Despite the Fed’s rate rise, the convergence to zero continues unabated

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Back in January, I said that as far as bond markets go, the convergence to zero would be a dominant issue as the deflationary macro environment made it difficult to raise interest rates. The US is trying to buck this trend, but in doing so, it is creating the kind of volatility, due to Chinese currency devaluation, that will make the next year extremely difficult for traders. Some brief comments below

First, here’s how I ended my piece in January:

“Countries like Germany are suppressing wages and relying on export-led growth because they know after two decades of falling and weak domestic demand growth that they have to look abroad. But banking on emerging markets to fill the gap is not a good idea due to the indebtedness that has built up in those markets and due to the rebalancing now underway in China, which is reducing global growth. The downturn in commodities prices is a direct result of these events, adding a deflationary impulse to the global economy that further weakens nominal GDP growth and therefore puts pressure on future policy rates, flattening the yield curve.

“The closer a country is to zero on the short end and to zero term premium in medium- to long-term rates, the less flattening will occur. Japan is now at zero out to five years. There is not a lot of upside there. Switzerland is at 0.18% out to 10 years. Again, upside there is very limited indeed. But there are a number of countries with room for yield suppression which also have sovereign central banks and no foreign currency liabilities. These countries are the Anglo-Saxon countries. British 10-year bonds go for 1.54%. Canadian yields are 1.60%. US yields are 1.88%. Australian 10-year yields are 2.61% and New Zealand’s 10-year bond fetches a hefty 3.47%. While Switzerland’s 10-year bond has only 18 basis points of non-fear related compression feasible, New Zealand’s 10-year bond has more than 300 basis points to go.

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“Right now, we are still in the midst of a global growth slowdown. And while there are some countries like Britain, Canada, the US, New Zealand and Australia, which have been outliers in terms of growth performance, the downward drift of oil and commodity prices, the lack of external demand, the lower rate of EM growth and the rebalancing in China is going to put inexorable downward pressure on nominal GDP growth in these countries. This will put downward pressure on future policy rates and help to make the convergence to zero trade most severe in these countries in 2015.

“I am not saying that New Zealand and Australia are the cleanest dirty shirts here. I am saying that safe asset yields are converging to zero and the most convergence will occur in the highest yielding, high rated safe asset countries. That favours Anglo-Saxon government bonds over others. And to the degree there is crisis, then investors will flee into safe assets and shun risk assets, hastening the move toward zero across the curve.”

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I continue to favour Anglo-Saxon bonds, particularly New Zealand and Australia, because of the interest rate differential. Earlier this week, the Reserve Bank of New Zealand lowered the base rate to 2.5%. And while this move was widely expected, it is a faster clip of rate cuts than anticipated. Here’s the Wall Street Journal from May:

New Zealand’s central bank is now set to cut interest rates due to weak inflation and tough times for dairy farmers, with some economists calling for a reduction as early as June.

The view marks a dramatic shift: as recently as late April the majority of economists predicted the Kiwi central bank would remain on hold at 3.5% for the foreseeable future, making it something of an outlier in a region where interest rates have been coming down.

A poll of 13 economists showed median expectations of rates at 3.25% in September and 3.00% in December.  Three economists are expecting a rate cut in June, followed by one in July.

Notice how the anticipated move to 3% was a dramatic shift. Yet, the rate is now even lower at 2.5%. It tells you the macro environment is unfavourable. In cutting this weak the RBNZ governor made the following remark “the rise in the exchange rate is unhelpful and further depreciation would be appropriate in order to support sustainable growth”. This is telling us that the currency wars have caught the central bank in a race to zero. The New Zealand dollar will stay elevated as long as the rate differential exists. That means more cuts are coming.

On the other side of the world, the US Federal Reserve is poised to raise rates, however. And I see this policy divergence as extremely important from a macro perspective. The US is simply trying to reload its ammunition because it has run out of policy space and because it is concerned about asset bubbles. The Fed knows that its policy has a greater impact on the financial economy than the real economy and that has made asset prices frothy even while the real economy has been middling at best. It doesn’t like this fact. But what can it do?

Raising rates is the only thing the Fed can do. And it has been desperate to do so for months, since at least this time last year. Only now has the economy been strong enough for the Fed to actually pull the trigger. But frankly, I think it has waited too long and that the credit cycle is already turning down as I wrote yesterday. The Fed has said it wants to normalize. But it won’t be able to fully do so. The economy is going to be too weak to do so. So that by the time the economy rolls over, the Fed won’t be anywhere close to normal. And that will basically mean it will run out of ammunition. And given the fact that the fiscal is dead in the US, the Fed is the only game in town. It will forced to turn to unconventional policy: quantitative easing and negative interest rates. It may even buy municipal bonds. Anything is possible because the Fed will be desperate to prevent another crisis. This is what I anticipate will happen. 2016 is the year when we will be able to gauge when and how this all proceeds.

As this occurs, we need to watch China. China’s tether to the US dollar is set to become unhinged due to the 30% appreciation in the Renminbi’s real effective exchange rate in the last 3 years. This week, the Chinese central bank has allowed its Renminbi exchange rate to drift lower to the point that it now stands at its lowest level in four years versus the US dollar. I expect significantly more weakening in 2016. This weakening will see the Chinese exporting deflationary pressure via the currency wars, with a particularly negative impact on commodities producers and their domestic economies. Emerging markets will suffer enough that we should start to watch their private business credit metrics for signs of distress that could mean crisis. A credit event in a company as large as the recently downgraded Petrobras is the kind of trigger that would set off not just an EM crisis, but a global one. I believe this kind of event has now moved from the Black Swan status it was when I broached it in April to a known unknown.

This is the kind of volatility and uncertainty 2016 will bring. Meanwhile expect Australia, New Zealand and Canada to continue their convergence at both the short and to begin more at the long end. And expect the US and Britain to join on the long end during periods of volatility.

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