A risk off day in the markets – drawing some of the implications for inflation and growth
The markets yesterday must be regarded as having had a risk off day. Global government bond yields fell further (ie bond prices rose) while most equities, including those in the US, moved lower.
The US dollar, the safe haven currency, gained further strength against the euro, trading this morning at USD1.186. This dollar strength was also highly consistent with a further widening of the interest rate spread in favour of US Treasuries over equivalent German bunds. This morning the US 10 year Treasury has yielded 1.9487% compared to the 10 year German bund that offered a mere 0.446%. The gold price also rose, providing further proof of more risk aversion in the markets.
What exact form the additional risks took was perhaps not so obvious. The further decline in the oil price may well be the most likely suspect. A lower oil price clearly helps consumers and household spending and must be regarded as helpful to the growth outlook, given the important share of household spending in GDP, over 70% in the US and over 60% in SA. Yet while oil consumers stand to benefit, the rapid magnitude of the oil price decline must threaten those banks with exposure to the producers and service providers to the oil sector way beyond the US oil patch.
The full impact of such large shocks to the global economy, of the kind represented by these dramatic moves in the oil price, is hard to measure accurately with any degree of confidence. The extra risks priced into the bond and equity markets generally, understandably reflect some of this. More stable oil prices at these lower levels would help calm the markets and provide time for the full impact of a permanently lower oil price (if this is to be the case) to be better calculated and priced into bond and equity values.
A permanently lower oil price is on balance likely to be helpful for the global economy that has wanted for growth in household spending. It is likely to mean faster growth with less inflation, possibly accompanied by falling prices, that is deflation. If this happens, it will mean lower interest rates and so discount rates attached to income streams expected from oil and energy consuming businesses. They may well enjoy improved operating margins as production and distribution costs rise more slowly or, better still, decline when measured in money of the day. These trends, as they materialise, should show up in higher rather than lower values attached to most listed companies.
Yet while interest rates can be expected to decline with less inflation or even deflation expected, inflation linked interest rates offered by governments may well rise as growth picks up and demands for capital to invest by more profitable businesses also gains momentum. These real rates, highly indicative of the real cost of capital for all capital raisers, have been stable over the past year at low levels. Inflation expectations in the US, indicated by the difference between the yields on a vanilla bond exposed to inflation risk and the inflation protected equivalent (known as TIPS for Treasury Inflation Protected Securities), have declined also quite sharply in recent weeks (see below where we show the premium offered for bearing inflation risk in the US over the next ten years and the 10 year real TIPS yield).
However it is of interest to observe that yesterday, while nominal rates in the US fell away, the equivalent real yield actually rose. Perhaps this indicates that while less inflation is expected in the markets, growth expectations for the US may well have improved marginally on oil price trends.
