Monday, 24 September 2018

Treasuries: Joy, woe or head fake?

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The price of money is going up, but it’s difficult to know if this signals a return to normality, a step down inflation’s slippery slope or just a cunning head fake.

James Saft, Reuters Columnist

Yields on 10-year U.S. Treasuries hit 2.38% on Monday, the latest leg in a move that’s taken the borrowing rate up by nearly 25% in just three weeks.

The yield on 10-year Treasuries is perhaps the world’s most important financial indicator. Besides representing the cost of money for the US government, it helps to set the price of money for all borrowers in dollars, and for many world-wide.

There are, broadly, two leading explanations for the move. The first, and most-straightforward, is that yields are rising because investors are seeing something like a sustainable recovery take hold. Interest rates, on this theory, have been exceptionally low and are now moving up to reflect a more normal outlook for growth, and by extension, for inflation.

This argument has the great advantage of being simple, and is also supported by a generally positive run of US economic data in recent weeks. Employment and manufacturing are looking better than they were just months ago and even bank lending is on a decidedly upward slope.

The market for bonds that pay out based on inflation is still forecasting price rises of just 2.17% annually over the next five years. That’s a big rise on the 1.63% expected in early January but hardly runaway inflation.

The second thesis is that investors, having bemoaned the lack of growth for years, are becoming just a little bit spooked about the inflation that will inevitably accompany it. The Federal Reserve, Bank of England and European Central Bank are all being exceptionally loose in historical terms, having created money and suppressed long-term interest rates through a variety of rarely used and little-understood measures.

“The three central banks in question all have a clear and visible inflationary bias” writes Ben Lord of M&G Investments in London. “They would rather have inflation than deflation (rightly). But now they are showing a propensity to favour above-target inflation over below-target inflation. This is tantamount to a (temporary or permanent, we do not yet know) change in the inflation targets. And this must, in my opinion, see higher inflation risk premia.”

Even if the Fed has been successful in engendering a recovery, it still faces a difficult task in successfully normalising monetary policy without losing control of inflation. The Thomson Reuters/University of Michigan’s survey of one-year inflation expectations showed a jump on Friday to 4.0% from 3.3% last month. This may be a knee-jerk reaction to higher gasoline prices, but it is a notable jump nonetheless.

Fun house investing

Indeed, despite the sell-off and the data, New York Federal Reserve chief William Dudley, a good bellwether for the Bernanke-led consensus at the central bank, was stressing caution about the outlook in a speech on Monday. Dudley noted that dropping labour force participation was partly behind improving labour data and that business inventory building that helped growth at the end of 2011 may imply a drag on growth in early 2012 as those inventories are sold down.

This is the third real possibility: The run-up in yields is really a head fake, a precursor to a growth bust this year similar to that of 2011. This view is predicated on belief that government spending will likely be a drag on growth this year, as will the consumer’s continued preference for paying back housing debt.

The truth is that any analysis of the economies past, present or future is made far more complex by the uncertainty around monetary policy. That is a huge irony, given the Fed has taken extreme steps to convince the market it will keep rates low for a long time.

The uncertainty isn’t just about what the Fed will do, though it is obvious people no longer firmly believe rates will stay low until 2014. It is about the widely dispersed range of outcomes and the deep uncertainties about extending, retaining or retracting tools like quantitative easing.

Investors, or more broadly people allocating capital, are in a wilderness of mirrors, one in which things can easily turn out to be exactly what they seem, or just the opposite.

Yet despite this, equity markets are booming, volatility in financial markets is at multi-decade lows and even bond markets are asking for only a tiny amount of extra money in compensation for all this uncertainty.

Investors seem to be assuming they aren’t in a wilderness, but on a fun house ride, one controlled by the authorities and from which they will emerge blinking in the sunlight.

(James Saft is a Reuters columnist. The opinions expressed are his own)

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