US Treasury yields at 2.0% cannot be justified unless a US recession is imminent. We were shocked when German 10 year yields fell below 1% in the course of August. Since then, bad news from the euro area has to some extent underwritten the market action. Yesterday, 10 year US Treasury yields briefly fell below 2%, before recovering slightly. We believe that the only event that could justify yields that low would be another round of quantitative easing, a QE4.
Here is the maths: simulating the impact of an ultra-dovish Federal Reserve (Fed) (no rate hike before end 2016, then very gradual rise of the Fed funds rate to 3.0% by 2020, then stable), bond yields today would have to be at least 2.0%, so that investors would not be punished if taking the duration risk. Only QE4 (lifting the price of long bonds above their fair value) could justify such low rates. And the only thing that could justify QE4 is a high probability of a downturn in the real economy and/or falling core inflation.
Humbled by what has just happened in the euro area, should we anticipate that in a few weeks, data from the US economy will confirm that the market action was justified? We think the answer is NO.
The probability of a US recession is close to zero
First, high frequency economic indicators are pointing at a continuation of the US expansion at a clip between 2.5% and 3.0%, to take a conservative view. It is likely that the ISM index, a reliable coincident indicator, will decline further in October, but from 56.6, there is still ample cushion before it may indicate a material risk of recession. A more forward looking analysis, based on our ISM-based Surprise Gap (SG), shows that the SG is likely to fall into neutral territory if production slows significantly. Even so, this would be consistent with a steady growth rate of the economy in the next few months, compared to the recent past.
Second, the fundamentals of the US economy are steadily improving, whether seen from the consumer side (debt/income ratio back to end-2002 level), the corporate side (high profitability) and even the government side (federal deficit falling fast). True, there are still weaknesses in the labour market, despite the fall in the unemployment rate (5.9% in Sept), the housing market has performed poorly in recent quarters, and the strength of the US$, although positive for consumers’ purchasing power, may weaken the capex cycle. Yet, overall, there is not one single indicator flashing red, as far as the risk of recession is concerned.
In short, it seems very unlikely that the Fed could be forced to renege on its commitment to end QE next month on the basis of news from the real economy. But what about the risk of ‘lowflation’?
Going for QE4, really?
Federal Reserve Bank of San Francisco Governor John C Williams was quoted by Reuters saying: “If the outlook changes “significantly,” with inflation showing little sign of returning to the central bank’s 2-percent target, (…)he would even be open to another round of asset purchases”. This may have convinced markets to price a high probability of QE4 because of a large risk of falling inflation. That seems to us overstretched.
First, core inflation, as measured by the core CPI index, has been volatile in recent months, yet without showing a distinctive downward trend. Smoothing out its monthly changes by a statistical filter, we find that core inflation has been hovering around 1.9% since mid-2012.
Second, lower energy prices and a stronger US$ will most likely pass through core inflation in the future but at the same time, rents (including rents imputed to home owners) are likely to continue to follow house prices (the Case-Shiller 20-city index was up 6.7%Y in August) and wages are more likely to accelerate than to decelerate. Net net, there is no hint of a significant risk of falling inflation.
Overall, the probability of QE4 seems very low. Our subjective estimate is that it could be between 10 and 15%. But even with a 15% probability it is very hard to justify 10Y yields at 2.0%.
A plot theory
We are left with only one hypothesis, which belongs to the plot storyline: since the ECB is turning to its own quantitative policy and the Bank of Japan is buying all net issuances of JGBs, the Fed might wave the threat of QE4 to prevent the US$ from appreciating further. We do not buy this story. QE 1/2/3 have resulted in a weak dollar, which was instrumental to foster the US recovery. Yet, US Treasury officials in charge of the exchange rate policy have repeatedly called for a more proactive monetary policy in Europe, that is, a quantitative policy. Now that the euro is declining as a result of the ECB’s decision, it would be inconsistent to retaliate and, doing so, increase the systemic risk emanating from Europe. In other words, it is in the interest of the US that the euro depreciates, now that the US economy is robustly recovering, because a weaker euro is one of the rare macro levers that could pull the euro area out of its quagmire, seen as a threat to the US economy and rightly so.
Back to the markets, we believe that investors have generally had a positive view on the US economy and an expectation that rates would begin to rise in 2015. As such, positioning has tended to be “short duration” in US Treasuries. Over recent months a series of risk “events” and policy ambiguity from the Federal Reserve has generated a risk-off behaviour which has intensified this week. Typically as risk assets sell-off the bid for US Treasuries increases and, on this occasion, appears to have triggered widespread capitulation of the consensus interest rate bet. The result is that the rates market has overshot fundamentals.
We have cut our end-of-year target for US Treasury yields to 2.4%. There is no reason to cut it further: the market is over-reacting and a correction is due.
Eric Chaney, head of Research at AXA IM and Chris Iggo, CIO and Head of Fixed Income Europe & Asia at AXA IM