Global Policymakers Are Starting to Shiver
The year 2013 is a fascinating case study for markets and the economy, at least in parts where what happened was what was supposed to happen. It started under a cloud of suspicion, a lingering fear in that the year before, 2012, was an almost perfect case study about what was not meant to happen. There wasn't supposed to be a global relapse, yet there it was. All the world's major central banks were forced back into action as what looked like very real recession fears threatened to topple the fragile recovery.
To be successful this second time would mean to achieve what wasn't the first - normalization. In Europe, the dramatic and "unexpected" events of 2011 banking led to a full retrenchment, a re-recession. In the US as Japan it wasn't quite so severe, still noticeable nonetheless. The Federal Reserve responded with what Chairman Ben Bernanke believed was required force, an open-ended third (then fourth) quantitative easing program.
If it worked, the US would not only avoid the full setback, it would sail on into what almost everyone had been expecting since the start: full recovery. That would mean interest rates and financial conditions overall back to where they were before the crisis began, the world once more going about its business. The stock market enthusiastically embraced QE3 for only what it promised; the bond market remained far more aloof.
The day Mario Draghi issued his infamous (and still unfulfilled) promise to "do whatever it takes" to preserve the euro in late July 2012, the US Treasury curve at the 2s10s (the 10-year yield minus the 2-year yield) was just 121 bps, about as low/flat as it had been at any point in 2008. By March 2013, through all the world's combined "stimulus", including the QE's here in the US, the 2s10s steepened but only to about 180 bps. That was the level to which the curve had flattened during the actual 2011 crisis itself, still significantly far from even the hint of normalizing.
It wouldn't be until that May the curve would finally respond as stocks had. Highlighting what is and always was a natural tension between this kind of monetary policy and actual market forces (discounting anticipated future conditions), it wasn't until the word "taper" was first uttered that the UST market and its yield curve finally rejoined and in almost convinced fashion. By the end of 2013, 2s10s had decompressed all the way to 260+ bps, about as steep as the curve had been in the recovery years before absent the almost regular interruptions.
The original idea behind "forward guidance" was to guard against premature celebration. A market that accepts QE as stimulus is one that will respond to the future it represents rather than the here and now the central bank desires in order to achieve that future. In other words, the Fed intended for rates across the whole curve to drop so as to be "stimulus" for borrowers in all sectors. By lowering the risk-free benchmarks, policymakers assumed that would lower the base for all lending costs. To get recovery, as Bernanke told us, meant lower first.
A bond market that expects QE to work, however, would anticipate its fulfillment and counteract almost immediately, adding an upward force to interest rates where and really when the central bank least desires them. The trick of forward guidance was to add an element of, as Paul Krugman once described and urged of the Bank of Japan in the late 1990's, credible irresponsibility. From the central bank perspective, "everyone" expects that QE will work but the central bank will promise to keep it going for longer than necessary to ensure that it does by overcoming this basic market instinct to plan ahead for it working. It is, perhaps, the bond market version of "don't fight the Fed", though in this case by acting too early the same exact outcome policy seeks to attain.
At first blush, the introduction of "taper" seems to have fit all those marks. From the standpoint of forward guidance, it was the removal of the promise to be credibly irresponsible while at the same time adding much needed confidence that the economy was, in fact, moving in the right direction such that even the FOMC, whose job it was to be highly cautious about such things, was seeing sufficient progress. So was the bond selloff that year due to taper or the unleashed expectations for normalcy, economy as well as interest rates? There are those who maintain even to today that it was the former; that the bond market only responds to what any central bank is doing at any given moment. Such is the power of the myth of the Great "Moderation" that even after a decade of open and obvious failure it lingers heavy in the minds of far too many, the blatant narcissism of the "best and brightest."
And 2013 proved to be yet another such failure. The treasury market has bid up prices (lower yields) more without QE than with it. It is another bond "conundrum" that policymakers have been unable to explain because it is a direct affront to everything they believe. Starting toward the end of 2013, nominal rates began falling again and the yield curve flattening, all the while the FOMC voted consistently to reduce the pace of the remaining QE's until they were eliminated altogether (leaving only the reinvestment of maturities to render a steady level for the Fed's overall balance sheet). And still interest rates fell and curves collapsed.
The response in 2014 here in the US was with only more confidence. After all, the unemployment rate was falling far quicker than anyone had figured, even those who believed QE would be quite effective. In addition, there seemed to be more improvement in economic statistics that seemed to further the notion that 2012 was just "transitory" weakness being put to the past. Now Janet Yellen's Fed would stand on the belief, exactly contrary to the bond market, that "liftoff" was at hand. Though economists were predicting full recovery right at that moment, the 2s10s had long ago moved out of agreement, flattening by the end of 2014 back to nearly as low/bearish as July 2012.
Yield curves were not shriveling only here, they were sinking everywhere. Other central banks responded with more "stimulus"; Yellen assured us all that it was just "their" problem and nothing to trouble us here. As we saw in 2015 and then confirmed in 2016, the bond market was, yet again, right.
But even now it is being credited with only a partial victory (such as being correct about the failure of QE and all that comes with it could be classified in that way). Economists, analysts, and the media (in many ways all those are indistinguishable) have shortened the time frame of reference so as to reduce the standards to which the yield curve judgment is applied. Now, belatedly, acknowledging that bonds were right globally about 2014 (meaning that the world was turning lower not higher), this is being revised to suggest that they were actually wrong in pricing what being right meant.
The economic world is judged upon the template of the business cycle. This is not, of course, without good reason as there have only been business cycles since the 1930's. After seven decades it seems a reasonable standard. And so where economists were clearly wrong about the expected upturn in the "cycle" entering 2015 (after first declaring its missed appearance as "transitory"), economists are now claiming that bonds were wrong also but in figuring a downturn. This is the binary model of recession/not recession that dominates discourse.
To start this year, it appeared as if a full downturn was actually a possibility, a danger that has since seemed to have passed as 2016 progressed. This is the basis for the current set of optimism that has taken hold in many places; a sigh of relief that what looked like recession is far less so now. But it is a fundamental misreading of all that has transpired economy, bonds, and all in between.
The true picture the bond market paints is not one that swings between probabilities of recession or not, rather it is one which recognizes something quite different than the business cycle. The global economy has absorbed several blows, and in response to each weakens in what looks like it might turn to recession, only to avoid it but also never recover from it. If your worst case is recession, then you are happy that it appears the upturn of the business cycle only continues even if mystified as to why that happiness is only intermittent and uncertain at best. If it is an upswing it is still unlike all others.
What has happened in the economy is altogether different than that. Removing the recession binary has the effect of aligning markets (stocks only recently) with reality. This has been so consistent and gone on long enough now that even some policymakers finally get it, if only partially at this point. Federal Reserve Vice Chairman Stanley Fischer in a speech on October 17 caught up part way with the yield curve:
"First, and most worrying, is the possibility that low long-term interest rates are a signal that the economy's long-run growth prospects are dim...One theme that will emerge is that depressed long-term growth prospects put sustained downward pressure on interest rates. To the extent that low long-term interest rates tell us that the outlook for economic growth is poor, all of us should be very concerned, for-as we all know-economic growth lies at the heart of our nation's, and the world's, future prosperity."
There is a maxim for stock investors that says when valuations are extremely high you should expect very low returns for more than the immediate future. It is cliché because history shows it to be correct. While that may be the case, it tells us nothing about how those low returns might manifest; with serious violence where crash and bull alternate; or like the dot-coms where slowly over time the market is almost strangled by fundamental imposition. I raise these possibilities not as a commentary on stocks but instead to suggest something similar in bonds as even Fischer now concedes as all-too-possible.
In other words, the collapsed yield curve of low nominal rates very likely means expectations for a very bleak future landscape; but like overvalued stocks, it isn't immediately clear what that actually means about how we get there. It could very well be a violent and unstable period where the global economy contracts and grows by turn, with each offsetting over time the other, though I doubt it. No, I think the pattern is quite well-established, proved in the uncertainties of 2013.
If we look objectively at the economic statistics all over the world from that time, removed of the binary recession/not recession expectation, what we see is that in 2012 the prior recovery speed just ended. What was insufficient to begin with as compared to the size of the Great "Recession" itself, suddenly downshifted right then. The US and global economies had experienced close calls or near-recessions fairly regularly throughout the years, but those had always ended in the familiar "V" if but miniaturized (where the bottom of the "V" doesn't quite make it all the way into recession territory). In other words, the economy slows for a brief time causing some minor angst and then resumes its prior speed to be quickly forgotten.
In 2012, however, the global economy decelerated (in some places like Europe to full contraction) and then at best only partially rebounded; it got slower and then remained slower overall. But this fooled the mainstream recession dynamic which was relieved where recession was avoided but then misread what that avoidance truly meant. The modest improvement in 2013 and really 2014 was just that and nothing more. Compared to the slowing of 2012, it wasn't improvement at all; it was merely the absence of further deceleration.
To policymakers, if the economy isn't falling into recession it is therefore on the upswing. Modest improvement seemed to validate that expectation even though by late 2014 bonds were already moving lower (in yield and curve shape) to what was already by then in progress - the next economic blow. What happened in 2012 and 2013 was repeated again in 2015 and 2016; it slowed in the first year and then remained slow the following one. The economy gets weaker and then appears to stabilize at that weaker state; only to be pushed weaker all over again in a ratcheting effect that gets lost in the mainstream binary obsession.
Unlike 2013, however, 2016 has proved devastating to mainstream thought; given the unemployment rate and so many promises related to it there was just no way 2016 would not be appreciably better than 2015. This pattern, however, is well-established now tracing all the way back to 2007. That is why nominal yields and curves have been falling since then, not as "stimulus" for more borrowing but as recognition of the dimming future prospects. Though there have been times when "normalcy" was considered a possibility, even a good one as in 2013, these bursts of optimism have been short-lived because the global economy only gets worse, slowly over time as if the proverbial boiling frog, though in this condition us amphibians are being slowly frozen rather than boiled.
This year was the first time authorities noticed the temperature change. Having essentially ditched QE in Japan, Europe, the US, and everywhere else, central bankers are desperately groping for their next big solution. Many think it has already been found, and, in fact, has already been deployed. In the middle of September, the Bank of Japan inaugurated what some have called "yield curve targeting." Rather than add to QQE, which had been augmented once before in late 2014, BoJ has promised, essentially, to steepen the yield curve.
We are back into the troubled landscape of forward guidance. What does a steeper yield curve mean in this conduct? Well, even Stanley Fischer now knows what a flatter curve might mean, so in elementary school logic it seems as if forcing the curve to the opposite condition will achieve the desired result. If the yield curve shrivels in foreseeing a further bleak future, then the central bank will steepen it on its own initiative and force the bond market to see what the central bank wants it to see? It's a preposterous idea because it assumes again that bond investors are childlike in being unable to differentiate between a truly steep yield curve anticipating truly good times and one that is made so by non-economic factors in response to truly bad times. The former is actual normalization; the latter is mere recognition of just how far from normal we are.
Unlike Stanley Fischer's fit of reality, some central bankers actually believe that their QE's have been "too successful" and that is to blame for the flat yield curve. As I wrote above, there are those who refuse to believe that markets are anything other than a tool or toy for monetary policies. You can already see plainly the illogic of it, or where it devolves into circular logic. QE has, in this view, been so successful with rate "stimulus" that it needs to be pulled back so that it can actually be successful in the real economy. This is a partial offshoot of another idea being debated in policy circles where a central bank needs to raise its inflation target.
In other words, these people truly believe that buying bonds has worked so well it has actually undermined itself, especially at the long end. In reality, even if it were true it only proves the complexities of markets and how they operate in other dimensions central bankers and economists don't appear to be able to perceive until far too late. I wrote in mid-August about the sudden infatuation with higher inflation targets, particularly for Japan:
"In the meantime, the Japanese economy, like the global economy, suffers from economy while economists search the skies for answers to the magic number problem they created. It is entirely logical and reasonable that people would become so highly skeptical of these Rube Goldberg-type plans, especially when every time "stimulus" "needs" to be increased it is itself an acknowledgement that past "stimulus" failed to actually stimulate."
In Japan, the JGB curve had flattened to an almost perfect straight line; the 2s10s had dropped to a low of just 5.6 bps on July 6. By mid-September, however, the JGB curve had steepened back out to 25.3 bps, and with the recent pronouncement for "yield curve targeting" the JGB 10s have steadied and the curve spread sticking to around 20 bps. Does that count for more successful "stimulus?" The answer might be clearer had these spreads been calculated on a curve where both ends were actually positive. In other words, when the JGB curve was at its flattest it was because the 10-year bond had fallen in "yield" to a ridiculous -27.8 bps, as compared to -33.4 bps "yield" for the 2s. As of the latest close, the curve has "steepened" to where the 10s are back at -6.4 bps "yield" and the 2s -25.4 bps.
The BoJ actually purchased fewer 10s in their last September operation than they had been purchasing in those that came before. I have no doubt that the governing council is congratulating itself on such good execution of its new strategy if only because they truly don't know from any realistic standpoint what that strategy actually is. They set out in QQE to buy a whole lot of 10s as if that was what Japan needed; then they decided three year and a half years later they bought too many 10s, and cut back because that is what Japan needs. Maybe what Japan needs is none of this?
Japanese interest rates and its JGB curve have been collapsing in on itself for a very long time. Economists want to believe that it was all due to monetary policy when in fact it wasn't; it was the bond market seeing past central banks to the utterly austere future that it was correct in predicting. Monetary policy isn't proactive stimulation to avoid that future; it is reactive attention to it as it actually transpires. Every time a central bank feels it necessary to change its "stimulus" regime it is only doing so because something it didn't expect already happened to disprove the last one.
As Japan has shown time and again, the worst case is not recession or even repeated recession. It is stagnation of a kind far more sinister than that of the Great Inflation. At least in the 1970's there was action and activity. This version is where the economy is simply frozen. In Dante's Inferno, Hell is not hot, it is increasingly cold as each layer is further removed from God's true warmth. Heat is passion and life; cold is where living is further stripped away toward the inanimate. The bond market is making that same journey, if not in a straight line, further into the lower reaches as the economy grows colder and colder.
Policymakers, now starting to shiver, are trying desperately to find meaning, not even answers, in the variability of the descent. For the record, the US 2s10s, even after the most recent bond market deviation on the road to economic Hell, remains near its lows at less than 100 bps.