In an article published by the WSJ today, which was originally titled “Are Central Bankers About to Lose Control?” but after some shoulder taps was renamed to the far more neutral “Can Central Banks Keep Control of Interest Rates?” author Jon Sindreu looks at the current Goldilocks state of the market, in which global growth is “coordinated and widespread” yet inflation remains absent preventing central banks from hiking rates rapidly, resulting in “elated investors” who nonetheless are haunted by a question “will interest rates develop a mind of their own?”
The response to this question will also answer the overarching question posed by the WSJ: are central bankers about to lose control after nearly a decade of artificial vol suppression and asset inflation on the back of $15 trillion in excess liquidity. The goalseeked response that the WSJ is looking for, is also the result of a Blackrock report released last week titled “The real story behind low interest rates.”
For those who are too busy to bother with the semantic definitions of interest rates and their technical components, whether breakevens or term premia, ultimately the cost of money boils down to one thing: the inflation-adjusted opportunity cost of holding one asset relative to another. This is why the world’s central banks have been scrambling over each other to push rates as low as possible for the better part of the past decade to force investors into risky assets, or, as the WSJ puts it, “low inflation-indexed—or “real”—rates push money into risky assets, because investors get little extra purchasing power for holding safer securities.” Here the WSJ references the BlackRock report which claims that “subdued real rates have been 2017’s main driver of returns in global infrastructure debt and investment-grade corporate debt. They also boost gold and real estate, analysts say, which don’t pay coupons but don’t lose value when inflation rises.”
Here a problem emerges: real rates have often move in lockstep with central-bank policy—but not always. In the 1970s, runaway inflation pushed real rates down even as the Fed and other central banks increased nominal rates.
Such non-parallel moves also explain why the yield curve always inevitably inverts when central banks commence hiking rates. Still, at least for the short-term central banks end up having a disproportionate distorting effect on real yields. For some perspective, yields on 10-year inflation-linked Treasurys are currently near 0.5%. Before the 2008 financial crisis, they hovered at around 2%. After the Fed unleashed unseen amounts of monetary stimulus, they hit a record-low of minus 0.87% in 2013. Many analysts and investors see it as a sign of either “policy makers having strong control over real rates” according to the WSJ, or simply flooding the system with so much cash that one central bank’s actions has an impact on other central banks and what securities they end up purchasing.
“We are overweight global indexed bonds,” said Paul Rayner, head of government bonds at Royal London Asset Management. “We’ve done a lot of analysis on this, and ultimately the biggest driver of government bond yields still remains central bank activity, even for [inflation-linked bonds].”
Another problem: eventually even the most manipulated markets learn to price out central bank stimuli and intervention:
“classic economic theory says that central banks can only influence rates at first, as people ultimately see through their meddling. So unless officials set policy to reflect the economy’s long-term economic trends—which is how the Fed’s Janet Yellen and Mark Carney at the Bank of England have justified keeping rates low in recent years—inflation or deflation will follow.
According to this view, rates are so low because people are saving a lot and these saved funds can be lent out and used to invest, a copious supply that pulls down the cost of borrowing.”
Ah yes, Greenspan’s “great conundrum” aka the global savings glut – wrong then, wrong now and wrong always – but it makes for an entertaining editorial detour.
Here is Sinderu channeling Blackrock which last week decided that enough of today’s 20-year-old algo programmers and asset managers had never heard of the “savings glut” fabrication, that it could recycle it as credible economic theory once more.
Some money managers and analysts now warn that the tide is about to shift, whether central banks keep policy easy or not. By looking at the share of the population aged between 35 and 64—when people save the most—research firm Gavekal predicts real rates will soon rise as people retire and spend their life savings, eroding gains in stock markets. It “could happen tomorrow or 10 years from now, but I’m not counting on the latter,” said Gavekal analyst Will Denyer. J.P. Morgan Asset Management argues that aging is already starting to push rates higher, meaning that 10-year real yields will be 0.75 percentage point higher over the next 10 years.
Well, if this theory is right, it better hurry: as we showed last week, the personal savings rate in the US dropped below 3% for the first time since 2008, and is rapidly approaching the lowest prints in US history, as consumers finally tap out to buy that must-have CIA Amazon microphone that listens in to their every conversation courtesy of Jeff Bezos…
… and are forced to rely almost entirely on their credit cards.
Other investors have a different worry: as the WSJ notes, “they fear that yields will stay low even if central banks try to tighten policy because they are concerned a recession may be coming. This year, the Fed has nudged up rates three times and yields on long-term government bonds—both nominal and inflation-linked debt—have stayed unchanged or declined, echoing similar issues that then Fed Chairman Alan Greenspan had in 2005.”
It is this worry that is the bogeyman every time the pancaking yield curve is mentioned: the yield curve is now at its flattest since 2007, and many investors underscore that, in the past, this has always preceded an economic slowdown in the U.S. “Unless the evidence is very compelling that’s a false signal, I think the market’s going to be nervous,” said David Riley, head of credit strategy at BlueBay Asset Management, who is now investing more cautiously.
Yet others such as the BIS have a different theory altogether. “In research looking at 18 countries since 1870, the BIS found no clear link between rates and factors like demographics and productivity—it is mostly central-bank policy that matters.” It is here that things get especially hair.
Does this mean investors can rest easy because rates won’t creep up on them? Not so fast, said Claudio Borio, head of the monetary and economic department at the BIS, because officials may still raise them to contain market optimism. Central banks in Canada, Sweden, Norway and Thailand are thinking along these lines, analysts said.
If central banks control real rates, then it is inflation that has a life of its own—it isn’t just a reaction to officials deviating from economic trends—and it could explain why central bankers have failed to stoke it for years. So officials might as well raise rates to quash bubbles instead of “fine-tuning inflation so much,” Mr. Borio said.
Still, Isabelle Mateos y Lago, global macro strategist at BlackRock, thinks investors don’t have to worry about this yet. “The conversation is moving this way, but I don’t think central bankers have a fully articulated view,” she said.
Which, of course, goes back to the original question: central banks may or may not have a view, but have they lost control? And while it is obvious why the WSJ, Blackrock and various finance professionals – whose earnings and advertising dollars depend on perpetuating the myth that central banks are in control – would deny the rhetorical question, it is what Citi’s credit team admitted last month that is especially troubling. Recall What Citi’s Hans Lorenzen said in late November:
In the context of a self-reinforcing, herding market, the pivot point where the marginal investor is indifferent between putting more money back into risk assets and holding cash instead is fluid. But when the herd suddenly changes direction, the result is a sharp non-linear shift in asset prices. That is a problem not only for us trying to call the market, but also for central bankers trying to remove policy accommodation at the right pace without setting off a chain reaction – especially because the longer current market dynamics run, the more energy will eventually be released. That seems to be a growing fear among a number of central bankers that we have spoken to recently. In our experience, they too are somewhat baffled by the lack of volatility and concerned about the lack of response to negative headlines.
Translation: when asked if they have lost control, “a number” of central bankers – at least in private – will say that yes, they have. Which is bad news for those hoping that the great reflation experiment will be tame and controlled, because if it was all nothing more than a giant con game to which the markets were voluntary participants as long as everything went up, then all hell is about to break loose now that the process is officially in reverse.
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