HSBC HAS JUST published a fascinating piece of research, the crux of which is the forecast that global interest rates will remain low for at least the next five years. I’ve heard of long-range weather forecasts (which are notoriously unreliable, global warming excepted) but the idea of a five-year forecast is entirely new to me.
My gut feeling is to place such a financial forecast in the same bucket as its climate-focused peer. I simply don’t believe anyone can know how the weather will be in Skegness or Pattaya in five years’ time, however diligent the underlying research work may be.
Mind you, HSBC’s research and diagnostic skills are formidable and the whole piece is terribly convincing, based as it is on the failure of inflation to re-emerge despite all the central bank tolls thrown in its direction.
One core recommendation is to play the swaptions market in dollars and receive five-year fixed in five years’ time. While that particular derivative rate is notoriously volatile and has long been favoured by proprietary swap desks looking to book a quick turn, the logic which produces that tenor is the idea that rates will remain low for five years – at least.
Well, that’s a nice piece of housekeeping, but in my experience most punters put that trade on with a time horizon of around three months maximum given its tendency to the roller-coaster volatility ride. The research team’s stringency is admirable but I’m not sure we need chapter and verse regarding matching maturity in the “real world” to validate the trading call.
You can see where HSBC is coming from though. Forward-starting five-year US dollar swaps earn you a handy net present value of 169bp at last week’s rates, while spot is at just 114bp. Enter spot in the euro and Japanese swap markets and you earn minus 16bp and 10bp respectively and a relatively parsimonious 65bp and 20bp at the five-year rate in five years’ time.
Honestly, I’d rather own 30-year Treasuries and pick up some accrued interest along the way in case the trade goes wrong and I’m suddenly forced to reverse at a huge loss. In any case the argument for forward-start swaps is the same as for owning long duration bonds. Neither will go well if the market turns and the vicious yield reversal so many have waited so long for actually happens.
I predicted the spread of negative yields as far afield as Asia in this column a few months back and I haven’t yet revised this view, barring the victory of Donald Trump in the US presidential elections. I wouldn’t, however, extend that prediction as far out as five years. Not because of Skegness-weather kind of thinking, but because it strikes me the risk of inflation appearing at some point during that timeline is relatively high.
THE WORLD WANTS, and indeed needs, the return of inflation to deflate the value of its unprecedented debt pile. But it refuses to appear in the big economies. Except one: the United Kingdom. It hasn’t happened yet, but it will, thanks to the precipitous collapse of the pound as a result of the Brexit vote. Import costs will rise and be passed on in the form of a higher CPI.
Glimmerings of that surfaced in somewhat farcical form last week when Unilever, the producer of the British people’s favourite eccentric dietary staple – Marmite – attempted to slap a 10% increase on the price of that glutinous spread to supermarket chain Tesco. This despite scant justification of the price hike given Marmite’s domestic-focused supply chain.
Should Britain become a relatively high inflation economy, I suspect the phenomenon could, er, spread.
INDEED, THAT THOUGHT brings me to the most fascinating element of the HSBC research piece: that quantitative easing is fungible to other economies thanks to the mechanism of the basis swap. Easy money conditions in, say, Japan are transmitted to other countries because of a benign basis swap which can make even negatively yielding Japanese bonds look attractive on a swapped basis.
Might not that mechanism be replicated thanks to higher prices in Britain, the world’s sixth-largest economy? The immediate J-curve effect of a weaker sterling will conceal that dynamic, but over time it will kick in.
Indeed it might well be that newly emerging UK inflation will prove to be “fungible” and kick-start a process that no amount of central bank easing has yet been able to achieve. The Gilt markets will of course help to facilitate it as the switch out of pricey sectors of the European government bond market and into UK securities takes effect, raising yields in the process.
Far away, in Asia, something similar may happen in terms of inflationary pressure thanks to competitive currency devaluations versus the renminbi, plus the region’s sharply rising cost of oil imports. That latter factor, which is set to become more burdensome on the back of the region’s failure to invest in oil exploration and production because of the slump in the oil price, may well produce an unforeseen rise in inflation in the coming years in the Asia.
These are what-ifs, but I’d be happy to sell some five-year put options against them. While I, like many readers of this column, have lived through a 30-year bull market in global interest rates thanks to the death of that old bogeyman – inflation – I retain sufficient sensible superstition to imagine it coming back from beyond the grave. Whether he craves Marmite on his return is another matter entirely.
