Mind The Rise In The Term Premium!

Introducing the Term Premium

Through the use of economic models, academic research has decomposed the observable long-term bond yields (i.e. US 10Y Treasury bond yield) into the expected path of the real interest rate (r*) and the additional term premium, which is thought as the extra return that investors demand to compensate them for the risk associated with a long-term bond. Using the dominant measure developed by the NY Fed (Adrian et al., 2013), we overlay it with a set of macro and financial variables and look at the pros and cons of a rise in the term premium in the coming months.

Figure 1 shows that the evolution of the US 10Y yield along with the expected r* and the term premium. While we can notice that part of the fall on the 10Y was driven by the decrease in the expected r* from 3.15% to 1.80%, the elevated volatility in the short run was mainly coming from the moves on the Term Premium (TP). The TP hit a historical low of -1.47% on March 9th and is still standing at extreme low level of -1.1%. Many investors had expected the term premium to start rising the US in 2018 and in the first half of 2019, but it surprised most of them by constantly reaching new lows.

Figure 1

fig1Source: NY Fed

Term Premium: a counter-cyclical variable

One important characteristic of the term premium is that it is a counter cyclical variable that tends to rise when the uncertainty around unemployment (or the business cycle) and inflation expectations starts to increase.

Figure 2 (left frame) shows the striking relationship between the unemployment rate and the term premium since 1961. Periods of rising unemployment have been generally associated with a sharp increase in the term premium. Now that we expect the jobless rate to skyrocket following the dismal prints of NFPs and initial claims in recent weeks, could we see a response in the term premium as well?

Figure 2 (right frame) shows another interesting relationship between the US 2Y10Y yield curve and the term premium. We know that the inversion of the yield curve is usually marked by a sharp steepening effect within the next 12 to 24 months as the economy enters a recession. This is referred as a ‘bear steepener’ as the long end of the curve starts rising due to a surge in the term premium. Will the Fed’s emergency measures and QE purchases be enough to deprive the yield curve and term premium from rising significantly in the coming months?

Figure 2

fig2Source: Eikon Reuters

Term Premium vs. inflation expectations

The 2-trillion USD increase in the Fed’s balance sheet as a response of Covid-19 has brought its holding of securities to a new all-time high of $5.85tr. The Fed has recently been buying $625bn of securities each week, which corresponds to an annual pace of $32.5tr and is $25bn more than the entire QE2 run between November 2010 and June 2011. The balance sheet of the Fed is now expected to hit 8 to 9 trillion USD by the end of the year in hopes that it will bring back confidence in the market. Hence, it is fair to raise the following question: will we experience rising inflation in the medium term?

As the term premium is very sensitive to the uncertainty around inflation expectations, it shows an interesting co-movement with the 12-month volatility of the Fed’s balance sheet assets. When interest rates reach the zero bound, central banks run aggressive asset-purchase programs in order to decrease the shadow rate below the neutral rate of interest rate (r*) and stimulate demand and inflation. Figure 3 (left frame) shows that previous periods of rising 12M vol in Fed assets were associated with a short-term increase in the term premium.

Investors could argue that inflation expectations have been falling if we look at the market-based measures – the USD 5Y5Y inflation swap. Figure 3 (right frame) shows that the 5Y5Y inflation swap is currently trading at a historical low of 1.75%, down from nearly 3% in January 2014. However, we previously saw that inflation swaps have been very sensitive to equity and oil prices in the past cycle; in theory, an oil shock should not impact inflation expectations as better monetary policy readjustments from central banks will offset that shock. Hence, these products represent more the demand for inflation hedges (which decreases when energy prices fall), but do not tell us anything about long-term inflation expectations.

Figure 3

fig3Source: Eikon Reuters

Term premium and free-floating bonds

Certainly, moves on the term premium also depends strongly on the amount of free-floating securities in the market. As central banks keep increasing their balance sheet through the purchase of securities such as government bonds, the amount of free-floating bonds have dramatically been reduced in the past cycle. For instance, it was estimated that large asset-purchase programs in the Euro area have decreased the free float of German government bonds from approximately 40% in 2015 to 3% in early 2020 (figure 4, left frame). Figure 4 (right frame) shows how the relationship between the 10Y Bund term premium and the free float flattened in the past few years; low free float is associated with a flat term premium.

In the US, the amount of free float is much higher due to the large quantity of marketable debt securities (USD 16tr) held by the non residents; non-resident holders (NHR) hold nearly 40% of the US debt. Hence, even though the Fed’s aggressive purchases will reduce the free float in the medium term, there is still the risk of a sudden rise in the term premium in the short run as the economy enters a recession.

Figure 4

fig4

Source: Danske, ECB

To conclude, the risk of higher long-term interest rates in the US is still there in the coming months; even though we do expect long-term rates to eventually go to zero, there is still a high probability to see a little short-term surge in the 10Y -plunge in US Treasury prices (TLT), which would significantly steepen the yield curve coinciding with the drastic rise in unemployment.

Great Chart: G10 policy rate vs. World equities

As more and more regions in developed economies have been put under a dramatic total lockdown amid growing concerns over Covid-19, central banks have started to cut rates aggressively in order to avoid a complete market meltdown. We saw in the previous week that both the Fed and the BoE held emergency meetings and cut rates by 50bps, the most since the Great Financial Crisis, benefiting from their positive benchmark interest rate to act faster than the rest of central banks. Economies already experiencing a NIRP policy (i.e. Sweden, Euro area) will probably implement or expand asset-purchase programmes in order to fight against a significant economic shock and therefore implicitly reduce their ‘shadow rate’, a rate first introduced by Fischer Black (1995) that can measure the effects of QE, to lower levels.

However, it is important to note that a significant reduction in benchmark policy rates globally has been associated with sharp equity sell-offs. This chart shows that in the previous two downturns, the GDP-weighted G10 policy rate was cut by approximately 4 percent and coincided with a global equity sell-off of 45% to 55%. Are we set for a similar story in 2020?

Chart. G10 policy rate vs. World equities (source: Eikon Reuters)

fig4

Some Yen Charts…

In the past few months, investors have been questioning the Yen’s status of safe haven as the currency has constantly been depreciating in the past year despite the elevated uncertainty. The first surprising chart is the divergence between USDJPY and Gold prices (in USD terms). Figure 1 (left frame) shows that after co-moving strongly for 7 years, the USDJPY exchange rate decoupled from Gold (in USD terms). While Gold prices have been constantly soaring in the past year, and especially in recent weeks over growing concerns around Covid-19, USDJPY has remained steady oscillating around 109. In addition, we also noticed a significant divergence between USDJPY and US 10Y Treasury yield. Even though currencies have a variety of short-term drivers, the 10Y US-Japan interest rate differential has been one of the popular ones in the past cycle. As long-term interest rates in Japan have been trading around 0 percent in the past few years after the BoJ decided to keep the yield on 10-year Japanese government debt around zero percent, we just look at the US 10Y yield. Interestingly, demand for US Treasuries has been very strong in the past few weeks, leading to a sharp fall in the US 10Y yield to below 1 percent, while the move on the Japanese yen was more moderate (figure 1, right frame). Has the Yen lost his popularity in periods of market stress?

Figure 1

fig1

Source: Eikon Reuters

First of all, even though the US Treasuries have been considered as the ultimate safe haven in the past 30 years, which explain the success of risk parity strategies during that period, the Japanese Yen remains the preferred currencies in the G10 space in periods of elevated price volatility. For instance, figure 2 shows that the Yen tends to appreciates strongly when VIX starts to surge; in the past 30 years, the JPY has averaged 44bps in monthly returns against the USD when the VIX was trading above 20, nearly four times more than the other traditional safe CHF (Swiss Franc).

Figure 2

fig2

Source: Eikon Reuters, RR Calculations

Secondly it is important to know that the Yen is usually sensitive to the dynamics of the stock market and tends to appreciate in periods of equity sell-offs. Figure 3 (left frame) illustrates perfectly this example and shows a great co-movement between our favourite cross AUDJPY (also known as the proxy for carry trade) and the SP500. We can also see the strong relationship between USDJPY and Japanese equities in figure 3 (right frame); a cheaper currency is usually associated with higher equities in Japan (‘Pavlovian’ response).

Figure 3

fig3Source: Eikon Reuters

Hence, we do not think that the Yen has lost its status of safe haven and we saw last week that it has responded pretty well to the global equity sell-off, appreciating by nearly 5 figures against the greenback. In addition, to the exception of the US Dollar, the Yen has been strengthening in the past two years against most of the popular crosses such as EUR, GBP, AUD and CAD. Figure 4 (left frame) shows that the EURJPY and GBPJPY exchange rates have depreciated by 12% and 10%, respectively, since the start of 2018. We can also notice that the AUDJPY exchange rate has been constantly weakening amid elevated uncertainty, pricing in further weakness in global (ex-US) equities (figure 4, right frame). Is the AUDJPY actually right about the ‘fair value’ of equities.

Figure 4

fig4

Source: Eikon Reuters

Figure 5 shows that the USDJPY exchange rate has been also nicely co-moving with the digital safe: Bitcoin. In the past 3 years, strength in the crypto market has been associated with JPY appreciation. Even though the relationship is pretty new, it will be interesting to see if both assets (JPY and Bitcoin) continue to receive support if price volatility remains high.

Don’t lose faith on the Yen, not now!

Figure 5

fig5

Source: Eikon Reuters

Great Chart: CEO confidence vs. consumer sentiment surveys

In the past two years, the elevated economic and political uncertainty in addition to the lagged effect of quantitative tightening have significantly weakened growth expectations and as a consequence increased demand for safe assets such as the US Dollar and US Treasuries. While the situation seems to have improved slightly in the past 6 months on the back of aggressive rate cuts from central banks globally, business surveys are still pricing in further deterioration in the US economy. For instance, the ISM manufacturing PMI hit a low of 47.2 in December 2019, diverging significantly from the 50-percent threshold that separates growth from contraction. CEO confidence also dropped to its lowest level in a decade and is currently pricing a much higher probability of recession than other popular indicators. On the other hand, consumer confidence indicators have remained strong in the US as consumption remains solid (real PCE expenditure has been averaging 2.5% in the past few quarters).

How long can that divergence persist until US consumer sentiment starts to fade away? This great chart shows that the CEO confidence survey has acted as a good 12-month leading indicator of consumer confidence (University of Michigan) since 1980. We can notice that top executives in the US are currently pricing a significant deterioration in consumer sentiment for the next 12 months to come. However, some divergences occurred in the past, particularly in the late 1990s when CEO confidence started to fall drastically in 1998 and 1999, but consumer confidence was constantly rising during that period mainly due to the tremendous rise in equities that was inflating household wealth. Even though we are concerned about the deterioration of those business surveys, we may continue to see a divergence within the next twelve months between business and consumer confidence surveys as equities keep reaching new all-time highs and interest rates remain ‘too low’ relative to the current pace of nominal GDP growth in the US.

Chart. US CEO Confidence (12M Lead) vs. Consumer Confidence (Source: Eikon Reuters)

CEOconf

Great Chart: Gold price vs. Negative-yielding debt

Empirical researchers have demonstrated that gold has had many drivers over the past few decades, but has been mainly influenced by interest rates, inflation trends, the US Dollar, stock prices and central banks reserve policies. Baur and McDermott (2010) also shows that the precious metal plays the of a safe ‘zero-beta’ asset in periods of market stress and equity selloffs. For instance, in the last quarter of 2018, US equities (SP500) fell by 14% while the price of gold in US Dollars was up 7.6%. In the short run, participants usually look at the co-movement between gold price and real interest rate (TIPS) to define a fair value of the precious metal (gold price rises when real yields fall and vice versa).

However, gold has shown a stronger relationship with another variable in recent years: the amount of negative-yielding debt around the world. This chart shows us the striking co-movement between the two times series. After oscillating around USD 8 trillion between the beginning of 2016 and the end of 2018, the amount of negative-yielding debt doubled to nearly USD 17 trillion in the first half of 2019 amid political uncertainty and concerns over global growth, levitating gold prices from $1,280 to $1,525. However, we have noticed that investors’ concern has eased in the past two months, normalising global yields (to the upside), increasing the US 2Y10Y yield curve back to 25bps after turning negative in the end of August, therefore reducing preference for ‘safe’ assets such as bonds. The amount of debt yielding below 0% has dropped significantly since the end of August to USD 11.6 trillion this week, dragging down gold prices to $1,460. We think that market participants have overreacted to the global growth slowdown in the first half of the year and that the rise in leading indicators we have observed in the past three months (i.e. global manufacturing PMI) will continue to push preference for risk-on assets. The amount of negative-yielding debt could easily come back to its 2016-2018 8-trillion-dollar average in the following months, hence emphasising the downward pressure on gold prices. It looks like gold is set to retest the $1,350 – $1,400 support zone in the short run (which used to be its resistance zone before the 2019 rally).

Chart.  Gold price (in USD) vs. amount of negative-yielding debt (tr USD) – Source: Bloomberg, Eikon Reuters.

Gold

 

 

Great Chart: SP500 vs. US Treasuries (Risk Adjusted)

In this chart, we look at the performance of US equities relative to Treasuries over time. As you know, price volatility differs among different asset classes; hence, in order to compare the relative performance of equities versus risk-free securities, we need to vol adjust. Using monthly times series of total returns of the Bloomberg Barclays US Aggregate Bond Index and the SP500 index, we calculate monthly returns of each asset class and then adjust our US Treasuries exposure using the 1-year realised volatility of equities. We also rebalance our portfolio every single month so that the volatility of each asset remains constant.

As you can notice, the SP500 index has lost 65% of its value relative to bonds since January 1974, with a high of 77% reached in the last quarter of 2010. Moreover, in the past two economic downturns, equities have lost 20% of their values between 1999 and 2002 and 12% of their value between 2007 and 2009. We saw last year that US 10Y nominal yield topped at 3.25% and struggled to break higher despite a nominal growth close to 6% in the United States. With yield plummeting to 2% in the past 6 months, the bond market is currently pricing in a sharp deceleration of economic activity and some practitioners are expecting rates to fall to zero percent as fear over a 2020 recession have increased dramatically. This raises the following question: should we expect Treasury bonds to significantly outperform US equities once again in the next economic downturn?

Chart. SP500 vs. US Treasuries – Total Return. Source: Bloomberg, Eikon Reuters

Great Chart: US Yield Curves: 5Y30Y vs. 3M10Y

On Friday (March 22nd), the disappointing German PMIs led to little sell-off in global equities and a rise in risk-off assets such as government bonds and safe-haven currencies (i.e. JPY, CHF). For the past month, we have been warning that the elevated uncertainty in addition to the low level of global yields were challenging the healthiness of the equity recovery since the beginning of the year. Moreover, fundamentals have been fairly weak overall (in the US, China and even in the Euro area), with leading economic indicators diverging from equities’ performance. For instance, many indicators have been pricing in a slowdown in the US economic activity, however the SP500 index is up approximately 14 percent year-to-date and trading 100pts short from its all-time highs reached in the end of September last year.

With the German 10Y yield falling in the negative territory, the amount of debt trading below 0 percent reached $10tr, up $2tr since the beginning of the year. In addition, the divergence between the 3M10Y and 5Y30Y yield curved have continued; while the 3M10Y turned negative (gaining all the market’s attention), the 5Y30Y has been trending higher in recent months, up 40bps to 66bps in the past 6 months. In this great chart, we can notice an interesting observation: each time the 5Y30Y has started to steepen before the end of the economic cycle, the 3M10Y followed the move 6 months later. We know that the critical moment of the business cycle is when the yield curve is starting to steepen dramatically. Hence, should we worry about the steepening of the 5Y30Y?

Chart. 3M10Y vs. 5Y30Y (6M Lead) – Source: Eikon Reuters

US yield

Why have reserves fallen so dramatically since 2014?

The introduction of QE in order to re-instaure financial stability first and then bring back appetite for risky assets has led to an incredible expansion of the central banks’ balance sheet. For instance, the Fed’s total assets increased from roughly $900bn in the summer of 2008 to $4.5tr in 2015 after several rounds of monetary stimulus (see recap of QE history here). The purchase of those financial securities (Treasuries and MBS) through commercial banks led to a significant increase in reserves held at the Fed, which soared from a negligible amount prior the crisis to a high of $2.8tr in August 2014.

Then in October 2017, the Fed began Quantitative Tightening (QT), which consists in unwinding those massive portfolios and normalizing monetary policy. Since then, the Fed’s total assets balance has declined by roughly $500bn to $4tr, of which $2.2tr of Treasuries and $1.6tr of MBS. However, on the liability side, we noticed a strong reduction of reserves by approximately $1.2tr since their highs (current reserve balances of $1.6tr). Why have reserves fallen so dramatically since 2014?

The chart on the left shows the different components of the Fed’s balance sheet liabilities. While the excess reserves are down by $1.2tr, the currency in circulation and the Treasury balances have increased by $423bn and $291bn, respectively. The other smaller liabilities are foreign currency holdings and the reverse repurchase agreements (reverse repos, RRPs), which are roughly flat since 2014. Therefore, the increase in currency outstanding and Treasury balances accounted for $714bn, which confirms that the remainder is associated with the shrinkage of the Fed’s asset holdings (i.e. $500bn).

Reverse repos and Monetary Base

Even though the dollar amount of reverse repos is roughly at the same level where it was in 2014 (USD 250bn), an interesting observation arises when we look at the times series of the monetary base and reverse repos (figure 1, right frame). The monetary base, which is the sum of the currency in circulation and reserve balances, fell from $4.1tr in August 2014 to $3.4tr in January 2017 although the Fed had not started its QT process (assets were steady at $4.5tr). The fall in reserves was partly offset by an increase in reverse repos, which soared from $230bn to $520bn during the same period. This means that the Fed was already tightening its monetary policy back then by draining the banking system of the reserves it had created. The monetary base was reduced as the Fed was lending out its bonds in exchange for the reserves that the bond purchases created (transactions called reverse repos). Banks reserves are therefore temporarily reduced, replaced by ‘reverse repurchase agreements’.

Figure 1. Fed liabilities, monetary base and reverse repos (Source: FRED)

Repo Fed

Phillips Curve and Wage Inflation Dynamics

Abstract: Debates around the Phillips curve, a long-time relationship between unemployment and wage inflation, have been haunting both academics and practitioners over the past few years. Despite unemployment rate at its lowest level in decades, wage growth has been weak in most of the developed countries. There can be various factors that may be playing a part, ranging from a collapse in the rate of union membership for private-sector employees to a higher concentration of large firms (employers have become monopsonists, impacting level of wages). Therefore, in this article, we review the development of the Phillips Curves in the major development economies and look at the short-run and long-run determinants of wage inflation according to recent empirical research.

PDF Link ===> 

Great Chart: USD REER vs. VEU/SPY

An interesting observation arises when we plot the annual change in the US Dollar with the relative performance of US vs. World (ex-US) equities. As you can notice it in the chart, the World (ex-US) equity market tends to outperform the US market when the US Dollar is weakening. For instance, the US Dollar (USD REER) performance in 2018 led to  an outperformance of US equites (SPY) over World (VEU) up to 20% before the last quarter.

In addition, this chart shows that the annual change in the USD tends to mean revert over time, fluctuating between -10 and +10 percent. Hence, investors could not only benefit from playing the range on the greenback, but also speculate on equity relative performance between US and non-US stocks. As we expect the US Dollar to weaken through the course of the year, this could lead to a significant performance of the world (ex-US) equities. A weaker USD also eases the pressure in the EM corporate bond market, which is heavily USD-denominated, and therefore loosens financial conditions.

Chart. USD REER vs. US / World (ex-US) equities – YoY Change