Lower Rates ?

December 10th, 2015 9:41 am | by John Jansen |

Steven King is chief economist for HSBC (which has a line on my resume) and he has an op ed in the FT. He expects that by year end 2016 we will be staring at a 1.50 10 year note. If that be the case then I suspect that the Long Bond will be kissing the 2 percent level.

Via the FT:

Time for something different?

Lower not higher. Our forecasts of 1.5 per cent and 0.2 per cent for 10-year Treasury and Bund yields, respectively, by the end of 2016 reflect a world fraught with risk and economies still struggling to recover, burdened by previous excesses.

A US Federal Reserve tightening this month is now widely anticipated, but we are already looking beyond that. What if the first hike — and any subsequent ones — don’t stick? Why does consensus thinking expect a conventional outcome from unconventional policy? Some scenarios could see the Fed pause or even reverse course, as many other central banks have been forced to do since the financial crisis.

We are forecasting lower US and G4 bond yields, when most other analysts are forecasting higher ones, because we think there is now likely to be a non-conventional tightening of monetary policy to match the unconventional loosening of recent years. Almost by definition, history can be no guide to the future here.

In any case, flatter yield curves reflecting declining inflation expectations and weaker forward-looking data suggest the policy measures already implemented are not working. US monetary conditions have tightened via a strengthening dollar, high real rates and wider credit spreads. Just about every other major central bank remains in easing mode. This not only constrains how much US yields can rise, it might well pull them lower.

So what would happen if, faced with another downturn, US policy has to be eased again? Here are five plausible policy scenarios:

First, more quantitative easing. Given the fact that successive rounds of asset buying have been increasingly ineffective at achieving their desired aims, we wonder whether “quantitative exhaustion” is now a better term.

Perhaps the policy has had its day. The Fed and BoE have long since ended their QE programmes.

Other central banks — the Swiss National Bank for one — could testify that there are practical limits to how many bonds can be bought. If QE is ever to meet its objective, bond curves should be steepening, reflecting stronger growth and higher inflation expectations. Experience from various programmes shows steepening is what happens mainly in anticipation, or in the early stages.

Second, negative rates. Since the start of the financial crisis, real rates have often been negative in the developed world. Now we are seeing how far nominal rates can go below zero. Switzerland and Denmark already have rates significantly further through zero than the ECB. All else equal, this should drive yield curves steeper, but we can see from the eurozone, where both negative rates and QE are being deployed, that the steepening pivots on the five-year maturity.

Third, looser fiscal policy. Canada, Japan and China are all shifting towards looser fiscal policy. Unconstrained, many eurozone countries would loosen more (and some are failing to meet budget deficit targets). Recent geopolitical developments, including migration and counter-terrorism measures, are likely to result in more spending than originally budgeted.

Even though high indebtedness limits the scope for manoeuvre, in a crisis fiscal constraints will be tested. Increased government supply traditionally leads to a steeper yield curve, reflecting increased issuance.

Fourth, helicopter money, newly created by the central bank and given to households and corporates. In its most extreme form this would differ from QE because it would involve a permanent increase in the money stock but without asset purchases.

Under QE, central bank reserves are swapped for bonds while with some of the extreme versions of helicopter money, the amount of money in circulation increases without more government debt. Such a policy experiment would be risky. This alone tells you why it is the least likely option.

Fifth is policy paralysis, reflecting policymakers’ inability or unwillingness to try something new when existing policies are not working. Arguably this is what we might have right now. The flatter US yield curve is the clearest sign that we are closer to policy paralysis than governments and central banks would like to admit.

In four of the five policy scenarios we would expect lower yields and steeper curves. These help explain our forecasts, which reflect a far from conventional outcome.

Steven Major is global head of fixed income research at HSBC

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