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Bonds

Roger J Kerr says the reasons for super-low interest rates no longer exist

20th Nov 17, 9:30am by Roger J Kerr

The probability of US long term 10-year Treasury Bond interest rates correcting back down again (as they have repeatedly done so since 2009) seem to be dwindling.

Current 10-year yields at 2.35% seem much more likely to increase from here as US short-term interest rates continue to increase in markets.

US economic data for housing. jobs, retail and manufacturing continues to be really positive and the Trump tax reform bill now seems a lot closer to being passed.

There is also emerging evidence in the US economy that the blip down in inflation earlier this year was indeed temporary, or “transitory” as Fed Chair Janet Yellen always insisted was the case.

The US bond market now seems to have moved on from the disappointments earlier in the year when Trump failed to deliver on any of his promised growth agenda i.e. infrastructure investment, tax reform and repealing Obamacare.

The irony is that the US economy has continued to expand at a robust clip despite Trump’s lack of delivery on his promises.

There do not appear to be any economic reasons (in the US or globally) for US long-term interest rates to move downwards in direction.

Rising oil prices over recent weeks will be pushing up general inflation in the US, which supports the Fed plan to keep increasing their short-term interest rates next year.

The only question is how soon the US 10-year Treasury Bond yields move above the previous resistance at 2.60%.

Our long-term swap interest rates will follow the US yields higher.

The only factor that would push long-term interest rate back down again would be a global geo-political shock.

We have not experienced any great “flight to safe-haven” in the bond market due to this risk for more than 12 months now.

The North Korean situation has not escalated to a point to cause wide-scale buying of bonds for safe-haven reasons.

New Zealand 10-year Government Bond yields and thus swap interest rates closely follow the US 10-year Treasury Bond movements.

The margin that our NZ bonds trade above US bonds is currently 55 basis points (2.90% c.f. 2.35%).

That bond margin or spread can be expected to increase over coming months as the new Government adopts a looser fiscal policy and bond issuance (Government debt) increases.

New Zealand’s risk premium above the US will naturally increase as the bond markets build in the new Government’s higher spending agenda.

Daily swap rates

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Source: NZFMA

Roger J Kerr contracts to PwC in the treasury advisory area. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com

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21 Comments

by bw | 20th Nov 17, 9:47am 1511124464

"We don't have a corporate debt problem, we have a housing debt problem. For us that's where this Minsky-style moment would be the most clear and present danger to my mind."

http://www.afr.com/markets/paul-keatings-minsky-moment-prediction-rings…

by Boatman | 20th Nov 17, 10:27am 1511126864

As much as I like and respect Roger Kerr , his articles are thought-provoking , and I also want higher interest rates , I think he is farting against thunder.

Having said that , I hope his prognosis is correct .

In my laypersons view until the Fed , The European Central Bank , China and Japan start increasing rates and remove the QE liquidity or start doing so ,I reckon we are stuck in this low rate environment .

There is no political will to do so either , and the risks to European Banks are too great if liquidity dries up or the ECB takes away the punchbowl.

Those major European banks are not only to big to fail , they are also too big to bail.

They ( European Banks ) have consistently refused to correctly mark non -performing loans "to market" and adequately write them down for fear of falling foul of capital adequacy ratios and wrecking their balance sheets .

The ECB is hangstrung by what is in effect a dysfunctional currency , and cannot afford to act too drastically

China is impossible to predict , but it is certain to act in self interest only, and it appears that removing liquidity or increasing rates could topple the whole edifice , so dont expect any action there.

The Fed is in the driving seat , and will drive carefully , so as not to cause an accident

And finally Japanese monetary authorities will do what they have been doing for the past 2 decades ......... not much other than keeping rates as low as possible

Back home , if we Kiwis do our favorite trick of marching to the beat of our own drum by increasing our OCR, it will lead to greater carry-trade activity in pursuit of yield , thus neutralizing the Reserve Bank completely, keeping borrowing rates low and the currency too high .

Right now we should just accept what the market dictates

by dictator | 20th Nov 17, 11:58am 1511132298

The ECB have put out a warning that no one should expect the QE tap to be turned up again. The markets haven't registered the changes that are going on.

Slight interest rate increases, QE being turned down (except in Japan), US sanctions on lending to Venezuela, etc are putting the pressure on. I'm wondering how many countries will be hit by the cash flow from Venezuelan bonds being cut off? How many entities are now paying out for credit default swaps on those bonds? Will the ripple through the financial system cause problems months down the line?

It's an exciting time with all this uncertainty.

by custard | 20th Nov 17, 1:14pm 1511136869

Agree 100% Boatman.
The Fed is to be applauded for their impending buyback program – time to begin hoovering up all that excess liquidity – as you say “carefully”.
The ECB are hamstrung for some time to come and the inaction in China will only ensure the myriad of resultant distortions spread ever deeper and wider and authorities will remain constantly busy plugging one hole after another.
Early this year I heard many an observer talk of US 10yr at 3.00% by this year end – but despite various scenarios playing out that would have caused some sort of upward jolt, it basically remains almost totally impervious. If you had presented the type of economic data coming out of the US currently to someone 15 or 20 years ago and then presented a 10yr at 2.35% it would have seemed quite odd.
Having said that the 2yr is looking interesting – an ever flattening curve – something will have to give – who knows, maybe that 2.60% will again be challenged not too far in the future.

by Grant A | 20th Nov 17, 7:04pm 1511157840

Boatman - we won’t be “ beating to our own drum’ as we’re already well behind the Fed in terms of hiking - they have hiked 4-5 times in the past 2 yrs,and when they hike again next month (already 100% priced into markets), they will be within 25 bps of NZ cash rates, a spread I never thought I’d see in my life time bearing in mind the liquidity, currency and credit risk associated with foreign investors putting money to work here.

So the NZD, already down 7% since the new Labour Govt scared markets, is only to keep going in one direction, and ultimately inflation with it to the upside (add in rises in minimum wages, return of some industrial wages settling, pressure on wages from falling immigration etc), and then we’ll have the RBNZ bringing their first rate even closer (after having moved it forward 3 months in their MPS last week).

You’ll get your wish

by Colin | 20th Nov 17, 12:03pm 1511132632

With so much leverage across the world the idea of any significant rise interest rates in this environment is clearly a none starter e.g many housing markets would simply implode. However if inflation does actually start to pick up the central banks may not have any choice

by Henry_Tull | 20th Nov 17, 12:31pm 1511134309

Would interest rates go up because there is a shortage of money?

by dictator | 20th Nov 17, 1:06pm 1511136370

There's the implication in your question that market forces apply. When there is a shortage of money this would be addressed by more money printing (lower interest rates). However the financial system is flooded with so much money that there aren't enough financial assets to purchase with the money. The flood of money should be countered with high interest rates to suck some of the money out of the system. We have an excess of money and low interest rates which is blowing a global bubble.

Interest rates and the money supply are interlinked with control ultimately being with central banks, although money printing is licensed to most banks.

by PKchew | 20th Nov 17, 12:52pm 1511135557

People have been paying down their loans(anecdotal) possibly because interest rates are so low. So if banks have more money to lend but and sales of houses are far less, do you think interest rates will go up with demand for residential mortgages down?? I dont.

by dictator | 20th Nov 17, 12:56pm 1511135802

Interest rates are ultimately set by large Central Banks, not the market (at this time). The debt market is centrally planned.

by Ludwig | 20th Nov 17, 3:14pm 1511144097

In the end the market will win and the lessons will likely be brutal. Those that believe that CBs and Govts can control interest rates and the economy at will have obviously never read any economic history...

by THE MAN 2 | 20th Nov 17, 4:07pm 1511147233

Roger, I would be betting on interest rates being around current levels for many years.
Constantly economists have been saying thAt rates were going to go up and all along they have always been wrong!
If they were being paid on accuracy they would be in the dole queue.
U.S. can not afford to have high interest rates as they will go into another recession.
We won’t see 6 per cent again this decade,

by Retired-Poppy | 20th Nov 17, 4:32pm 1511148749

THE MAN 2, what do you think will happen as a result of the unwinding of QE? Its QE that led to the collapse of interest rates in the first place. Some highly leveraged individuals could be caught out big time as we are coming out the other side of this illusion. I understand that there are a lot of very successful people who are in reality just Landlords to their banks - by borrowing up large. You are what your worth after you minus what you owe.

by Laminar | 20th Nov 17, 5:58pm 1511153921

I think his pointy is that in his opinion the USA/Europe/China cant unwind very far, or perhaps more accurately, cant unwind very fast.

by Retired-Poppy | 20th Nov 17, 6:08pm 1511154518

Hi Laminar, USA/Europe/China are not concerned about crashing our economy. If withdrawing of QE doesn't crash their economies, that's all what matters to them. I suggest QE was first introduced with an inward focus but had global consequences.

by custard | 20th Nov 17, 5:23pm 1511151780

A couple of bold calls there regarding interest rates remaining at current levels for years, and not seeing 6% again this decade (although this decade doesn’t have that far to go to be fair).
Everything screams at me that you will be wrong – except for one annoying little fact - as you rightly point out – an awful lot of people, most far more knowledgeable than me have been talking interest rates up for years, and it simply hasn’t happened.
So you may well be right – I think its madness, given negative interest rates in Europe Land and a US 10yr at 2.35% - but it’s a madness that has lasted for several years and may well do so for some years to come.
Common sense says it will go “pop” with very serious consequences to follow – but when??
And yes, some will counter that such a “pop” would not be allowed to happen – hmmmm?!?

by Retired-Poppy | 20th Nov 17, 6:01pm 1511154089

custard, I suggest the withdrawing of QE may result in much tighter lending conditions. I cannot see rates going much higher than they are now without some serious consequences. Going forward, tighter bank lending margins and deteriorating bank profitability. Barring another equities crash or China shock, it's the tighter bank lending conditions that I feel will cause a prolonged and painful slump, in particularly here and Australia. It's been a good run and banks overreliance on property (80% of lending) as security will be their achilles heal. It's understandable why there are many out there that say it will never crash, simply because it's too big a risk to ignore.

by custard | 20th Nov 17, 7:19pm 1511158744

Agreed – but thankfully the Fed has at last begun its plan to escape this bizarre gravitational pull of QE that other participants appear powerless or unwilling to resist. Yes, the early part of is very much a baby steps exercise and will take some length of time to ramp up – and why not, this is unknown territory and no one really knows what may happen.
I take your point re liquidity regarding NZ and Australia– and unfortunately, on the bigger world stage, who will pick up the US$3.5 trillion of QE securities / assets left in its wake, and what will that do to liquidity.
And then there is always the chatter of simply inflating ourselves out of this.

by gingerninja | 20th Nov 17, 6:44pm 1511156657

Some comments from the Chief Economist at Fitch;

“I think there is maybe too much confidence that the Fed is not really going to do too much more on interest rates, that we’ll have one or two more rate hikes and that’s it,” Coulton told Reuters

Fed fund futures prices show that investors expect just one more rate hike as likely by August 2018. The Fed raised rates in December 2015 for the first time in a decade and has raised rates three times since to a range of 1.00 - 1.25 percent. However the U.S. central bank had forecast four rate increases for 2016 and three for 2017, which would have put overnight interest rates at a range of 1.75 - 2.00 percent.

Coulton said he expects the Fed to pick up the pace of rate hikes even if U.S. inflation remains low.

“We think they’re going to be ... getting more worried about some of the negative consequences of (quantitative easing), the fact that it encourages risk taking and may create some issues for the banks,” he said

https://www.reuters.com/article/us-usa-rates-fitch/fitch-chief-economis…

by solardb | 25th Nov 17, 7:49pm 1511592599

would be interesting to compare a dart and dartboard against all analysts.

by solardb | 25th Nov 17, 7:50pm 1511592605

would be interesting to compare a dart and dartboard against all analysts.