Download The Central Bank Cycling Race (and Long-End Yield

September 30, 2014
Brian Smith
Vice President
U.S. Fixed Income
Viewpoints
The Central Bank Cycling Race (and Long-End Yield Implications)
“I want to ride my bicycle / I want to ride it where I like.” – Queen
Morgan Stanley economists Joachim Fels and Manoj Pradhan recently revisited their analogy of global central banking to a cycling race,
where riding in isolation is significantly more difficult than riding in a pack (or peloton). A peloton defers wind resistance and therefore
makes the ride easier. In macroeconomics parlance, wind resistance takes the form of currency appreciation. Any rider that tries to break
from the pack faces increased drag, which makes it extremely difficult to achieve meaningful separation.
The global central banking peloton is currently led by the big 3 — the U.S. Federal Reserve (Yellen), the European Central Bank (Draghi)
and the Bank of Japan (Kuroda). The inability of this peloton to achieve its usual speed (economic growth rate), has resulted in the
riders staying very close together (global short-term yields at the zero lower bound). Yet, while Mr. Draghi and Mr. Kuroda look to keep
drifting and recovering strength (further quantitative easing), Mrs. Yellen is now signaling an intention to raise front-end rates (in early
to mid-2015) and break from the pack.
Recent experiences of smaller central banks have shown how difficult it is to break from the pack.
The Bank of England, led by Mark Carney, signaled earlier in the year that they might start normalizing rates as early as this fall, only to
then pull back on that statement. The Reserve Bank of New Zealand also embarked hikes policy rates 100 bps this year before backing
off due to a slowing economy. Currency appreciation is very impactful in bringing one’s growth rate back to that of the peloton!
Viewpoints
The Central Bank Cycling Race (and Long-End Yield Implications) (cont’d)
Will the Fed actually be able to make a clean break from the slow growth peloton?
The recent appreciation of the U.S. dollar relative to other global currencies forecasts difficulty. Currency appreciation has two major
limiting impacts on the ability of rates to move higher. First, a stronger currency acts as a drag on economic growth because it makes
exported goods more expensive. Slower growth reduces the odds of an overheating economy and thereby tempers rate hikes. Secondly,
the stronger currency also makes foreign goods cheaper, which adds deflationary pressures that further squash price pressures and
give the domestic central bank further cover to keep rates lower for longer.
In the last 3 months, the U.S. Dollar Index has strengthened a meaningful 9%. Fed officials have taken notice, comparing this exchange
rate move to a de-facto tightening of monetary policy. New York Fed President Dudley stated, “If the dollar were to strengthen a lot, it
would have consequences for growth.” Chicago Fed President Charlie Evans expressed similar understanding of the current global
interplay, stating that “the world economy is dictating lower interest rates around the world.”
While any clean break from the peloton would likely require relatively stable currency exchange rates, what if the dollar were to
strengthen just enough to boost overall economic growth and guide global interest rates higher?
In other words, if the Fed is not able to break from the slow global growth peloton, can the Fed take the lead in such a way whereby
other riders are aided enough to get the whole group moving faster – thereby turning a low speed global economic peloton into a
faster speed one?
A strengthening currency can be seen as redistributing some degree of domestic growth abroad. This isn’t an entirely bad thing, as, unlike
an actual race, the Fed is not being graded on a curve. As long as the Fed is able to achieve 5% nominal GDP, then debt servicing costs
can be comfortably met, employment gains should persist, and the financial crisis can be put further in the rear view mirror. The
strengthening of other global economies relative to the United States could be mutually beneficial if free trade is maintained and
demand for exports accelerates. While willfully remaining in the front of the peloton for a prolonged period of time is not typically an
optimal racing strategy, in this instance it might be to the U.S. economy’s advantage to do so.
Riding in the pole position can be taxing on the rider however, and therefore the sooner that other global economies are able to recover
and assist in reducing wind resistance, the more promising the future riding pace of the United States’ economic bike will be. The
greatest risk to the global economy is that a premature tightening of front end rates causes the U.S. economy to slip into recession,
which would leave the global economy without a torch bearer to lead the recovery. If this were to occur, then a global deflationary
“bike crash” scenario would once again be in play.
Janet Yellen remains steadfast in her desire not to allow this to happen. Although the pace of anticipated hiking was raised through the dots
in the Fed’s latest Summary of Economic Projections, Mrs. Yellen was careful not to expedite the anticipated start of hiking (keeping
“considerable time” language) and emphasized that any projected hiking pace could change along with changes in economic data.
Relating this back to global interest rates, until investors become more optimistic about the longer-term global economic growth rates,
longer-term bond yields across developed market countries should remain at depressed levels. Low long-term yields are a reflection
of global economic pessimism and negligible risk/term premium due to the high correlation between global developed economies
and the more fluid cross border movement of capital seeking positive real returns amidst a backdrop of global financial repression
and a low growth outlook.
The foreign exchange market should therefore provide clues for global interest rates going forward. A stable dollar will likely correspond
to a prolonged exit from the current low rates regime in long-end global yields. Other developed market economy sovereign yields would
likely remain low, with U.S. Treasury yields eventually leading the move higher. In such a scenario, the 10-year UST/Bund spread of 155 bps
could remain this wide and Spanish and Italian 10-year paper could continue trading at yields through that of U.S. Treasuries!
If, however, the dollar continues to appreciate noticeably, then global growth should be aided and the spread between U.S. yields and
other sovereign yields should narrow as non-U.S. long-end yields lead the way higher. In this scenario, German, Japanese, and other
developed market sovereign yields would be the first movers to higher yields as their longer-term economic growth prospects
2
Viewpoints
The Central Bank Cycling Race (and Long-End Yield Implications) (cont’d)
Global Developed Market 10-year Yields (in %)
8
7
6
5
4
3
2
1
0
Oct-2009 Feb-2010 Jul-2010 Nov-2010 Mar-2011 Aug-2011 Dec-2011 May-2012 Sep-2012 Jan-2013 Jun-2013 Oct-2013 Mar-2014 Jul-2014
10yr Germany Yield
10yr Japan Yield
10yr Italy Yield
2.00%
10yr U.S. Yield
10yr Spain Yield
10yr U.K. Yield
2.70%
Source: Barclays Live
improve markedly. Long-term Treasury yields would then follow other sovereign yields higher only after the global economic recovery
becomes more robust. In this case, the normalization process to higher yields occurs globally and not domestically – the peloton
rides together!
Conclusion:
The Fed’s ability to raise the Fed funds rate meaningfully from the zero bound will depend both on the sustainability of the domestic
recovery in the face of higher rates, as well as the degree to which the U.S. dollar strengthens, thereby benefiting global growth and
creating a drag on domestic growth. Significant normalization will require either a very robust domestic economy or a strengthening
global economy that mitigates appreciation pressure of the dollar.
Long-end rates are similarly correlated to global factors. It will be very hard for U.S. long-term yields to rise meaningfully without
global yields following suit. The true catalyst of higher long-end yields should therefore be sharp additional appreciation of the U.S.
dollar, but in such a scenario other sovereign long-end yields will likely lead the way (compressing the Bund/Treasury spread and the
Japanese JGB/Treasury spread in the short-term).
In the past, foreign exchange rates followed inflation and interest rate differentials. Going forward, in a world of non-standard central
banking policies, foreign exchange rates should increasingly forecast future policy and nominal growth projections – the primary
drivers of long-term yields.
Keep an eye on the foreign exchange market as it remains the pace car in the global central banking cycling race!
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