We are all Sectoral Stagnationists now

The  decision by the  US Federal Reserve to leave monetary policy unchanged at the recent FOMC meeting was interesting on a number of fronts, including the emphasis given to the global situation in informing  the outcome. OF more significance was the economic forecasts supplied by the 17 Fed members in confirming a trend evident for some time- the US Central Bank, like other policy makers  across the world, has become increasingly gloomy about the medium term outlook for growth, and as a corollary expects interest rates to remain much lower than generally seen in the post-war era. That view has been around markets and academia  for a while but it now seems to have permeated official thinking in a serious way.

Secular Stagnation is the thesis that growth in the medium term  will be weaker than we have become accustomed to, certainly in the developed world and possibly also in many parts of the developing world. Labour force growth has slowed in the West and in some cases is already falling, which reduces potential GDP growth, but a feature of the stagnation view is an emphasis on the savings/ investment balance. Ben Bernanke was one of the more prominent economists drawing attention to global excess savings, which he saw as putting downward pressure on interest rates  and sought to link this to the observed trend decline in longer term bond yields in the US, the closest approximation to a global risk free rate of interest. More recently, others have drawn attention to  investment spending, which is weak by historical standards,  which is put down to a number of factors, including  changing technology ( the capital spending generated by the internet versus railways or electricity for example) or simply a  perceived decline by companies  in profitable investment opportunities. Capital spending by governments, once the mainstay of Keynesian expansionary fiscal policy, has also fallen foul of the new orthodoxy ,  which extolls retrenchment.

The result of this combination of higher savings and lower investment demand is a decline in the equilibrium real rate of interest. Indeed, some argue, like Larry Summers, that the equilibrium  real rate may now be negative. With nominal rates now at the zero bound the only way to get negative real rates is to generate some inflation but so far policy makers have not succeeded in that aim, with inflation closer to zero than to official targets in many economies. Indeed, with deflation in some cases, real rates are positive.

Given that background it is interesting to observe the evolution of the Fed’s thinking over the past few years. The long term rate of  US GDP growth, which used to be thought of as around 2.7%, is now put at only  2% in the latest Fed projections, although that is still  deemed consistent with inflation picking up to the 2% target. The forecast Fed funds rate ( the Dot Plot) in the long term has also fallen, to 3.5% from around 4% a few years ago, which implies a 1.5% equilibrium real Fed Funds rate( 3.5% nominal less 2% inflation).

The Fed’s view on the timing in reaching this target has also changed appreciably; a year ago the median expectation was a  Fed Funds rate of 1.375% by the end of 2015 and that is now 0.375% (with only two meetings remaining this year).  Similarly, the current median expectation for official rates at end-16 is 1.375% against 2.875% twelve months ago. What is also striking is the distribution  of the forecasts for next year, with a range of -0.125% to 2.875%.

Equity markets did not react well to the FOMC leaving rates on hold, which implies that it is  the Fed’s nervousness about the short-term outlook that is dampening investor spirits, offsetting any positives from the absence of tightening. The Fed’s gloomier  longer term  view is  perhaps more significant , however, in that we are all Secular Stagnationists now it would seem.

 

Are current euro sovereign yields irrational?

The Irish Government issued a 15-year bond recently at a yield of 2.49% and the 10-year benchmark is trading at under 1.6%, a far cry from the double digit levels seen in the latter just a few years ago. Sovereign yields across the euro area have plunged of course ; 10-year yields in Italy are down at 2.3%, Spain is trading at 2.1% while Portugal is just over 3%.The perceived risk of default  over the next five years has clearly changed dramatically and judging by Credit Default Spreads is now around 10% for Italy, 17% for Portugal and less than 5% for Ireland.

German yields are lower still and bund yields can be considered the nearest thing to a risk-free rate in the euro area. Consequently, a 10-year bund rate of just 0.8% implies that the market expects short term  euro interest rates to stay low for a long time and then to rise only slowly; the implied 5-year forward yield in five years time is under 1.5%.Interest rates are also extremely low in other currencies but higher than bunds, with the US 10-year yield at 2.34% and the UK  trading at 2.1%. The 5-year forward rates also tell a  very different story- the US implied yield is just over 3% , with the UK at 2.8%.So the bund curve indicates  that investors expect inflation to stay low for a long time and not to threaten the ECB’s 2% target. This , in turn, indicates an expectation that growth will remain weak in Germany, with the prospect of  secular stagnation clearly seen by many investors  as more than just an academic debating point.

That scenario  may or may not materialize but it would appear to be a plausible rationale for the current level of bund yields. The problem is , though, that such a scenario would be very negative for other euro zone economies, particularly those with extremely high debt burdens and needing an internal devaluation to become more competitive within the zone. A prolonged period of very low nominal GDP growth, possibly with price deflation, would severely damage fiscal capacity and via the denominator put further pressure on already stretched debt ratios; Italy’s ratio in q2 of this year  was 134% , for example, with Portugal at 129%.Indeed, Italy’s GDP is already falling steadily and in real terms is back to the level recorded in early 2000.

Buyers of peripheral euro sovereign bonds can point to Draghi’s ‘whatever it takes’ mantra and  it would seem that the market views full-blown QE (i.e. buying sovereign debt)  by the ECB as inevitable and that somehow this will save the day. The Governing Council is clearly split on the issue, however, and some opposed the current plan to buy Asset Backed securities which explains why Draghi is at pains to add the qualification ‘within our mandate’ to his statement that there is unanimous support for additional non-standard policy measures.- clearly some members feel that the ECB could be acting ultra vires. So QE is not inevitable but if it did emerge (through a majority vote perhaps) it is still problematical relative to experience elsewhere. The banking system in Europe  is the main source of credit, unlike the US where the disintermediation of banks is the norm, so QE may not have much impact. Moreover Central banks in the US, the UK and Japan have bought their own sovereign bonds but the ECB has no sovereign bonds to buy- it would have to choose among the sovereign bonds of the 19 member states. How would it proceed if it chose a €1,000bn target- would it buy in proportion to the country weights within the euro area, or target higher yields? The former would imply the purchase of large amounts of  bunds and say only €12bn of Irish bonds. In addition the ECB would be buying at extremely low yields ( elevated prices) so adding a high degree of market risk to the credit risk inherent in QE.

More fundamentally, transferring ownership of some sovereign debt from one group of investors to another (in this case the ECB) does nothing to change the debt burden unless of course one believes that the ECB will effectively tear up the bonds or hold to maturity and then pass the proceeds back to the respective governments. One doubts if that would be acceptable to the Germanic school within the Governing Council, at least on any scale that would make much difference to high debt countries, but such concerns do not seem to weigh much on investors at the moment.