Everybody knows US interest rates are set to rise. Just ask Janet Yellen, or any other member of the Board of Governors of the Federal Reserve System (the “Fed”). Just look at Fed Fund Futures which reflect market expectations for future interest rates. Indeed, it is difficult to find anyone who is not absolutely convinced that rates in the US are about to start rising.
We are not so sure. And if rates do rise, we wouldn’t be surprised if the increase was merely temporary before the Fed reduces again to provide further monetary stimulus.
The most recent Minutes of the Fed’s Federal Open Market Committee (FOMC) meeting of June 16-17, 2015 noted that: “Respondents again saw the September 2015 FOMC meeting as the most likely time for the first increase in the target range for the federal funds rate.” The chart below produced by the FT illustrates these expectations.
If the FOMC are so sure that interest rate increases are just around the corner, why should we doubt them?
Well, it is interesting to remember that, in January 2012 for example, the number of FOMC participants that predicted policy rate firming before the end of 2014 outnumbered two-to-one those who believed interest rates would not rise until 2015/16.
And the chart below from the same FT article as above illustrates what market forward rates have been telling us over all these years. As you can see, these are not particularly accurate predictors of what the future actually holds.
So against this backdrop, we share with you our analysis on how we think about interest rate expectations and why we arrive at the conclusion that low rates in the US are likely here to stay for a little while longer yet.
While we monitor global macro events and develop thoughtful hypotheses here at Montaka, we should reassure clients that we do not consider ourselves to be macro investors. Every stock in the Montaka portfolio rests on its own bottom-up, company-specific, fundamentally-driven thesis. Whether interest rates in the US rise or fall, we are indifferent – our dual-portfolio approach enables us to profit from opportunities in all market conditions.
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THE STATE OF THE UNION
We are living in a unique time with lots of indicators looking unusual relative to our documented history. Interest rates are falling globally – as shown in the chart below. Furthermore, market-implied inflation expectations have been on steady downward declines for some time now – though we have observed a recent bounce in European inflation expectations following the recent announcement of the ECB’s QE program, as illustrated in the Appendix.
10yr Sovereign Bond Yields (Source: RBA)
CONSIDERATIONS FOR THE FUTURE OF INTEREST RATES
We highlight a number of considerations that serve to drive the level and term structure of interest rates. These considerations broadly fall into the following four categories:
- Inflation expectations;
- Growth expectations;
- The capital and labor intensity of future growth; and
- The scarcity of risk-free assets.
1. Inflation Expectations
- Nominal interest rates are considered to have a real component and an inflation component (as per the Fisher equation). Therefore, changes in inflation expectations will change interest rate expectations, all else being equal.
- Broadly speaking, there are three key drivers of inflation expectations, which we have named the following:
i. “Output-gap inflation” – When an economy grows at a rate higher than its “potential output”, inflation expectations will likely increase;
ii. “Input-cost inflation” – When input-costs increase due to supply-growth falling below demand-growth, inflation expectations will likely increase; and
iii. “Monetary inflation” – When growth in the supply of money (controlled by a Central Bank) exceeds growth in general demand for money, inflation expectations will likely increase.
- We consider each of these in turn.
1.1 Output-gap inflation
- When an economy grows at a rate higher than its potential output, demand growth for labor typically exceeds the supply of labor which drives wage inflation. This is associated with very low levels of unemployment in an economy.
- We consider the state of unemployment in global economies and conclude that, with the exception of China, general wage inflation remains fairly benign.
- United States: while the headline unemployment rate has fallen significantly – suggesting a tightening of the US labor market, the participation rate remains at a 35 year low.
- As demand for labor increases, the participation rate may well increase also, thereby keeping a lid on wage inflation for an extended period of time.
- We also note that in January 2015, the Congressional Budget Office (CBO) – the body in charge of providing the US Congress with economic data and forecasts – dramatically revised down their estimate for potential labor force in the US. This revision makes the labor market appear relatively tighter than it would look under the CBO’s original assumptions.
US Unemployment Statistics (Source: Federal Reserve Bank of St. Louis)
- Europe: unemployment remains extremely elevated, suggesting very low wage inflation, or even wage deflation, for an extended period of time.
- China: Since 2010, China labor markets have started to tighten, according to analysis by Macquarie illustrated below. Conceptually, this is not surprising given the slowing in China’s labor force, which will actually begin to shrink this decade.
Chinese Labor Market Statistics (Source: Macquarie, United Nations)
- Japan: We perhaps need only refer to the Bank of Japan Governor’s most recent comments suggesting that Japanese inflation could turn negative in 2015.
- “Today, the BoJ conceded that CPI growth is “likely to be about 0 per cent” in the coming months. And in a Tokyo press conference Mr Kuroda has now acknowledged he can’t rule out a dip below zero, either.”
- Australia: Since 2011, the trajectory of Australian unemployment has been upwards; notwithstanding a downward trend in the participation rate which is almost at a 10yr-low.
- Given the ongoing contraction in the Australian mining and energy sectors, as well as a consolidation of the Australian public sector, we believe unemployment will likely increase over the medium term. Wage inflation, therefore, is expected to remain weak at best.
Australian Unemployment Statistics (Source: RBA)
1.2 Input-cost inflation
- Input costs naturally impact the prices of goods and services consumed in the economy. As we know, commodity prices across the board have been in structural decline due to both excess production capacity and slowing demand growth. This is illustrated by the chart below.
- Such material declines in global commodity prices is globally deflationary.
- It is also worth considering the impact of global trade on a nation’s domestic price levels. To the extent Country A relies heavily on imports from Country B; and Country B devalues its currency, then Country A is effectively “importing” deflation from Country B.
- We illustrate some of the key import dependencies in the table below. For instance, nearly 40% of all imported goods into the US (equivalent to more than 5% of US GDP) comes from Europe, Mexico and Japan where currencies have significantly devalued. That is, Europe, Mexico and Japan are “exporting” deflation to the US.
- Interestingly, Australia has similar exposures to Japan and Europe which adds deflationary pressure to the economy, all else being equal.
Imports by Source Country (Source: Montaka; World Bank)
1.3 Monetary inflation
- When growth in the broad money supply exceeds growth in demand for that broad money, then inflation expectations will typically increase.
- Perhaps the most surprising aspect of the Fed’s QE program in the US has been the lack of inflation that has resulted as a consequence. The reason is that the enormous growth in the monetary base was not matched by similar growth in the broader money supply.
- This dynamic is illustrated in the chart below: while growth in the monetary base (purple line) has almost flown off the chart; growth in the broader money supply (red line) has been far more subdued, resulting in very benign inflation (green line).
US Money Supply vs Inflation (Source: Federal Reserve Bank of St. Louis)
- We can see a similar dynamic in both the Eurozone and Japan, as illustrated below.
Eurozone Money Supply (Source: Federal Reserve Bank of St. Louis)
Japan Money Supply (Source: Federal Reserve Bank of St. Louis)
2. Growth Expectations
- As we know, economic growth has been weak globally, with the major exception of the Chinese economy. It is for this reason that China has accounted for around a full 30% of global GDP growth in recent years.
- Yet, as the chart illustrates below, even China’s growth expectations have been steadily falling since 2012 as Beijing seeks to rebalance its economy away from fixed asset investment towards consumption.
Changes in Consensus Chinese Growth Forecasts (Source: DoubleLine Funds)
- The current Chinese GDP growth target put forward by Beijing is 7.0%. As recently as March this year, Chinese Premiere Li Keqiang told a press conference that: “It will by no means be easy to meet this target… The pain is still there and the pain is becoming even more intense.”
- The slowing of the Chinese economy will naturally impact the growth of the global economy.
- Stepping back, we evaluate some of the drivers of global growth below and conclude there are a number of structural headwinds that will hinder global aggregate demand over the medium and longer-term.
2.1 Organic growth drivers
- Aggregate demand growth is essentially a function of three inputs: (i) growth in the labor force; (ii) growth in the capital stock; and (iii) total factor productivity.
- On the first of these inputs, we can sensibly suggest that growth in the labor forces of economies representing nearly three-quarters of global GDP will likely slow over the coming decades. This is driving by ageing populations.
- Furthermore, ageing populations typically serve to place public budgets under increasing pressure as healthcare expenses increase.
2.2 Potential government stimulus
- We consider the potential for governments to stimulate their economies through the use of monetary and fiscal stimulus tools.
- With respect to monetary stimulus, there seems little more that can be done at this point considering that:
- The US has been engaged in QE since late 2008;
- The UK has been engaged in QE since 2009;
- Japan has been engaged in various forms of QE since the early 2000s; and
- Europe has recently started its own QE program this year.
- Australia is a unique example that still has some room to stimulate as shown in the comparison below of policy interest rates.
Global Policy Interest Rates (Source: RBA)
- Interestingly, however, there is considerable debate over the efficacy of additional monetary easing in Australia.
- Beyond some level, Australian banks will stop passing on RBA interest rate cuts to customers – as they try to preserve net interest margin.
- Bendigo & Adelaide Bank’s CEO recently stated that it may not be able to pass on interest rate cuts beyond the next 25bps; while a number of the Credit Unions did not even pass on the last 25bps cut in full.
- This implies that additional monetary stimulus potential in Australia may be more limited than many perhaps realize.
- With respect to the fiscal stimulus, we note the following public debt-to-GDP ratios of major economies.
- Clearly, government balance sheets of major economies around the world are highly stretched; and are set to become further stretched as populations age.
- There is an interesting interrelationship between monetary policy and fiscal policy. For highly indebted governments, tightening monetary reduces the potential for fiscal policy – both of which are disinflationary.
- The relationship stems from the incremental interest expense a highly-indebted government needs to pay its creditors on new debt issues when interest rates rise. We show in the table below the impact that +100%bps
Sensitivity (Source: Montaka; Bloomberg)
- Finally, the term structure of government borrowings is also noteworthy, as illustrated below.
- For instance, US public borrowings are much more short-term than those in other economies. Around half of all US government debt outstanding needs to be repaid over the next three years. This means that if interest rates were to increase tomorrow, then within three years, around half the country’s total public debt outstanding would be incurring the new higher borrowing costs. This is another reason why short-term US interest rates are unlikely to increase by too much for an extended period of time.
Distribution of Sovereign Debt Principal Repayments: Next 3yrs / Total (Source: MIM; Bloomberg)
3. The Capital and Labor Intensity of Future Growth
- Early last year, economist Larry Summers made an important suggestion that, due to technology, demand for credit may have decreased structurally. He coined the term “secular stagnation” to describe this:
- “Ponder that the leading technological companies of this age—I think, for example, of Apple and Google— find themselves swimming in cash and facing the challenge of what to do with a very large cash hoard. Ponder the fact that WhatsApp has a greater market value than Sony, with next to no capital investment required to achieve it. Ponder the fact that it used to require tens of millions of dollars to start a significant new venture, and significant new ventures today are seeded with hundreds of thousands of dollars. All of this means reduced demand for investment, with consequences for equilibrium levels of interest rates.”
- If Summers’ hypothesis is true, then this is another argument for an extended period of low interest rates globally.
- Along similar lines, many have observed instances of automation replacing labor within organizations. This too could have long-terms consequences for global interest rates.
- As a recent Economist article highlighted: “Society may find itself sorely tested if, as seems possible, growth and innovation deliver handsome gains to the skilled, while the rest cling to dwindling employment opportunities at stagnant wages.”
How Susceptible are Jobs to Computerisation? (Source: The Economist)
4. The Scarcity of Risk-Free Assets
- One final consideration that has emerged in a world of sustained asset purchasing by central banks is that of risk-free asset scarcity.
- Risk-free assets are required by many economic participants ranging from banks (both commercial and central), insurance companies, fund managers and others. To the extent the supply growth of these assets falls below the demand growth for these assets, then risk-free yields will be pushed down.
- Consider that, as of October 2014, the Federal Reserve held the following assets on its balance sheet:
- US$2.5 trillion in US Treasury securities; and
- US$1.7 trillion in mortgage backed securities.
- These enormous holdings reduce the stock of risk-free and low-risk assets in the market for other economic participants, thereby forcing down yields.
- Similarly, a recent UBS research report forecasted that the stock of public Eurozone debt would decrease for the first time as a consequence of the recently announced ECB QE program. Again, this asset scarcity places downward pressure on yields.
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- We are living in a unique time with lots of indicators looking unusual relative to our documented history.
- Even the RBA’s Assistant Governor recently admitted confusion at trying to make sense of global fixed income markets at the moment: “The low levels of yields globally and domestically are difficult to explain, most notably the low level of term premia.”
- Some commentators have gone a great deal further in articulating exactly what is going on. Respected FT columnist, Martin Wolf, for example, has named the current state of affairs in advanced economies as a depression: “Why are interest rates so low? The best answer is that the advanced countries are still in a “managed depression”. This malady is deep. It will not end soon.”
Appendix: Breakeven 10yr Market-Implied Inflation Expectations, Percent (Source: Bloomberg)
 FT: Beware the Fed on the ides of September, July 2015
 Blanchflower & Levin: Labor Market Slack and Monetary Policy, March 2015
 FT: BoJ’s Kuroda: CPI could turn negative, March 2015
 Essentially, the Fed primarily purchased assets from US banks and paid for them by marking up the reserves banks held on deposit at the Fed (an increase to the monetary base). These reserves can never directly end up in the real economy; instead the increased reserves act as increased lending capacity for banks to extend credit into the real economy. Since demand for credit has been weak, this “excess capacity” has largely gone unutilized.
 Definitions of money supply: There are several standard measures of the money supply, including the monetary base, M1, and M2. The monetary base is defined as the sum of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the Federal Reserve). M1 is defined as the sum of currency held by the public and transaction deposits at depository institutions (which are financial institutions that obtain their funds mainly through deposits from the public, such as commercial banks, savings and loan associations, savings banks, and credit unions). M2 is defined as M1 plus savings deposits, small-denomination time deposits (those issued in amounts of less than $100,000), and retail money market mutual fund shares.
 SCMP: China faces uphill task to meet lower economic growth target, says premier, March 2015
 Lawrence H. Summers, U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound, February 2014
 Economist: The onrushing wave, January 2014
 RBA: Global And Domestic Influences on the Australian Bond Market, March 2015
 FT: Strong currents that keep interest rates down, March 2015