Long term interest rates have kept surprisingly low – and the source of this surprise is the threat of deflation in Europe. The ECB will have to do what it takes to avert this threat.
We have long been of the view that the key to the short term behaviour of global equity markets is the direction of long dated US Treasury yields. Until fairly recently it may have been said that the actions of the US Fed were decisive for the direction of these interest rates. The Fed, via its Quantitative Easing (QE) programme had become a very large holder of US Treasuries and mortgage backed securities.
These exchanges of Fed cash (in the form of Fed deposits) for bond and mortgage backed securities were undertaken with the specific intention of not only protecting the financial system, but of holding down mortgage rates to assist the recovery of the US housing market and so of household wealth. At the peak of these operations US$80bn of these securities were being added to the asset side of the Fed balance sheet each month and simultaneously to the cash balances kept by US banks.
The slow but more or less steady recovery of the US economy allowed the Fed to suggest in May 2013 that it would be tapering such injections of cash into the system and that by late 2014 it would hope to end QE. It has since followed through on this prospect. Monthly net purchases of these securities in the market have been tapered and the security purchase programme will be over soon. This announcement of a likely end to the Fed support of the fixed interest market led however to the “taper tantrum” of May 2013. Long bond yields rose significantly and equity values declined. Volatility, in the form of daily moves in equity markets, increased and emerging equity and bond markets – regarded as more risky than developed markets – were particularly affected.
Then, despite the Fed taper in 2014, the trend in long term interest rates reversed direction, markets calmed down and share markets recovered. Indeed, market volatilities as measured by the Volatility Index, the VIX (the so-called “fear index”), had fallen back to pre financial crisis levels by mid 2014 and the US equity markets has moved back to record high levels.
The danger of the VIX at such low levels was that volatility could spike higher and share markets accordingly retreat (given that they were regarded by many observers as, at worst, fairly valued by the standards of the past, as represented by conventional Price/earnings multiples).
It could be demonstrated by reference to past episodes of low volatility and demanding valuations that such a combination of low volatility and generously valued equities would need more than good earnings growth to provide good returns. In the past it appeared that only lower long term interest could overcome well valued equities and low volatility. Moreover, it was widely assumed that long term interest rates in the US, very low by the standards of the past, could only be expected to increase. The upwardly sloping US treasury yield curve indicated very clearly such expectations of higher interest rates to come and incidentally still does so.
To the surprise of the bond market and despite the Fed taper, long term interest rates in the US fell rather than rose in July and August 2014. It was lower interest rates in Europe, especially in Germany, that led global rates lower in July. Not only did German Bund yields fall, with US and other rates falling in sympathy, but the spread between lower European and US rates actually widened, surely adding to the appeal of US Treasuries. The Spanish government now pays less for 10 year money than Uncle Sam.
The Fed therefore is no longer the lead steer of the bond market herd. The danger of deflation in Europe is that it leads interest rates lower. And this deflation is all the more likely given quantitative tightening in Europe to date, rather than easing. Unlike the Fed or the Bank of Japan, the assets and liabilities of the ECB have been falling significantly rather than increasing. That the supply of European bank credit and broader measures of money has been falling is consistent with a lack of demand for ECB deposits.
These broad trends will have to be reversed if European deflation is to be avoided. The ECB will have to do what it takes to increase the supply of money and bank credit. QE action is called for and can be expected to continue to hold down global bond yields. Euro deflation trumps the risk of higher interest rates.
The figures below fully illustrate this story of falling interest rates, declining volatilities and higher share prices. We also show how the US dollar has strengthened in response to this improved spread in favour of the US and how developed and emerging equity markets (including the JSE) when are running together, when measured in US dollar terms.
