Surprise plunge in bond yield forecasts may spell more trouble ahead
By Rahul Karunakar
The spread between 2- and 10-year U.S. Treasury yields will shrink to 180 basis points in a year according to the latest Reuters bonds poll – the narrowest margin since August 2008, the month before Lehman Brothers collapsed.
Historically, that spread has been a key indication of what investors and traders are thinking about the economy’s prospects: the narrower it gets, certainly with short-term rates already at rock bottom, the darker the outlook.
It wasn’t looking particularly good in August 2008, and of course we all know what happened the following month: the start of an epic financial and economic crisis the world is still struggling to shake off.
A narrowing spread, driven by long-dated yields falling, might be welcomed by central banks who are aiming to bring them down to stimulate growth. But it’s also a dark sign for what people broadly feel is going to happen in the economy.
Said John Silvia, chief economist at Wells Fargo:
“I don’t think it is good news. It just tells you that the overall expectation for growth in the U.S. is weaker over time.”
What the Fed twisteth, Treasury issueth away
So much for policy coordination. Just days after the Treasury published a note touting its progress in lengthening the average maturity of its outstanding bonds, the Fed decided to extend Operation Twist – a policy aimed at doing the exact opposite. By selling an additional $267 billion in short-dated bonds to buy long-term ones, the Fed is trying to take Treasuries with longer maturities out of the market, to lower yields and entice investors to take on more risk.
In a narrow sense, the Treasury’s approach is perfectly reasonable: U.S. interest rates are at historic lows, so it stands to reason that the government should lock in that low cost of borrowing for the longest period possible. However, in the context of an economy that remains exceedingly weak – and where the only source of stimulus appears to be a reluctant central bank – the move could be viewed as somewhat incongruous.
Fed Chairman Ben Bernanke himself addressed the issue when he was asked during the post-meeting press conference whether it would make sense for the U.S. government to issue more longer-term bonds given the current low-rate environment.
The government is very gradually increasing the duration of its debt, the Treasury I mean, it’s been doing that for some period of time. There’s a bit of an issue here which is that, what the Federal Reserve is doing, with the program we announced today, the maturity extension program, is we’re taking longer-term debt off the market in order to induce investors to move into other assets and to lower longer-term interest rates. To the extent that the Treasury actively sought to lengthen the duration of its borrowing it would to some extent offset the benefits of those policies. So, my understanding of what the Treasury is doing is that they have a plan, they’re sticking to that plan, and therefore on the margin the effects of the Fed’s actions can be felt.
That may be the case. But it still seems odd for the two institutions charged with the stewardship of the economy to be working at apparent cross-purposes. All the more so if, as Bernanke himself argued in 2003 as a Fed board governor giving advice to a stagnant Japan, tough situations call for “explicit, though temporary, cooperation between the monetary and the fiscal authorities.”
The Bank of International Settlements has also highlighted the idiosyncrasy. In a March paper that looked to quantify the effects of the Fed’s first Operation Twist, the BIS said:
The effectiveness of the Federal Reserve asset purchase programmes depends on Treasury debt management policy. When the Federal Reserve acts to lower yields for longer-dated bonds and the Treasury has large longer-term borrowing needs, a conflict of interests may emerge.
Central bankers vs. politicians: High-stakes chicken?
Are politicians playing chicken with central bankers? More to the point, if the U.S. Federal Reserve or the European Central Bank step up, yet again, to protect their economies from the global slowdown, will it take U.S., German, Spanish, Italian, Greek and other governments off the hook?
Such questions are swirling as Europe’s financial crisis boils and starts to bubble over into Asia and the Americas. Expectations are growing that the Fed will take more monetary policy action when it meets June 19-20. The messy possibility that Greece could exit the euro zone was not enough to prompt the ECB to cut interest rates last week – and that was before a deal over the weekend to bail out Spanish banks was dismissed by markets as just another kick of the can. Underlining the standoff between monetary and fiscal policymakers, ECB President Mario Draghi told European Parliament this on May 31:
Can the ECB fill the vacuum of lack of action by national governments on fiscal growth? The answer is no.
European central bankers “feel in some ways that the more they do, the more it takes pressure off the fiscal authorities,” said Lewis Alexander, U.S. chief economist at Nomura Securities. “So they’ve been reluctant to be more aggressive.”
The Fed, for its part, has one worried eye on the European crisis and the other on the U.S. “fiscal cliff” of big tax rises and spending cuts scheduled to kick in at the end of this year. Policymakers at the U.S. central bank rarely pass up a chance to publicly chastise Congress for putting off action on the cliff, which could slash U.S. GDP growth by an estimated 3 percentage points if left unaddressed. Meaning, of course, the United States would join much of Europe in another recession.
Chairman Ben Bernanke has said the Fed stands ready to protect the fragile U.S. recovery, but gave few clues that was imminent at a Congressional hearing in Washington last week.
I do want to say, and I’ve said this before, that monetary policy is not a panacea. It would be much better to have a broad-based policy addressing a whole variety of issues… I’d be much more comfortable in fact if Congress would take some of this burden from us and address those issues.
Forecasting gymnastics on the BoE’s printing presses
The fluctuating fortunes of the British economy in the last year have left forecasters in a fix, unable to make up their minds how much longer the Bank of England’s money printing presses need to roll on.
Forecasting gymnastics on the subject could make many economists Olympic contenders for the gold medal.
Deutsche Bank, Morgan Stanley and Lloyds Bank are the latest to predict the BoE will announce that it will buy an additional 50 billion sterling worth of government bonds, taking the total amount spent in the programme to 375 billion sterling.
That was a sudden change from saying just a week ago that there would be no further increase in QE.
Why such an abrupt hairpin turn?
“Last week’s May manufacturing PMI survey was, to put it simply, a game changer. Until then we had been arguing the BoE would sanction no more QE after ending the previous programme last month. But conditions have worsened,” George Buckley, chief UK economist at Deutsche Bank wrote.
The overwhelming majority of economists polled by Reuters last week expected the Bank to keep policy steady, although many major banks have changed their forecasts since the release of a far weaker than expected factory survey on Friday.
Inflation no obstacle to more Fed easing
Another reason the Federal Reserve may have additional room for monetary easing: Inflation expectations fell sharply in May, according to the latest Thomson Reuters/University of Michigan survey of consumer sentiment. Inflation expectations five years out dropped to 2.7 percent in May, the lowest since January. Fed officials often say expectations are a key leading indicator of actual price increases.
Daniel Silver, economist at JP Morgan:
This level of longer-term inflation expectations is towards the bottom of the range that has been reported in recent years – 2.7% has been hit on several occasions (most recently between October 2011 and January 2012) and 2.6% was only reached back in December 2008 and March 2009, early on in the crisis period. Most other inflation measures that the Fed watches (including core PCE inflation and the 5yr-5yr breakeven inflation rate) have signaled that inflation expectations are still anchored and underlying inflation pressure is modest.
The downshift comes in the wake of inflation figures for April that also pointed to a tame price environment. This is why Eric Green at TD Securities argues “U.S. inflation favors the doves.”:
In many ways the release today is emblematic of what we expect to see on the inflation front over the next six months. That is, steady disinflation on headline prices (driven by roll over and seasonal effects from energy prices) and stable core prices. Headline inflation will fall through core next month as energy prices alone virtually ensure a gain of no more than 0.1%, probably less. As headline inflation drifts to 2.0% y/y next month (from 2.3% y/y April) and 1.8% y/y by August, the inflation metric will work in favor of the more dovish contingent on the FOMC.
Still, deflation fears, a key underpinning of the Fed’s second round of quantitative easing, are not likely to make a comback, says Green:
That does not mean we are in a period of disinflation akin to the pre-QE2 period. Inflation will not be the cause célèbre of more accommodation, it will merely be removed as a potential obstacle among those favoring stronger growth, and truth be told, higher inflation.
Put your rate hike where your mouth is
Jonathan Spicer and Van Tsui contributed to this post.
This week, for the second time ever, the U.S. Federal Reserve published policymakers’ forecasts for when the central bank should start raising rates. The chart suggested a split Fed, with three policymakers expecting a rate rise this year, three next year, seven in 2014 and four in 2015. That’s useful information, as far as it goes.
But as much as the Fed has embraced transparency in recent years, it stopped short of saying which policymaker backs a rate hike in which year – a key bit of data for grasping where the voters on Fed Chairman Ben Bernanke’s policy-setting committee stand, and how their positions shift over time.
Below is the bar graph that the Fed published Wednesday, with Reuters’ best estimates of who fell where. We stand ready be convinced otherwise by readers offering evidence or insight that supports a different view. Send us an email, gives us a call, write a comment or shout us out on Twitter.
You can find more information about the policy leanings of each top Fed official in our handy interactive hawks-doves chart.
The going gets tougher for Italy and Spain
One trillion euros is a lot of money. And as we have previously noted on this blog it did a lot for stock markets early this year but not much for the real economy.
But recent bond auctions in the euro zone suggest the impact of two rounds of cheap 3-year ECB funding on the region’s struggling bond market may also be fading.
Italian three-year borrowing costs surged more than a full percentage point at an auction to 3.89 percent – its highest since mid-January.
Nick Stamenkovic, strategist at RIA Capital Markets says:
Clearly it shows investor appetite for Italian bonds even at the short end has diminished recently as the effects of the two LTROs (long-term refinancing operations) from the ECB dissipate.
That was not the only patchy bond sale recently. Italy’s one-year borrowing costs doubled at a sale of short-term bills on Wednesday and, just last week, Spain had to pay dearer to borrow through medium-term bonds.
The new jitters in the market have partly been fueled by Spain’s fiscal conundrum: austerity aimed at reducing its budget deficit risks choking off the very growth that is needed to repair the country’s fiscal position.
Spain: ¿Cómo se dice “contagion”?
It was not a good day for Spain.
The euro zone’s fourth largest economy had to pay dearer to borrow through medium-term bonds, a sign that concerns over the country´s fiscal problems was curbing appetite for its debt. It sold 2.6 billion euros of 2015, 2016 and 2020 paper – at the low end of the target range.
In contrast, Portugal’s 1 billion euros sale of 18-month treasury bills was a successful test of market appetite for the longest-dated debt since it took an international bailout. Appetite for short-dated paper has been especially supported by the one trillion euros of cheap three-year European Central Bank funding injected into the financial system since December.
The problem is that Spain is the latest country to come into the firing line of the euro zone debt crisis. This week’s tough budget was not enough to calm investor nerves and many fear too much austerity could choke an already struggling economy where unemployment rose to a staggering 22.9 percent in the fourth quarter of 2011 – the highest in the European Union. Meanwhile, the government expects Spain’s public debt to jump in 2012 to its highest since at least 1990.
And although Spain has already sold around 46 percent of this year’s planned issuance of long-term debt and therefore is in a favourable funding position compared to its peers, analysts worry it could become the next source of euro zone contagion. In the secondary market, yields on 10-year Spanish government bonds rose to their highest since January at 5.72 percent after the auction.
DZ Bank rate strategist Michael Leister says:
It was only a lukewarm auction. This shows that the LTRO (ECB’s long-term refinancing operation) effect is losing momentum and that Spain is having a much more difficult time.
Europe’s wobbly economy
Things are looking a bit unsteady in the euro zone’s economy. Just ask Olli Rehn, the EU’s top economic official, who warned this week of “risky imbalances” in 12 of the European Union’s 27 members. And that’s doesn’t include Greece, which is too wobbly for words.
Rehn is looking longer term, trying to prevent the next crisis. But the here-and-now is just as wobbly. The euro zone’s economy, which generates 16 percent of world output, shrunk at the end of 2011 and most economists expect the 17-nation currency area to wallow in recession this year and contract around 0.4 percent overall. Few would have been able to see it coming at the start of last year, when Europe’s factories were driving a recovery from the 2008-2009 Great Recession. And it shows just how poisonous the sovereign debt saga has become.
Not everyone thinks things are so shaky. Unicredit’s chief euro zone economist, Marco Valli, is among the few who believe the euro zone will skirt a recession — defined by two consecutive quarters of contraction — in 2012. This year is “bound to witness a gradual but steady improvement in underlying growth momentum,” Valli said, saying the fourth quarter was the low point in the euro zone business cycle.
That could still happen. Business surveys support the idea that the worst is behind us, while European Central Bank President Mario Draghi agrees that last year’s collapse in confidence has now steadied, albeit at low levels. So far, the ECB has not given a strong signal on whether it will take interest rates below the 1 percent level for the first time, but the bigger risk is whether a disorderly Greek default or the threat of a severe credit freeze — which the ECB’s nearly 500 billion euros in loans has so far helped avoid – come back to crush the green shoots of growth.
The ECB’s latest lending survey showed for the last three months of 2011 reinforces the concerns of a credit crunch, as banks are still not passing the money on to the real economy. Thirty-five percent of banks reported they had tightened the standards they apply to loans to businesses, compared to only 16 percent in the third quarter. The ECB is set to make its second offer of three-year loans at the end of the month and that could ease credit risks, but may also discourage banks with bad loans on their books to reform.
So, in economist-speak, the risks are still on the downside and uncertainty remains high. Basically, things are still looking wobbly.
Fed hasn’t silenced markets, Williams says
Federal Reserve policymakers have long watched markets to gauge what investors think is in store for interest rates and the economy. Some – like former Fed Governor Kevin Warsh – have worried that the Fed’s unprecedented purchases of trillions of dollars of U.S. Treasuries and its long-term guidance on the future path of interest rates shuts off a key source of policy-guiding information. The Fed’s recent decision to publish policymakers’ interest-rate forecasts will make the problem worse, he predicted in a speech at Stanford University last month.
In some sense I have partially been made blind by these asset purchases. I, for one, consider financial markets an incredibly useful source of information. If the markets take the Fed’s projections and build that into their own, then the Fed won’t have a full set of gauges in front of them. The markets will simply be a mirror to what they say.
Now comes San Francisco Fed President John Williams with a research paper that argues, to put it bluntly, that Warsh is wrong – that markets are providing just as much information about expectations for Fed policy as they did in the days before the Fed had bought $2.3 trillion in long-term securities and began signaling short-term rates would stay low for years.
In the working paper co-authored with San Francisco Fed economist Eric Swanson and quietly posted to the San Francisco Fed’s website on Monday, Williams argued that five-year and 10-year Treasuries traders still respond with as much vigor to economic news as they did before the financial crisis. As Williams explained to reporters after a speech Monday at Claremont McKenna College:
We continue to see the markets reacting to information — they still give a signal for what they are thinking about when the Fed’s going to do (what), what policy is going to be, what they think of the future path of the economy. The markets are still working, they are still digesting the information, and they are still responding to it.
Williams’ paper also adds to research arguing there’s plenty the Fed can still do to help the economy, even with interest rates near zero for the last three years – and likely to stay there for another three. It’s a view that several of Williams’ colleagues, including Dallas Fed President Richard Fisher, have taken issue with, but one that Williams says his paper backs up. If long-term interest rates can rise and fall on unexpected economic news, as Williams and Swanson show in their paper, the Fed too can make its influence felt on long-term borrowing costs, the reasoning goes. The authors write:
Even when short-term interest rates are constrained by the zero lower bound, there may still be considerable scope for monetary policy to affect medium- and longer-term interest rates and, therefore, the economy. On several occasions since 2008, the Federal Reserve appears to have done exactly that, by managing private-sector expectations of future short-term interest rates and by conducting large-scale purchases of longer-term Treasury bonds and mortgage-backed securities.
