which would hamper growth and inflation readings as U.S. trade becomes less competitive still. It is because of this circular logic that it appears the Fed will be stuck in neutral in the coming months as rate adjustments in either direction may cause more harm than good. Indeed, market pricing did rebound from mid-February lows to end the month implying two thirds of one hike in 2016 tightening and a three in five chance of another the year following. This marks the first time since mid-January that 2016 expectations have surpassed 2017 hiking expectations in terms of quantity of hikes per year.

While February had fewer direct market catalyzing events than January, there is an ongoing, palpable change in sentiment towards central bank policy action. No longer are monetary stimulus measures met with markedly higher equity prices and steeper FI curves, instead further stimulus has generated a risk off feel as of late. The case of the recent BoJ policy action is an instructive example of this paradigm shift. While the policy move by the BoJ should have weakened the currency as dictated by wider interest rate differentials, the yen rallied significantly as market participants were willing to challenge the BoJ’s ability to materially weaken the currency further. Not only does this market rejection of policy action significantly undermine central bank credibility but it also leaves countries with high levels of debt without a way to reduce the debt burden via inflation or growth. Nations like Japan, which has a debt burden in the order of 2.5x GDP, can ill afford to allow falling growth or inflation to increase the debt burden in real terms at this point in the business cycle. If asset markets continue to reject further central bank policy easing, it will rest on their fiscal policy counterparts to shoulder the load. However, expectations should remain tempered in that regard as fiscal policy makers globally have proven unwilling to take the mantle from their monetary policy counterparts.

Source: Bloomberg

Source: JP Morgan

Global 10yr Yields

Source: Bloomberg

Goldman Sachs Financial Conditions Index

Source: Bloomberg

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