Update on market views

FX

USD

On May 30th I wrote a post explaining why I was bearish the USD (Framework for FX valuation – where is the USD heading?). Value seemed to me to be the most important driver and so I had paired a short USD view against a basket of currencies which I considered the most undervalued i.e. CAD, AUD, EUR, NOK and SEK.

This has been working very well so far.

However currently I do not think the USD has moved enough to warrant a reduction in my conviction level, as the long-term potential for the move is still far greater.

GBP

I have been very bearish on sterling for a long time. I may write a post explaining the key reasons in more detail, but essentially I see GBP as highly vulnerable for many fundamental reasons and it is heading towards a large negative trade shock with Brexit. This results in a heightened potential for a calamitous drop.

My 5th May post (Who loses more from Brexit? The UK or EU?) is where I laid out why the UK has far more to lose then the EU from Brexit. Since then sterling has performed very poorly vs. my basket of undervalued currencies (AUD, EUR, CAD, NOK and SEK.)

I retain my bearish view of the currency but am aware that it is hard to justify looking solely at historic value. My view for continued weakness rests on my view that Brexit will happen and very bad economic consequences will follow.

If there is a political earthquake leading to a U-turn, or perhaps the UK ends up in some permanent transition limbo within the single market, then I would revisit my view.

Equities

In early June I laid out why I was bearish on US equities. Since then they have barely moved. My views have not really changed but I intend to update my analysis given some interesting data releases since then. Most importantly wage growth has continued to disappoint which means that there remains an opportunity for corporate earnings to keep rising, despite lacklustre GDP growth.

Fixed Income

I looked at the front end of US fixed income on May 16th and noted that the continued slow drift lower in rates had been a good trade and that it could be about to change.

There has been no sign of a change at all in the market i.e. a very slow move to lower rates continues. This is not a trade I have any appetite to hold either side of.

The story is similar in the long end with little movement in any direction.

With mediocre growth and no acceleration in wage growth, there is no catalyst but my concerns with overall valuation mean I have no desire to own any fixed income at these levels.

How to reduce your Risk Part III

Trick question (click here for the question, and here for the answers)
There is no right answer because risk cannot be minimised.
It can only be transformed from one type into another.


What did people choose?

Option A was the most common answer. For those who trade in financial markets, this may be surprising.

If I reframed the question and asked:

  • Please calculate the DV01 of Options A and B
  • Please calculate the VAR of Options A and B
  • Please tell me which of A or B has greater risk

You would quickly work out that B has zero DV01 and zero VAR. Hence by the definition of risk used on trading floors, A has higher risk. Unsurprisingly asking this question to a room of traders at investment banks, I get the overwhelming answer B because that is the context in which they think about “risk”.

If I ask the question to people who work in property or private equity, then I am more likely to get the answer A as certainty of cashflow is critical, especially when thinking about assets and liabilities. In the accrual accounting world of regular banking, they think about Earnings at Risk (EAR) and Option A is the way to reduce the risk.

The answer given likely relates to your personal circumstances and the exact framing of the question. If I had the time running a series of experiments with slightly different wording, rates or quantities I think would give interesting results.

But for now, the practical lesson is important. People do not instinctively understand risk at all well. We are presented with questionnaires from investment advisors which ask us for our risk preferences with no definition of risk. From the results of typically recommended portfolios, it would suggest that bonds are low risk and equities high risk.

My approach

I think that the best way to think of this question is in terms of a balance sheet. Whether choice A or B “reduces” your risk depends on the extent to which it matches the tenor of your liabilities. If your liability is short term then Option B is the sensible answer. For investment banks, they have no corresponding long-term liability apart from capital. They typically hold wafer-thin amounts of capital against market-to-market assets so naturally recognise A as a risk. For someone who is keenly aware of what they see as fixed longer-term liabilities such as paying school fees or retirement expenses then the choice of a long-term asset i.e. Option A, is far more natural.

Risk matters

Whenever risk gets mentioned, I very rarely observe a discussion of this nature. Often only one side of the balance sheet is being examined and the vastly important implicit assumptions from the liability side are not considered. I am an advocate of multiple forms of risk measurement, including VAR, but only if it is used in the correct context. Many of the worst financial disasters have occurred by taking a risk and accounting concept that was appropriate in one context and transplanting it to another. AIG and Enron are the biggest ones that spring to mind.

Framework for valuing fixed income – Long end

I do a very different analysis of the long-end of the yield curve, compared to the front-end. (Framework for valuing fixed income – Front end) Mathematically, you could take the same approach and bootstrap the curve from a complete set of forecasts of short-term rates for the next 30 years. But this seems a bit silly and begs the question of how you would get these forecasts anyway.
To simplify the analysis, what we have to work out is what the long-term “equilibrium” rate will be and ignore for now how we get there or use the analysis from the front end to build a path.

Simple Hypothesis: Long-Term rates = Nominal GDP

An approach that appeals to me is to look for a link between long term interest rates and long term nominal GDP. I think of it as a “Wicksellian” natural rate which the market will tend to revert to i.e. If interest rates are consistently far away from the growth rate of nominal GDP then there would be a persistent drag or stimulus to growth which would not be sustainable. You can get to a similar idea from several different economic frameworks.

If we look at the data then, the hypothesis looks reasonable. Below is the 10-year average of nominal GDP growth alongside the 10y10y interest rate for the US. The 10y10y rate is the rate you can calculate as what the market implies the 10y interest rate to be in 10 years’ time.

Before the early 2000s, interest rates were consistently a little higher than GDP. Academics were happy with this and explained it in terms of some type of premium which bond owners would demand to own bonds. They were then confused in the early 2000s by the “conundrum” that long term yields dipped, explaining it either by Chinese ownership of Treasuries or a global “savings glut” which was forcing down yields.

Outlook for Nominal GDP

Current yields do not look very remarkable to me, but they are only correct if you think that nominal GDP will remain as low as for the past decade. The most prominent argument that we should expect this to continue comes from Larry Summers and his promotion of the idea of “Secular Stagnation” – http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/

I find these arguments a little hard to engage with as we must recognise how utterly useless long-term forecasts of anything generally are. I should admit that I am not a big fan of anything which looks like a restatement of the savings glut theory to me, but I do not want to engage here in an academic debate. As a more practical question, I think that the burden of proof is on ideas such as Secular Stagnation and the “New Normal” that the world will need permanently far lower rates than it has in the past. Arguing that nominal GDP will be lower, due to slower population growth, demographics and potentially lower productivity is easy. Explaining why it is 3% lower is not so easy.

My view is that this economic cycle does not require new theories to explain it. A financial crisis results in a very deep recession and leaves scars which mean the recovery is slower than many expect. These hangovers from the financial crisis are what Yellen refers to as “headwinds” which are slowing down the economy. Risk aversion among consumers and businesses after such a bad recession is only to be expected and the impairment of the credit channel after such a disruption is also understandable. But there is no reason to think that these headwinds are permanent. They can abate and we can return to a world similar to the one before, both in terms of the level of nominal GDP and also the relationship between interest rates and growth. The financial crisis has been traumatic, especially for countries like the US and the UK, that have not seen one like this recently. However, the history of financial crises is that they are worse than people think, but they are not permanent.

Are we renormalizing?

Unemployment fell slowly but is now down to 4.5%. wages have been sluggish but are now picking up.

If I draw the first chart again but this time use a 5yr rather than 10yr moving average then perhaps I can argue the market is reacting too slowly. Nominal GDP has been rising recently and with rising wages and inflation can easily be seen to be likely to continue to do so. If that is true then market rates are too low.

Why are long term rates still so low?

The idea that long term rates are too low is hardly new. After all this was the whole point of QE!! The central banks buy huge amounts of long term debt to drive up bond prices and yields down. This helps to stimulate the economy and boost other asset classes which look relatively cheaper to bond markets, and so drives reallocation flows.

As I mentioned in this post (https://appliedmacro.com/2017/05/01/government-debt-framework-uk-follow-up/), we are living in a new era of financial repression. Therefore, I really do not need any grand theory from the supply side of the economy to explain low rates. I just look at the huge boost in demand for bonds from the central banks.

Is there a catalyst for change?

  1. One potential catalyst would be from the front end. If the Fed hikes rates faster than the market expects, then this can cause a shock to ripple down the whole curve. We saw an extreme version of this in 1994.
  2. If wages start to accelerate then the Fed, economists and market participants would have to radically reassess their assumptions about the inflation outlook and the appropriate level of rates. If you are very confident this cannot happen, you have more faith in our understanding of this type of macro variable than I have.
  3. Even without any fundamental driver we may see a repricing simply from a change in the supply and demand dynamics of the bond market.

QE buying has been high for the past few years but it is finally slowing down. This may be the catalyst for a repricing of bonds.

Conclusion

A simple and yet historically useful framework for considering long term rates is to use nominal GDP. In recent years, we have seen the combination of a major downshift in long term expectations for both nominal GDP and the level of rates relative to nominal GDP. While many arguments justifying this change as permanent have some merit, I think that they are more temporary then current market pricing implies. Which means that I do not think that bond markets are cheap. In fact, I think they are wildly expensive.

 

Framework for valuing fixed income – Front end

In a previous post, we looked at a model of relative value of equities versus bonds (https://appliedmacro.com/2017/05/09/are-equities-expensive-part-i/).
But it does beg the question of whether bonds are good value themselves.

I am not aiming for a full review of global bond value, I will focus purely on the US market. In this post, I shall look at the front end of the curve and in a later post the long end.

Expectations

The simplest and best model for the short end of the yield curve is the expectations hypothesis.
The yield is an average of short-term interest rates that are expected to prevail through the life of the security


Such expectations may not match the market yield, so there may be a residual. This residual r is sometimes called the premium (choose any: risk premium, term premium, liquidity premium, it does not matter which). At times such as during the financial crisis, I spent a long time modelling precisely the premia, but in normal market conditions it’s not very productive. Merely knowing if the premium is large or small, positive or negative is sufficient.

The other term often used for premium is expected return. If you think in terms of academic “efficient market” models or asset allocation in a real money environment, then you may prefer to use excess return but the language does not matter here.

US Front End

short term interest rates, the Fed Funds rate, and these days they helpfully publish quarterly forecasts of where the committee thinks it will be. A sensible starting point is to compare these forecasts to the tradable yield and calculate the residual.

If you have not been following fixed income markets for the last few years or have learnt how markets work from finance textbooks, you may find this chart surprising.
We, as market participants, are well used to the fact that the market is pricing that rates will be significantly lower than the people who set them expect them to be. This has been the case for a long time but so far, the market has been better at predicting how the Fed will behave than the Fed itself.

If we look at a chart over the past 2 years where rates have been expected to be at the end of 2018, we see some fluctuations but very little net movement. In contrast, the Fed has been consistently revising lower its forecasts of where it thinks rates will be.

If we cannot just assume the Fed know what they will do, we must form our own opinion on where rates might go and determine whether the market is under or over pricing the path. The way to do this is to break down the elements of the forecast and analyse each of them.

The Fed’s reaction function & the Taylor rule

To start with the obvious, the Fed decision can be thought of as a function of things they care about. It is often called their “reaction function” and the things they care about are employment and inflation, their explicit objectives as given to them by Congress.

A common and useful form of this is the Taylor rule, which models Fed behaviour on just two variables.


Using this to make investments

The Taylor Rule is not that useful as a predictor of rates, but it forms a useful framework to think of what drives them.

There are 3 obvious places where you can disagree with the market and so make an investment call.

  1. A different view on growth

One of the largest and most obvious trades in my career was short term rates in 2002. The economy had been very poor in 2001, but the memory of the bubble was perhaps still so vivid that the market priced a rapid rebound in growth and thus interest rates. 2002 did not turn out to be the year of recovery and rate expectations fell accordingly all year.

  1. A different model of the economy

A good example of this would be 2008. Even after Lehman went under in October 2008, it took a long time for people to understand how serious it was and the devastating impact on the broader economy. The market was still pricing that rates would be nearly 3% at the end of 2009. They ended up close to zero. Rates eventually plummet in 2008 because the economy is falling apart.

A counter-example where a commonly believed idea turns out to be wrong is the idea that Quantitative Easing (QE) is going to lead to high inflation and so bonds will collapse. This comes from the idea that inflation is caused by “money” and the Fed is “printing money”. A simple and appealing argument that comes from a misunderstanding of what “money” is and how the monetary and banking system works. (a good topic and controversial later post I am sure).

  1. A different view on reaction function.

An example here would be that after the crisis many people were very premature in thinking that the economy would get back to normal.

In the summer of 2013, rates were still zero and the Taylor Rule suggested that was appropriate. But taking the economic forecasts at the time and projecting what that meant, suggested that rates would be much higher. So back in 2013 the market was pricing that rates would currently be about 3 %. In fact they are around 1%.

This difference is not because the economic growth forecasts were wrong. But the reaction function was. If you listened to Fed Chair Yellen’s speeches she was clear that the Fed would be very “patient” in raising rates. They desperately wanted to avoid hiking prematurely and actually wanted inflation to be higher. So a new reaction function should have been understood – that the Fed were waiting longer to hike to get the economy to be running hotter.

What about now?

My experience of financial markets is that is that expectations are more commonly adaptive than rational. By this I mean that humans (including market participants) tend to overweight recent experience. Given that the Fed has been consistently too high in their forecasts for the last few years, people expect that will continue to be the case. I am not so sure.

I am inclined to use an even simpler new reaction function for the Fed based upon wages. In previous cycles, they would hike before wages rose because

  1. They were confident in the economy
  2. Inflation and wages were high enough already to take a risk if they go lower again
  3. Wages are a lagging indicator, so by the time wages rise the economy will have been running too hot for too long

This time they want wages and inflation to be higher before they even start. The data suggests to me that wage growth is finally recovering.

It is reasonable to think that the economic cycle works the same now as in previous periods, and so wages are a lagging indicator. That means that the labour market has been tight for a while now and is continuing to get getting tighter adding more upward pressure on wages.

Conclusion

This cycle has been very different from prior periods because

  1. The recession was very deep
  2. The recovery was slow
  3. The Fed wanted to wait until they were sure they needed to raise rates.

This has meant that being long the front end has been a reasonable trade for a long time i.e. the front end was cheap against my expectation of where the Fed would set rates. But with the signal that wages are finally rising, we may be approaching the end of this phase. Furthermore, with so little still priced for rate hikes from the Fed the front end does not look good value to me.

If the US recovery has been slow, but the economy not long-term impaired then this means that the rate cycle has been delayed, not that it is not coming or that where rates end up will be so much lower than in previous cycles. But that is the topic for the next post.

How to reduce your risk?

Let’s do an experiment.

I am going to present with you with an investment decision with two options.
Please choose the one which will reduce your risk.

You have £100k.

A. You can invest your money by buying a 10-year bond with a 10% yield

This means you will receive £10k per year and your £100k back at the end.

B. You can put your money in a bank checking account which currently pays 10% APR

This means that if interest rates stayed at 10% then you again receive a total of £10k every year with your £100k initial capital still yours.

These investment options look identical if interest rates never change.  But the rate of interest is not going to stay at 10%.  To make it very clear I will let you know that interest rate are going to change tomorrow and will either be 5% or 15% but you do not know which.

Remember I’m asking for the option which reduces your risk.

Answer in a later post.