April 5, 2018

Market Voice: US Rates in a World of Their Own

by Alexandre Hardouin.

The US Federal Reserve Bank (Fed) made it clear in the March Open Market Meeting statement they anticipate two more rate hikes this year and bumped the 2019 outlook up to three hikes from two. This on balance adds to a Fed rate policy that contrasts with other major central banks which remain on hold and in most cases are still in quantitative easing mode. As an example, ECB policymakers are now debating how to phase out their unconventional tools and normalize policy in a time of robust growth but weak inflation – this will not happen before September. The variance in expectations on rate paths is reflected in the table below taken from the Eikon Rates View App. US rates have risen significantly along the whole rate-curve so the market is priced for not just the Fed tightening near term but a higher nominal rate environment for many years to come. While rates have firmed in other markets farther out the curve, anticipated hikes significantly lag the US market. US rates are now at least a full percentage point above the three major markets Japan, Europe (note the German bund market is used to proxy for Europe since some EUR area government bonds have significant credit risk affecting their rates) and the UK along the entire yield curve. Indeed, rates on much of the German and Japanese curves remain negative.

The expectation of a series of Fed rate hikes reflects a US economy that is now in an extended expansion with historically low unemployment (4.1% in February 2018 vs a maximum of 10% in October 2009, see USUNR=ECI in Eikon) and diminishing excess capacity. While inflation is still modest (Core CPI at 1.8% in March see USCPFY=ECI), it has been trending higher over the past year and the rise in yields across the curve indicates expectations that higher US rates and, by inference, higher inflation are ahead. The rate profile also suggests low inflation vs the US market is priced in for the other major markets with Germany and Japan remaining in deflation for many more years.

Over the past few decades, the global economy has become increasingly integrated resulting in increased cross-border correlation in economic and financial performance and compression of interest spreads. The general decline in market volatility is also, in part, reflective of convergence in economic performance. But the table below suggests the market is priced for the coming decade to be characterized by a reversion to more global economic diversity. This month’s Market Voice ponders whether the relative rate profiles are consistent with prospects for growth and inflation.

The Major Market Government Bond Yield Curves

Source: Thomson Reuters Eikon, Rates Views Spread (RVSP) Bond Yield Tab –  Click to Request a Free Trial

While a one or two percentage point rate spread for US rates over these other markets may not seem large, at least in the case of Germany and the UK, this gap is quite profound. The chart on the next page shows the history of the spread of US 10-year rates vs. these other three markets. The Japanese rate spread while at multi-year highs is well within the range that prevailed before the financial crisis. But the spreads vs. Germany and the United Kingdom are at levels that have not been seen since the early 1980’s, a time when US inflation was in double digits. So it seems reasonable to ask whether the spread in 10-year rates reflects a plausible outlook for inflation.

US 10-Year Bond Yield Spreads vs. Other 10-Year Government Bond Markets

Source: Thomson Reuters Eikon – Click to Request a Free Trial

Are We Returning to an Era of Bellbottom Pants and High Inflation?

Don’t worry you don’t need to go digging through the attic to find your (or more likely your parent’s) old bellbottom pants and tie-dyed shirts. While the US 10-year rate spreads vs. Europe and the UK shown above suggest an 80’s like profile for inflation, the tracking with inflation shown below suggests a less extreme outlook. In the case of Europe (again using Germany as a proxy) the spread implies an increase in the US inflation spread from half a percentage point to around 2.5% pts and roughly the same degree of widening is also implied for the US vs. the UK. While this does not imply a return to a high inflation environment, a 250 point rise in US inflation vs. Europe and the United Kingdom is still substantial so it is worth considering whether this is plausible.

US CPI (Y/Y) Inflation and 10-Year Bond Rate Spreads

Source: Thomson Reuters Eikon – Click to Request a Free Trial

EURUSD and GBPUSD and Respective 1-Year Rate Spreads

Source: Thomson Reuters Eikon – Click to Request a Free Trial

Rates and Currencies, Two Sides of the Same Coin

Conventional wisdom is that a relative rise in interest rates is a plus for a country’s exchange rate. While the relationship between exchange rates and interest rates can be complex, the charts above indicate the conventional wisdom largely holds for both EURUSD and GBPUSD. In both cases, periods of diminished 1-year maturity interest rate advantage is generally associated with a weaker currency. If the Fed tightens ahead of the ECB and the BoE, this virtually guarantees a widening of the rate spread which the long-term trend points to a weaker EUR and GBP. Open the Central Bank Poll App (CBP) in Eikon to access Reuters Polls for Central Bank policy.

There are periods when the relationship turns perverse and EUR and GBP may strengthen even as the rate advantage diminishes; the market has been in this perverse mode since late last year. But over a decade of experience indicates that the traditional relationship will eventually reassert. Indeed, last month’s Market Voice focused on the sources of the current perverse relationship between EURUSD and rate spreads and it appears the special factors behind the pattern are fading and the markets will soon revert to norm. It remains likely that a widening US rate spread over the next few years is likely to be associated with trend weakness for both EUR and GBP.

The US Yield Curve and the Trend in the Trade-Weighted USD

Source: Thomson Reuters Eikon – Click to Request a Free Trial

The Dollar Likes a Flat Curve

The chart above shows that periods when the US yield curve flattens (the 2-year vs 10-year Treasury rate) are associated with broad dollar strength as measured by a rise in the nominal USD trade-weighted index. There are two general – somewhat overlapping – explanations for the connection between the curve and dollar performance:

  • The higher yields implied in the future by a steeply rising curve may cause investors to defer purchases of US securities
  • The yield curve is a proxy for the net return an offshore investor earns buying a USD bond on a hedged basis – e.g., net not buying USD. A flat curve is indicative that hedging results in a low net return serving as an incentive for investors to accept the risk of USD exposure – e.g., being net buyers of USD.

Fed tightening normally results in yield curve flattening because long-dated rates are priced for eventual mean reversion. Indeed, the late stages of the Fed tightening often are accompanied by an inversion of the curve with short-term rates moving above the back end. So it is highly probable that the expected Fed tightening in the year ahead will flatten the yield curve so the USD should not only benefit specifically vs. EUR and GBP but should also experience broad gains on a trade-weighted basis.

A Stronger Dollar Should Depress Inflation – But Hence, an Enigma

For most of post-World War II history, the dollar has had little effect on US inflation and, hence, the value of the dollar has generally not been something the Fed has taken into consideration in forming monetary policy (one rarely hears mention of the dollar exchange rate in the Fed Minutes). But as shown in the next chart, the link between US inflation and dollar performance has become much stronger since the financial crisis. The inflation dollar link means that the dollar strength that is a likely consequence of Fed tightening will prevent the inflation that is the motivation for the tightening – a true paradox!  The paradox is likely to be resolved by either less US rate hikes than are expected or more aggressive moves in rate hikes in foreign markets than are priced into their yield curves.

USD Trade-Weighted Weakness and the Trend in CPI Inflation

Source: Thomson Reuters Eikon – Click to Request a Free Trial

The Bottom Line – and a Few Thoughts on Tariffs

There seems to be potential that a stronger dollar in response to Fed hikes may make it unnecessary for the Fed to tighten as much as is implied by the US curve. Another possibility is that the Fed delivers the expected hikes and the surprise is unanticipated rate hikes abroad which deter the dollar strength. As was discussed in the January Market Voice, we began the year biased that bond yields were likely to be capped and remain biased on the first outcome. The recent move by the Trump Administration to proactively adopt tariffs does muddy the overall picture. High tariffs reduce foreign competitive pressures making an economy more susceptible to inflation creating the prospect of higher inflation even with a stronger dollar. It is difficult at this early stage to anticipate where tariffs are headed but a broad rise would be worrisome especially if reduced competition and higher consumer prices lead to an increasing trend in US nominal labor costs – the true wellspring of inflation.

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