Long-term interest rates about to rise
Last week, two events occurred that could have been expected to send bond yields lower, both in Europe and the United States:
- The ECB cut short-term interest rates and announced it would create far more money
- At 145,000 jobs, the August increase in US employment was much below the expected number of 225,000 jobs. In the past period, we mentioned the possibility that US consumers are saving more diligently. If this proves true, consumption growth could slow until businesses employ fewer people, the unemployment rate stops falling, wage rises drop, deflation looms, and economic growth declines across the board. Under such conditions, long-dated government bonds would be the best hedge.
However, instead of falling, bond yields have risen slightly.
In relation to the latter, we can say the following. Fed Chief Yellen's big fear is that there is still a lot of (hidden) slack in the US jobs market. If she is right, the Fed will need to tread very cautiously and beware of raising its key interest rate too soon. In that sense, the disappointing job creation data suggests that the US central bank will delay the rate hikes (at least until the second half of 2015). But perhaps we are jumping to conclusions; there are two other ways to look at this.
First, that last month's job creation data fell short of expectations could potentially signal a lack of suitable workers rather than an economic slowdown. Relevant in this respect is a Fed study that was published last week. It focuses on the participation rate of the working population as a follow-up to a study that was issued three years ago. The writers of the earlier paper predicted what would happen in the future and it appears that they hit the nail on the head. They forecast that the rate of participation will fall so much – 75 percent of this drop was expected to be structural against 25 percent cyclical – that by 2016 just 45,000 job seekers will enter the labour market. From this perspective, it is no surprise that businesses have a hard time finding the right employees. Also because most indicators point to high labour demand and very few redundancies. Of course, many people are still out of work but the reason may be that they do not meet the requirements of potential employers. The rising wage increases of the past quarter point in the same direction.
A second take on the weak August employment increase is that one month does not make a trend. Lately, we have seen so many strong US economic figures that the disappointing data can easily be an aberration. In that event, job creation will continue to grow in the near future and the labour market will soon tighten.
In both cases, it is high time that the Fed starts to prepare the financial markets for rising short-term interest rates at an earlier point in time and at a higher pace than the markets are discounting. In either case, we would expect the yield on 10-year US Treasuries – now near 2.4% – to reach 2.75% - 3% by year's end. However, if the first assumption is correct (that the weak data is structural) the short-term interest rate will rise sooner/faster than if it is an anomaly.
Remarkably, the ECB is not (yet) planning to purchase government bonds although the central bank has announced that it will facilitate lending by the banks; especially in the weak Eurozone countries. This is very important as the unavailability of credit is having a downward effect on economic growth in Europe (which is already sluggish). After the results of the stress tests are published in October, many banks will, in any case, be less reluctant to supply credit. Once credit eases substantially, economic growth could accelerate as inflation rises (i.e. in the course of next year). All the more so if the euro remains weak. In our view, there is a less than 50/50 chance that the ECB will launch a large-scale bond-buying programme (alongside massive money creation) in 2015. Yet, that the 10-year German yield is below 1% - and the EUR 10-year Interest Rate Swap barely above 1% - means it is discounting such a prospect. Therefore, we think the 10-year IRS will climb to 1.40% - 1.6% in the coming months (also in the wake of higher US long-term interest rates).
The time may well have come to rapidly reduce the position in long-term bonds; in the US as well as Europe. Presently, the best alternative is to purchase two or three-year dollar paper (although we would be inclined to wait until the start of next year when we expect the yield for this maturity to have increased by 0.5%). In the circumstances, such yields will be reasonable and investors may profit from the appreciation of the dollar against the euro. Owing to policy divergences between the Fed and the ECB – monetary brakes versus monetary accelerator – EUR/USD could drop to 1.20 over the coming quarters. Nevertheless, as the pair is currently oversold, any moment EUR/USD can rally (perhaps by a few percentage points).