I think current unconventional policy measures remind us that central banks’ willingness to provide ultra-cheap liquidity is high and should remain so for some time. The market believes this for now. Authorities are aiming at low short-term rates while creating inflation expectations on the long-end. After all this seems to be to only viable strategy to significantly reduce debt/GDP figures. Also central banks today operate under much more transparency than, lets say, 20 years ago. FOMC minutes are announced few days after the meeting and the banks basically operate under specific growth and unemployment targets.
In the US the FED is committed to purchase mortgages at a rate of 80bn per month, which is a key driver to lower rates. It is also the single biggest holder of US treasuries at the moment. At the same time attempts by central banks in Asia, first and foremost Japan, to suppress rates on the one hand and devalue their own currency should not only lower rates but in a feedback loop lead to additional USDs flowing back into Treasury markets further maintaining and stabilizing the lower rate environment.
Therefore I fundamentally see the market pricing the situation correctly as the next few years will see both deflationary forces from attempts of deleveraging in the private and public sectors which are being neutralized by government intervention resulting in a very flat trajectory back to a normal rate environment. However I do not believe that this necessarily means that the current rate environment will act as unsupportive for other asset classes. On the contrary, the artificially low-rate environment could through other channels lead to stimulating effects especially in the international equity markets.
2nd order consequences of low rates
Given the global developments described above I could imagine rates to behave differently than expectations by bond vigilantes in the current debt-laden environment. Japans central bank is quite figuratively no longer independent. At current rates of 0.77% for 10Y JGBs roughly ¼ of tax revenues are used for debt service. An increase to only 2%, a current international average will increase this to ¾ and make it mathematically unsustainable to return to a normal path. As such there will be massive pressure to keep rates low.
So as currency wars could potentially unfold in 2013 we could see something similar to the Greenspan conundrum of the early 2000s as new funds from attempts of currency devaluation flow into treasury markets. There have already been reports of CB investments in asset classes such as equities and corporate bonds hence continued devaluation of currencies could prove as a natural stabilizer for these asset classes. The second round effects can be seen as an international type of QE4 potentially even stronger in combination with the structural flows into the equity markets.
The continuing dichotomy between inflationary stimuli measures from CBs and depressionary deleveraging effects will persist but I tend to believe that CBs will be continue their support for the markets and continue to be the dominant force.
Irrational investors?
I think the current moment coined as the “great rotation” out of bonds into equities is very interesting. Although investors are aware of uncertainties and the general obliviousness to risk is low they feel compelled to progress with this secular shift.
We are in a very unique point in the cycle right now. Risk aversion is low although risk-awareness is high. This is quite paradoxical and makes for a quite dangerous investment environment. The Fed’s intervention has helped drag Treasury yields to extremely low levels. The present S&P 500 dividend yield of 2.2% commands a 150 bp premium over five-year Treasuries, which has not been seen in 50 years.
As such the market no longer reflects the fundamental economic environment but follows a self-induced risk-on attitude despite prevalence of all the uncertainties. Investors desperately looking for income (see rally in HY bonds and high div equities in 2012) could have sparked a secular rotation from fixed income into equities. The probability of this occurring is linked to sustainability of international debt service. As mentioned above, Japan is currently in a precarious situation so authorities are fully aware and ready to act accordingly.
This is definitely a high priced environment defined by market participants compelled to buy equities that look very cheap to bonds when looking at earnings yields. At the same time institutional clients which need to obtain income to fund liabilities are compelled to shift funds into higher income asset classes than conservative bonds.
So to sum up, Fed policies could have opened the door to an environment where markets are unwillingly turning investors risk-prone for the coming months.
