Co-manager of Ignis Absolute Return Government Bond fund says the nascent US recovery shows we’ve hit the halfway mark in 10 years of volatile inflation and limited expansion
The US economy is recovering. Financial conditions are highly stimulative and the improvement in real incomes and employment is expected to lead to faster growth in the second half of the year.
These factors are leading the debate on Federal Reserve tapering. There is pressure on the Fed and other central banks from both the International Monetary Fund and the Bank of International Settlement to avoid repeating past mistakes and, in particular, keep interest rates at emergency levels for a prolonged period.
Tapering of the Fed’s enormous liquidity programme is expected to begin by the 18 September Federal Open Market Committee meeting at the latest, and the process should be completed by March 2014. This will lead to inevitable speculation over the first rate hike.
Forward real treasury yields have already responded to the prospect of tapering, though there is still some distance before we reach levels that are likely to dampen US activity.
The sharp movement in Japanese and US forward yields over the past month show this inevitable adjustment period can be accelerated over shorter periods of time. Our long-held short position in Treasuries in the Ignis Absolute Return Government Bond fund has benefited from the recent sell-off.
The five year-five year real interest rate in the US sets the international standard, and rising US real rates will push up real rates globally, despite the weakness of activity in the rest of the world. We expect this to reinforce the global disinflationary trend.
The US economy is benefiting from unprecedented levels of stimulus but the momentum does not seem to represent escape velocity; it has not been a normal recession and it will not be a normal recovery. Indeed, the length of the recovery is already consistent with the pre-leverage accumulation recoveries of the 1950s and ’70s, and it is likely the high level of debt and still-elevated liquidity preference should have increased the US economy’s sensitivity to rising real yields.
Higher US real rates from their negative levels in the fourth quarter of last year mark a turning point in the ‘vile’ decade (volatile inflation, limited expansion). The second half of this decade will see false dusks rather than false dawns as central banks identify the limits of unconventional monetary policies.
These false dusks will reflect periodic slowdowns in response to higher real yields, which will force the central banks partially to reverse their attempts to withdraw liquidity.
The main beneficiary through the second half of the vile decade is likely to be the US dollar. We expect rising real global yields and increased economic volatility, with forwards that are driven by competition for capital showing the best gains in the next six months.
The global cycle is out of sync with the US. Mercantilist central banks that complained about the splurge of liquidity from Fed quantitative easing will find the end of this liquidity provision even more difficult to negotiate as the appreciation of the US dollar provides the conduit for tightening financial conditions in their domestic markets.
The major industrialised economies will experience a lost decade of sub-par and volatile real GDP growth. This is inevitable after a major financial crash and has historical precedents history. The ‘vile’ decade began in 2007 and is now middle-aged.
In the next phase central banks will try to engineer higher real interest rates in the belief that their economies are gradually recovering as the financial crash becomes a diminishing memory. This represents a marked change from the first half of the decade. Then, central banks were focused on adding liquidity to offset the impact of consumer, corporate, financial and government sector leverage. This led to numerous false dawns as the sugar rush of QE offset deleveraging.
The Fed’s QE stimulus has provided an offset to fiscal tightening through the recovery of the housing market, while the improvement in the banking system is laying the ground for faster employment and investment growth. These gains have been driven by the central bank driving negative real forward Treasury yields in the second half of last year. But these negative rates are no longer appropriate for the economy.
Global central banks are concerned about the longer-term consequences of ultra-low interest rates. As a result, they will attempt to raise real interest rates against the biased advice of liquidity addicted investors.
This will likely lead to numerous false dusks for central banks. These periodic swoons in response to higher official and market real rates suggest that despite the progress made in curbing corporate and consumer indebtedness, the central banks cannot effectively model sensitivity to interest rate hikes so soon after a major financial crash. Nevertheless, central banks have little alternative to higher real interest rates in the second half of the ‘vile’ decade.
The prospect of a smooth recovery once escape velocity has been reached is not supported by past history of post-financial crash expansions. This is the mirror image of the first five years of the vile decade but stopped during the false dawns of the past three years. In the second half of the vile decade, the appropriate policies will be to be short of short and medium-dated treasury forwards and long the US dollar.
Stuart Thomson is chief economist at Ignis Asset Management and co-manager of the Ignis Absolute Return Government Bond fund