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STRATEGY Higher interest rates could be great news Interview with Philippe Weber, co-head of Strategy at CPR AM Philippe Weber Since last summer, interest rates have begun to rise, albeit moderately, especially in the US. Why? They have indeed. Since 1 July of last year, yields on 10-year government bonds have risen by almost one percentage point in the United States and by almost half a percentage point in Germany. In the US yields have risen on all maturities. The trend has not been steady – after inching up during the summer, yields accelerated significantly with the election of Donald Trump. Things have stabilised somewhat over the past few months except for the shortest maturities – we’ll get back to those later. There are many reasons that yields have risen, but all can be summed up in one word: normalisation. Normalisation of growth, normalisation of inflation, and normalisation of monetary policy – all three being intertwined. 10-year government bond yields US Euro zone Germany All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be considered as having any contractual value. US yields 30Y 10Y 5Y 2Y 3M Almost eight years after the end of the recession, why are we only now talking about normalisation? Of course, the US has been expanding constantly since summer 2009. But the shock was such that both labour and equipment were heavily underemployed. Nowadays, the economy is no longer heavily into capacity under-utilisation. For example, the unemployment rate has returned to pre-recession levels, including in its broader measure (which includes, for example, forced part-time work). Yes, the workforce participation rate (i.e., the number of persons having, or seeking, a job compared to the population of persons older than 16) has not returned to its previous level, but a significant portion of the difference is due to natural attrition from the ageing of the population. As for equipment, the capacity utilisation rate has levelled off, albeit at a level lower than before the recession. But, all in all, the output gap, i.e., the difference between actual and potential production, has almost completely closed up very recently after exceeding 4% in 2009. United States Output gap Last 12-months inflation (right-hand scale) All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be considered as having any contractual value. The output gap cannot be observed. It can only be estimated through a set of assumptions and complex statistical methods but the various estimates do converge, and this is an important indicator. It is usually a good leading indicator of inflation and, moreover, is used in forming most monetary policy rules, like the Taylor rule. So, since you brought it up, is inflation moving back to normal? Yes, it is. We had the feeling it was for several months, and today this is definitely the case. All indicators are up, including the total consumer price index, the index ex-food and ex-energy, the PCE deflator (which is the Federal Reserve’s official objective) – all are accelerating. Some regional Feds use alternative measures of core inflation, for example, median inflation and, there again, the acceleration is clear. And this is not due just to a basis of comparison, i.e., the purely arithmetic outcome of the fall in energy prices one year ago. The acceleration has been even stronger over the past three months and neither energy prices nor what happened one year ago have much to do with it. The Fed has therefore achieved its dual mandate (full employment and 2% inflation, to sum up), and it has begun to raise rates. Here again, this is a mere normalisation and even the start of normalisation. The key rate is still very low, and the pace of tightening is extremely cautious and is being flagged as clearly as possible. We are likely to have at least two more rate hikes this year and, in my view, even three. So long bond yields were reacting to this key rate hike? Yes, but not just to that. Long bond yields were reacting to flat growth, to the return of inflation to 2% (all other things being equal, rates rise with inflation) and also to expectations – expectations of heavy fiscal deficits, of greater growth, and perhaps even of more inflation when protectionist measures when Trump was elected. And also expectations of coming rate hikes. But the Fed had flagged the March rate hike, for example, so abundantly that the actual decision had no significant impact on long bond yields. Lastly, the fact that the Fed is no longer buying up government paper and has even begun to shrink its balance sheet, is no longer a factor in long bond yields, as it was in recent years. Should we be happy or worried about these higher yields? As thing now stand, happy. Happy, first of all, for what they stand for – the return to normal. And it was about time, 10 years after the recession began! But happy, also for the rates themselves. For one thing, low rates were, paradoxically, not a good thing for the banking system. Moreover, while lending rates are higher, the remuneration of savings is also higher, and this penalises households less. Lastly, and most of all, higher rates and a more pronounced hierarchy between maturities and between borrowers will limit the risk of credit bubbles or asset price distortions. Obviously, at the same time, a rate increase, all other factors being equal, could slow credit distribution and, hence ultimately, economic activity. We’re far from that point, and, incidentally, a return to excess debt is not something to be desired at a time when we are just emerging from the worst debt crisis in 80 years. As for the equity markets, empirical research by CPR AM, which is corroborated by various broker publications, suggest that, below 3.5% and even 4%, they don’t react to shifts in interest rates. Will interest rates continue moving up? Probably so. Economic growth is likely to at least stabilise at its current pace or even accelerate if all or some Mr. Trump’s fiscal policies are implemented. True, we aren’t forecasting an explosion in inflation, but it is likely to level off a little higher than 2%. With this in mind, the Fed is likely to continue raising its Fed Funds target rate gradually, and this will drive long bond yields higher. All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be considered as having any contractual value. Will we move back to pre-recession interest rates? Probably not, at least in the short term. The Federal Reserve has analysed this issue in-depth, particularly to justify its cautious stance on raising key rates. According to the Fed, but also according to many analysts, academics, and economists, in the private or public sector, what we call the neutral, or natural rate of interest has fallen considerably. One definition of the neutral rate is the rate that, in the midst of full employment, keeps inflation stable. And many factors have brought it down. In normal times, it is the same as nominal growth – to simply things to an extreme, this correlation may be due to a constant trade-off between investments in bonds and investments in the real economy. Unfortunately, nominal growth has slowed. Real growth is weaker as the working population is expanding more slowly, and labour productivity is now rising very slowly, and this is not being offset by moderate inflation. This alone justifies a reduction in the equilibrium rate, but there are many other factors that are lowering it further. Here are some of them. Interest rates are the result of a faceoff between desired savings and desired investment. And we are now seeing an increase in savings worldwide, including precautionary savings due to economic uncertainty, savings due to the ageing of the population, and savings resulting from increased inequality, as the rich save more than the poor. Moreover, many investors have switched to assets deemed less risky, including US, German or Japanese government bonds, which is driving their yields down even further. And, lastly, in an environment where there are no fears of an outright inflationary surge beyond the ongoing normalisation, a saver will accept a lower remuneration than he used to, as his investment will be less risky. We have just seen that desired savings had increased but, at the same time, investment is lower than it used to be. The slowdown in potential growth mentioned above has limited the prospects for companies and, hence, their investment needs (hence, a vicious cycle – less investment and, hence, less productivity and less growth). Prices of capital goods have declined – a computer costs less today than it did 10 years ago and less than a machine tool. Fiscal austerity in many countries has caused public investment to decline and there are areas in which the private sector will never invest. Lastly, companies are paying out proportionally higher dividends than they used to, which, all other things being equal, limits investment. So we can see that interest rates – both short-term and long-term – will not move back up to their precrisis level. Potential growth and long bond yields Potential nominal growth 10-year yields All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be considered as having any contractual value. Nominal growth and Fed Funds target rate Nominal growth (18-month lag) Fed Funds target rate That doesn’t sound very encouraging… Unless… unless, if the economy does it part and precautionary savings decline. If surplus-carrying countries, China and Germany in particular, put through stimulus plans. If investment rises, in which case productivity will, as well. And productivity can also come from better education and better training, and technical progress. If interest rates were to rise for those reasons, then that would be great news! Written on 31 March 2017 Information: All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be considered as having any contractual value. This document has not been drafted in compliance with the regulatory requirements aiming at promoting the independence of financial analysis or investment research. CPRAM is therefore not bound by the prohibition to conclude transactions of the financial instruments mentioned in this document. Any projections, valuations and statistical analyses herein are provided to assist the recipient in the evaluation of the matters described herein. Such projections, valuations and analyses may be based on subjective assessments and assumptions and may use one among alternative methodologies that produce different results. Accordingly, such projections, valuations and statistical analyses should not be viewed as facts and should not be relied upon as an accurate prediction of future events. About CPR Asset Management: CPR AM is an investment management company certified by the French Financial Markets Authority, an autonomous and wholly owned subsidiary of Amundi Group. CPR AM works exclusively in third-party investment management (for institutional, corporate, insurance, private banking, fund management, and wealth management clients). CPR AM covers the main asset classes, including equities, convertibles, diversified investments, interest rates and credit). CPR AM in figures (End-December 2016) - €39.2 billion in AuM - More than 100 employees, more than one third of whom are involved in investment management. CPR ASSET MANAGEMENT, limited company with a capital of € 53 445 705 - Portfolio management company authorised by the AMF n° GP 01-056 - 90 boulevard Pasteur, 75015 Paris - France – 399 392 141 RCS Paris. cpr-am.com @CPR _AM cpr-asset-management All comments and analyses reflect CPR AM’s view of market conditions and its evolution, according to information known at the time. As a result of the simplified nature of the information contained in this document, that information is necessarily partial and incomplete and shall not be considered as having any contractual value.