Taper caper

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Federal Reserve (Fed) chairman Ben Bernanke has been trying to have it both ways this summer.

Germany: Meet the new boss – same as the old boss 2 of 6 Cycle still a headwind for bonds

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First he hinted that the Fed was ready to consider tapering its bond purchases, then – alarmed at the market volatility that resulted – he tried to reassure investors by stressing the conditionality of the move, and reiterating his “forward guidance” on interest rates. Because US bonds influence European yields too, the European Central Bank (ECB) and Bank of England felt the need to offer similar guidance.

The central bankers want to maintain orderly markets. More importantly, as bond yields rise, so do many corporate and household borrowing costs, which might threaten economic growth. The Fed, in particular, is formally responsible for jobs as well as for tackling inflation. But improving economies (Figure 1) don’t need as much support as they did, and an open-ended promise to keep buying Treasuries (or gilts) would surely risk re-fuelling credit market excesses. We think their concern may prove misplaced.

Figure 1: Key business surveys (manufacturing, standard deviations from trend)
Standard deviations from trend

Central bankers are dauntingly smart, but they are neither omniscient nor omnipotent.

Their medium-term forecasts are no less fallible than others’, and they do not have perfect control even of short-term interest rates. So their “guidance”, no matter how well-articulated and carefully conditional it may be, is of limited use. Economies may
grow a little more quickly than they expect, and even if they don’t, bond yields may rise further and drag expected short-term interest rates up with them – as has already happened, central bank reassurance notwithstanding, since April (Figures 2 and 3).

Figure 2: As 10-year bond yields have risen…
Nominal Yield Level 10 years (%)

Figure 3: …some implied short rates have risen too
Implied 3-month rates December 2014 (%)

Big turning points in interest rates are usually driven by economic developments and their accumulating impact on money and bond markets, not by central banks. As businesses and consumers spend a higher proportion of their income, lowered savings ratios – and the increased attractions of risk assets, which can divert funds from money and bond markets – can begin to squeeze money rates and bond yields higher. Central banks preside over this, and effectively rubber-stamp the process with their own policy rates, but they are not usually the prime movers of it.

Rising bond yields and interest rates may be more effect than cause

Eventually, of course, higher rates will restrain growth. As the initial willingness to spend more fades, they can become the straw that breaks the camel’s back, as it were, and contribute to recession. But over the post-war period as a whole, real US long-term and short-term interest rates have been positively correlated with GDP growth – rates and yields have been pro-cyclical. And, as investors, we are much more likely to sell bonds on good economic news than buy them.

This time, of course, the turning point in bond yields and rates is marking a new phase in the most remarkable financial episode in our working lifetimes. That said, there is no reason to think that it will be different in this key causal respect. Mr Bernanke’s signal in June echoed a growing market realisation that the prospects for US growth had improved and, at this stage in the cycle, cause and effect is more likely to be running from the economy to interest rates rather than vice versa. Further ground for optimism in this respect is the historically low level of US households’ interest burden to start with.

We’ve suggested here often that there are good reasons for giving the post-crisis US economy the benefit of the doubt. Consumer balance sheets and spending patterns have been much more resilient than received wisdom has suggested, and the dwindling budget deficit is reducing the likelihood of a potentially disruptive medium-term fiscal squeeze (even as another debt ceiling deadline looms in October). We’ve also argued that the UK has not been doomed to stagnation by fiscal austerity, and that the eurozone is capable of growth too, the smouldering euro crisis notwithstanding (see Germany: Meet the new boss – same as the old boss). So the uptick in the economic indicators in Figure 1 looks plausible to us. It’s not so much that we think it can withstand the tapering of Fed QE in the weeks and months ahead – it may be causing it.