At the 2014 European Investment Conference, Steven Major, CFA, global head of fixed-income research at HSBC, explained that a year ago, his team was criticised for predicting long-term government yields 1% lower than market consensus. He wished he had been wrong, but today, the term premium on long-end US bonds is negative.
To provide further analysis, Major evaluated four papers his team published in the past 12 months. He explained that “Just Another Sell-Off,” published in 2013, focused on term premiums and US bonds versus nominal GDP and highlighted that in the United States, secular factors are overriding cyclical factors and leading to negative term premiums, especially as half of the bonds were taken out of the market by the Federal Reserve Board.
The second paper, “Peak Rates,” published in February 2014, discussed the strong decline of the US five-year rate on five-year forwards while the five-year spot rate remains constant. He stated that as the market chose not to taper, the Fed was forced to adjust its policy — a typical case of the “tail wagging the dog.”
“Managing the Exit,” published in June 2014, and “US Curve Conundrum,” published in October 2014, reviewed the large-scale asset purchases (LSAPs) by the Fed, which led to the counterintuitive effect of a steepening yield curve. Major emphasised that the Fed created $2.7 trillion in excess reserves to finance these purchases. The only logical explanations as to why the Fed purchases led to a steeper yield curve, he added, are that the “flattening effects of the asset purchases were more than outweighed by the excess reserves — funding the ‘mother of all carry trades’ — and the forward guidance of not increasing interest rates in the near future.”
Following the findings of his research, Major concluded that yields will stay low for longer because:
- Secular drivers continue to overwhelm cyclical drivers.
- The Japanification of the eurozone is occurring.
- There is more Bank of Japan easing (clarification to be given in April 2015).
- There is an impact on US and UK expectations (e.g., the Fed is now having to point out international factors in its minutes).
- Investors are desperately searching for returns.
- Bearish consensus prevails.
What Can the Central Banks Do?
Major stated that “the global economy is weak, is sick,” because how else would you explain oil price decreases in times of geopolitical tensions, such as those in Ukraine and Syria? “Markets are twitchy because the Fed is planning a liftoff but does not know how to do it,” he added.
LSAPs contribute to a reduction of long-term volatility but at the same time increase volatility on the short end, Major remarked. The current forward rates imply a big front-end yield curve increase as the Fed is now giving up its efforts to contain the rates on the short end. According to Major, the “yield curve will flatten even further but at a much lower level . . . around the five-year yield.” He believes that the huge volume of carry trades is just an “accident waiting to happen.”
Major argued that the plans of the central banks to reduce their balance sheets are highly questionable and will inevitably lead to short rates going up. The last time the Fed and the Bank of England decided to reduce their balance sheets was in the 1950s, and it took them 30 years. Major believes that all the Fed is presently planning is shifting amounts on its liability side: reducing the excess reserves by $300 billion but at the same time increasing the reverse repos by $300 billion. However, this will not reduce the Fed’s asset base or balance sheet by a single cent.
At the same time, Major contended, the Fed cannot hike interest rates until it has reduced the excess reserves. He believes the Fed will try a gentle liftoff: “It was easy to get into QE [quantitative easing], but let’s see what happens when they try to get out of it,” he said.
Moving onto the eurozone, Major asked whether there is anything left for the European Central Bank (ECB) to do? He believes that the ECB was the most successful central bank regarding guidance and delivered in 9 out of 10 cases and that it was also successful in decoupling the euro money market from the US money market. Major stated that its “à la carte” easing was successful, but the ECB is now running out of options. He was particularly concerned about what is happening in the euro periphery (i.e., valuations do not fit the fundamentals) and the fiscal positions and fiscal sustainability.
To conclude, Major shared his forecast for fixed income:
- Front-end interest volatility risk approaches liftoff; the key for central banks is to get out of excess reserves.
- Eurozone yields will move even lower.
- The desperate search for return will contain spreads; because a lot of fund managers cannot invest in Japan, they will start buying Italian and Spanish bonds again.
- US and UK 10-year yield forecasts will stay below consensus.