Time for bonds to move
Imagine for a moment the electric atmosphere of an active Eurodollar futures pit at the Chicago Mercantile Exchange. The date is March 29, 2015 and the time is 12:45 Central and in 15 minutes the Federal Reserve will, in all probability, announce no change in its policy stance. You’re an independent trader making a living by taking a position in three-month Eurodollar futures contracts. The pit has not been active for some time, but traders in person and online all know the day of reckoning is nigh and the Fed will very likely pull the trigger on rates at some point in 2015.
You, like many investors, still believe that the Fed is most likely to make its first move at the June meeting and the data really hasn’t changed all that much so far this year. Having thrived on taking risk throughout your career, you’re long Eurodollar futures heading into the announcement. The position you bought several days ago has, however, turned against you since the moment your order was filled.
And now as the seconds drag into the announcement, your mind is churning and your mettle is being tested. Bond prices have slumped since the February nonfarm payroll reading beat expectations and yields have climbed. You thought you’d catch the falling knife with Eurodollars as implied rates began to price in a premature and now dramatic rise in yields. However, that position suddenly doesn’t look so good and your intention to hold on through the announcement is wavering as the gravity of losses starts to take its toll. At this moment you’d be happy to settle for the smaller loss facing you at the previous night’s close.
Sadly, the above vignette may become a major theme throughout 2015. If my expectations are correct, fixed income traders around the world are likely to become scared of their own shadows as the sun sets on the Fed’s ultra-easy monetary policy. In December Fed Vice Chairman Stanley Fischer noted, “We can’t give precise estimates of dates we don’t know.” Asked whether officials will drop a pledge to keep rates low for a “considerable time,” Fischer said, “It’s clear we were closer to getting rid of that than we were a few months ago.”
The year 2014 proved to be a learning experience for Wall Street analysts who incorrectly projected a return of inflation last year that they thought would prompt the Fed to tighten monetary policy. Rather than watching yields end the year higher, as predicted by the Bloomberg consensus poll of economists a year ago, yields fell across the maturity spectrum (see “Bond bull won’t die,” below).
The yield curve failed to react last year as was widely anticipated as investors had to reshape their expectations for the timing of the so-called lift-off in Fed policy. But the dramatic shift in the shape of the yield curve also speaks volumes about morphing expectations over the extent of monetary tightening. A year ago, money market traders were 20-basis points (bps) too cautious over where three-month cash would settle as 2014 drew to a close. But they were 38 bps too cautious about the cost of short-term borrowing for yearend 2015. Through the end of November, bond traders had shaved 86 bps off the yield on the benchmark 10-year Treasury note. But they had slashed 108 bps in yield off the U.S. long bond as the maturity curve flattened in response to unfolding economic data.
Perhaps legitimately, the only point on the yield curve to show an increase during 2014 was the policy-sensitive two-year maturity, which rose throughout the year by 9 bps to 0.56%. Given the well-flagged intentions at the Fed to raise interest rates in response to a reduction in unemployment, the rise in the two-year cost of borrowing is entirely palatable.
If the Federal Reserve raises its short-term cost of borrowing as widely predicted in June 2015, it will be the first increase in nine years. Kids entering fourth grade this fall have never heard their parents talk about higher mortgage costs associated with a tightening of monetary policy—something that for years had been routine. Since the turn of the century the Fed had lifted its short-term interest rate on 20 occasions until mid-2006.
A year ago, as the Fed started to taper its bond-purchase program, most investors failed to separate the end of quantitative easing from the timing of the first increase in the fed funds rate. As the year progressed and the economy failed to accelerate, the Fed was able to reaffirm its message that policy would remain ultra-easy for some considerable time after it finished its bond purchases in the context of stable inflation.
But as the year wore on it became apparent that the U.S. economy was not operating in a vacuum and that investors had overestimated the threat of price pressures. The Japanese economy required more medicine from the Bank of Japan. The Chinese economy slowed sparking a wave of stimulus measures, culminating in the first interest rate reduction by the Peoples’ Bank in more than two years. Price pressures stuttered in the Eurozone after the West launched a series of trade sanctions against the Russian economy in response to the downing of a Malaysian airliner and aggressive military actions in Ukraine. The world economy was starting to show stress at the seams and capitulated with a 10% correction for U.S. stocks and a “flash-crash” for bond prices sending the 10-year U.S. yield plunging to 1.87%.
The subsequent relief rally for stocks has, nevertheless, left its scar on investors’ mindsets, reminding them that the threat of economic slowdown and the difficulties cast by deflationary tendencies is likely to shape the prospects for U.S. monetary policy in the next 12 months.
“Eurozone yields decline,” (below) illustrates how Mario Draghi at the helm of the European Central Bank has revived confidence in the region’s government bonds. Spanish 10-year yields have crashed from 5% at the start of 2014 to below that on the comparable U.S. 10-year note. The trend lower across the European continent has left investors conflicted, not knowing for sure whether to trust their judgment on the certainty that 2015 will be the year the Fed moves, or whether the U.S. curve will be dragged lower as global yields contemplate more quantitative easing and a moribund outlook for inflation. Of course the fourth-quarter slide in global energy costs is also likely to affect consumer prices.
U.S. interest rates are likely to suffer from opposing forces of Fed action and global economic inaction. The real fun will begin when the Fed starts its northward march, having telegraphed its technical market operations well in advance. The quarterly Summary of Projections will be updated in March and Fed Chair Yellen will have a platform to shape rate expectations. The best time to do so would be at the next quarterly meeting in June, at which point Yellen can fully explain the Fed’s statement and change in policy.
What everyone will want to know is the frequency of future policy adjustments and the ultimate stopping point. According to the September SEP (the latest available) 14 of the 17 FOMC members see 2015 as the appropriate time to start policy firming. Ten members project the fed funds rate will end this year between 1-2%. In the following year, all but three members project the appropriate rate will climb into a window of 2 to 4%.
The disconnect in these projections is the implicit assumption that when monetary policy adjustment starts, it will mark a return to normal for the U.S. economy and be accompanied by firmer inflation. The individual members of the Fed, in that respect, are as guilty as economists in making assumptions about the return to normalcy for the global economy. One might hope that they are using the SEP as a policy tool to illustrate how expectations can be massaged lower as data demands.
The financial crisis decimated demand for housing and automobiles. Banks stopped lending as the housing bubble that was brewing for several years, burst. The collapse in housing created a ripple effect causing consumers to pull in their horns as unemployment rose. Consumers continued to service auto loans because they needed to commute to work and were more likely to default on an overpriced housing liability.
In each of the nine-years prior to the last interest rate increase from the Fed, total U.S. auto sales averaged 16.73 million units. Sales fell to barely above nine million units in 2009 and for the two-year period ending 2010 recorded an annualized pace of merely 10.97 million units. The latest report shows sales running at 17.3 million. Low interest rates and a recovering labor market were critical in the auto-market recovery.
Existing home sales are still running at a fraction of the peak pace achieved in 2005. Mortgages remain hard-to-get for many consumers while home values continue to appreciate. Despite significantly lower borrowing costs since the credit crisis hit, the pace of sales has not increased. The lower level of interest rates has helped the housing market recover but tougher lending standards have meant a full recovery remains incomplete. Meanwhile, neither rising home prices nor higher borrowing costs will sit well with the housing market (see “Better but not best,” below).
In essence the Fed appears to be somewhat snared by ultra-low interest rates, although many will disagree. Some state that the central bank is already behind the curve, arguing that the longer it waits to “normalize” rates, the harder it will become to achieve. It is easy to state that the Fed should just get on with its job and raise rates, but that overlooks the impact of its action. The Fed could be accused of trying to push on a shoestring when it does eventually start its uncomfortable task.
The protracted low level of interest rates is unprecedented in modern-day U.S. monetary policy. Interest rates have conventionally been used to influence consumer demand by changing the cost of borrowing. Rates in part are set with respect to actual inflation and the expected pace of inflation. The extremely well-behaved level of the consumer price index is a good reason to leave policy alone. Indeed, should the flat line depicting the fed funds rate start its rise, the outlook for inflation will likely improve (i.e., decline) because the real economy may start to show signs of slowing (see “Low rates, low inflation,” below). The Fed needs a good argument for reinstating its policy setting at an inflation-plus level and its success will be judged by doing so without interrupting the economy.
An argument could be made for doing so after inflation has taken grip because it is easier to stamp out price pressures with interest rates. Premature tightening could cause the economy to teeter, leading to the specter of deflation bearing all sorts of threats to consumer and business behavior. Just look at Japan.
The Eurodollar trader in the Chicago pit might be better off, or at least stand a greater chance of remaining sane for longer, by trading the curve using calendar spreads in 2015. What matters not is our opinion about the odds of the start of policy tightening this year, but an understanding that markets are prone to panic. Take for instance the bond flash-crash in November that drove the 10-year to its lowest level in many years (see “Don’t panic,” below). No one set off at the beginning of last year expecting a recession and further unconventional easing. However, in the few days surrounding the stock market correction, that prospect seemed very real in a way that had talking TV heads asking whether price action demanded it.