By John Authers
2019/6/17
Federal Reserve governors don’t want to make news. If the Fed is a topic of discussion, that is a tell-tale sign that people think they are doing something wrong, or that they are under pressure. And at the Federal Open Market Committee (FOMC) meeting this week, Powell certainly wants to create as little excitement as possible. It comes just before the G20 meeting in Japan that is billed as the next opportunity to seek a resolution to the trade dispute between the U.S. and China. To cut immediately ahead of it would be seen as an attempt to strengthen the U.S.’s hand, and an abdication of Fed independence. The continued efforts by the president to bully the Fed into cutting rates make it even more important for Powell to keep his head down and not make waves.
But Powell has no choice but to make a lot of news. First, he must contend with a remarkable shift in the market for inflation-protected securities which suggests that the market has lost all confidence in the Fed’s ability to keep inflation close to its official target of 2%. The break-even rate for inflation over the next 10 years is now its lowest since the presidential election in 2016, and shows that we are once more in the grips of a deflation scare:
Bear in mind that Friday’s sharp fall in break-evens came on a day when data on consumer confidence and retail sales suggested the U.S. economy was more buoyant than thought, and hence that inflation fears were overdone. It also came despite a sharp increase in tension over Iran, which would normally push up oil prices – a move that would directly increase inflation.
In this context, such negativity about inflation plainly forces the Fed to consider cutting rates. It also shows that the president isn’t the only one trying to bully the Fed into a cut; the market is trying to do the same thing. Powell will have to address this.
But while the market seems close to unanimous in the attempt to force the Fed into cutting, the variety of opinion over where the Fed should take policy over the next six months is remarkably varied. The following chart, taken from the Bloomberg WIRP (World Interest Rate Probabilities) function, shows how the market has changed in its assessment of the probable interest rate at the end of this year. The possibility that they will remain unchanged from where they are now has been downgraded to almost zero; but the market seems to think that one, two, three or even four rate cuts within the next six months are all possible. No single path for the Fed is seen as having as much as even a 40% probability:
Three rate cuts is seen as the most likely path; but four rate cuts, or a cut every meeting from July until the end of the year, is seen as more likely than only one. The fact is, both a drastic loosening of policy, as is usually only seen in the teeth of an imminent recession, and a single “insurance” cut to guard against the risk of a deepening trade conflagration, remain quite possible, as far as market participants are concerned.
Given this kind of uncertainty, it is hard to see how Powell can possibly fail to move these perceived odds, and hence move the market, when he gives his press conference on Wednesday. He will be as non-committal as he can, I imagine, but he will still almost certainly say something to make one path of action seem more likely than another. This promises to be a very difficult week for traders, with ample opportunities to be caught wrong-footed.
But deliver us from Austria.
What is going on in the bond market at present is truly extraordinary. The sudden drop in inflation break-evens is dramatic enough, but Deutsche Bank’s ever-resourceful chief U.S. economist Torsten Slok has drawn my attention to what I think is the best and most remarkable evidence of bond market excess - and also of the extraordinary power of bond math (or bond maths for my British compatriots): It is the century bond issued by the Republic of Austria in 2017. Investors won’t receive their principal back until 2117.
Austria once controlled a great empire. It gave the world some of the greatest composers ever to have lived, from Haydn and Mozart through Schubert and Bruckner to Mahler and Schoenberg. Vienna hosted Sigmund Freud and Ludwig Wittgenstein and any number of great artists. And far less positively, it also gave the world Adolf Hitler. Today it has one of the most settled and successful economies in Europe. Having said all this, Austria had a financially disastrous 20th century. According to the widely respected Credit Suisse Global Investment Returns Yearboo (compiled annually by the British academics Elroy Dimson, Paul Marsh and Mike Staunton), anyone who bought Austrian stocks on the eve of World War One would have had to wait 97 years before they made good their losses. Austrian bonds and bills fared even worse. Such were the financial consequences of losing an empire and being on the defeated side of two wars.
But even though Austria has been the great exemplar of what can go wrong in a century, it looks as though investors have decided that nothing can go wrong between now and 2117. Since the century bond was issued in September 2017, Austrian stocks have fallen almost 20%. The country appears to be in a bear market. And yet anyone who bought the century bond has made gains of more than 50%:
Can lending money to Austria, knowing that you will not get back for a hundred years, really be that appealing? It can, but the fact that investors want to pile into such a bond suggests something alarming. Eurozone bond yields and inflation expectations are dropping like a stone. Meanwhile, the Austrian century bond has consistently offered a yield about one-and-a-half percentage points above those on 10-year German bunds. It has been variable, but there has always been a big spread, even though the Austrian economy is tightly linked to that of Germany:
Investors love spreads like these. Any opportunity to make extra income as easily as this will be gobbled up.
Then we add the magic of bond math. A century bond with a low initial yield has an exceptionally long duration, meaning that it is exceptionally sensitive to moves in interest rates. To take the yield from 2.09% to 1.18% over its history has required the price to rise by half.
The problem is, duration can cut both ways, and those buying Austria’s bond now must know that. If the yield were to go back up to 2%, scarcely a remote possibility, anyone who has bought it recently stands to lose a lot of money. After years of the declining trend in yields, with no rest, judgments become fuzzy. So a lot of people are making a big bet that the latest deflation scare is a real one, and cannot be easily reversed by a shift in policy from central banks. In particular, they have to be betting that the latest fall in yields isn’t merely a reaction to the intensification in the trade conflict, that could be easily reversed by a truce in the trade war. If this is merely a trade-war swoon, then yields could rise again, and any investors in Austria could be setting themselves up for a damning date with destiny, and a nasty surprise.
Red Flags over Hong Kong.
This month’s selection for the Authers’ Note Bloomberg book club was meant to be topical. It has turned out to be far more newsworthy than I had bargained for. On Sunday, more than 2 million protesters took to the streets of Hong Kong, even though the Hong Kong chief executive had on Saturday announced the suspension of a controversial new law that would allow for easy extradition of suspects to the Chinese mainland. In response, Carrie Lam, the chief executive, issued an apology. The entire incident now appears to be the most significant challenge yet seen to the more authoritarian stance taken by Xi Jinping, China’s leader since 2013. If you want to find out more about the forces that have led to these momentous events, you cannot do better than read this month’s book: Red Flags: Why Xi’s China Is In Jeopardy, by George Magnus.
The book, which has been widely and well reviewed, makes as its central argument that the era in which China’s incredible growth of the last three decades can be extrapolated into the future is now over, and that Xi represents a radical change of direction. Mao and Deng both had their own models for communist China; now Xi has a third. I thought the topic would be of big interest in the context of the trade conflict between the U.S. and China, but in many ways the topic of whether China’s economic and political system can continue to survive under the weight of its own contradictions is even more important.
Plenty of feedback is coming in, but I would encourage everyone to participate, particularly those of you who are Chinese, or who have particulary knowledge of China. Debates about the country in the west are hampered by the language barrier, and by deep-seated assumptions which Stephen Roach, the former head of Morgan Stanley in Asia who is now a professor at Yale, describes as a “false narrative”. Roach is considerably more positive about China than Magnus and in his review of Red Flags (available, behind a pay-wall, here), noting that recent “doom-mongering” books on China “tell a compelling – and seemingly timeless – story about how Western observers’ assumptions shape their conclusions, leaving one to wonder how China ever got to where it is today.”
I don’t think that Magnus can fairly be accused of “doom-mongering” but he does, as his title implies, raise some important “red flags.” All responses to those flags are welcome.
One interesting point comes from Bruno Momont, and points to the dangers for the regime that have been caused by China’s intense urbanization since Mao:
[There is an] underappreciated risk to China’s economy and political system that I believe is growing, namely the longer-term effects of urbanization on political stability... The rate of urbanization helped fuel political stability through income growth and those trends are turning, challenging political stability. In addition, however, the higher rate of urbanization, in my opinion, by itself could also make it more likely that Xi’s authoritarian approach could be challenged. Protests and revolts are more likely when a large share of the population lives in city centres and can more easily communicate and organize. The recent protests in Hong Kong and the rumblings surrounding the 30-year anniversary of the Tiananmen protest may all just fade away. But with China’s economic growth slowing (exacerbated by the Sino-US trade war), they could also be the beginning of a stronger challenge to Xi’s leadership.
This could turn out to be a very important point. It may be harder to maintain control of aspiring middle-class populations leaving in mega-cities than it was for Mao to control a peasant economy.
One more comments on debt come from Kuan Hian Tan, recently graduated with a Masters' degree from Harvard with a thesis on China’s Belt and Road Initiative:
The rise in China's debt-to-GDP looks alarmingly quick, especially after stimulus in 2009. However, China's debt-to-asset ratio has not risen (and even fallen) in the same time, and is not anywhere near alarming. A major factor in the rise of debt-to-GDP is the explosion of debt backed by real estate. Real estate prices in China have risen something like 600% from 2003/2004 (on average; there's regional variation), which is when something approximating a private property market was instituted and real estate prices began reflecting what people would pay for them. Unsurprisingly this led to major rise in debt-to-GDP. By Yukon Huang's estimate in his book Cracking the China Conundrum: Why Conventional Economic Wisdom Is Wrong, around 70% of the rise in China's debt is explained by the rise in debt against real estate.
The big question is whether this rise in real estate constitutes a bubble. This is unclear - obviously such a dramatic rise might be a bubble, but prices in Shanghai and Beijing are lower than those of comparable apartments in Mumbai and New Delhi. You can think of the rise since 2003/2004 as the natural consequence (insofar as there is anything "natural" about the operation of financial markets, hat tip to the anthropologists) of allowing Chinese households to put years of accumulated savings to use in the property market.
The important upshot for investors is that the rise in debt-to-GDP may well be less alarming than it first seems.
There is much more commentary to come, I am sure. Please send any and all thoughts on “Red Flags” to authersnotes@bloomberg.net, or, better still, join in with the IB chat room we have set up on the terminal, where I hope to post links to the most interesting material. To request access, just send an email to authersnotes@bloomberg.net.
Follow the sell-side?
Sell-side analysts have cleaned up their act a lot in the last two decades. At the point that Eliot Spitzer, then the New York state attorney general, took on the sell-side and won, buy and sell recommendations had come to be virtually meaningless. Almost no stock was rated an outright sell. Grade inflation among analysts anxious to ingratiate themselves with corporate clients was so blatant that the recipients of their research had to mentally downgrade each recommendation by one; a “strong buy” meant a “buy,” a “hold” meant a “sell,” and so on.
These days, plenty of companies receive a sell rating. Brokers are doing their job and trying to separate the likely winners from the losers for us. The problem is that they still seem to be slaves to momentum, with the result that following their advice opens an investor to the real risk of buying at the top and selling at the bottom. These are the 10 most-popular stocks in the S&P 500 Index, as monitored by Factset:
Of course, many people have missed out by betting on an end to the incredible Amazon phenomenon over the years. But after the run that it had, does it really deserve to be a unanimous buy? Only four stocks, less than 1% of the entire index, command such widespread support from brokers. Meanwhile, this is the list of the 10 most widely recommended “sells:”
Franklin Resources, which controls the Franklin Templeton fund management group, has a name widely connected with emerging markets and with active management. Both are hugely out of fashion. But that news should surely be in the price. Why are more than half of analysts convinced that it has further to fall?
On a hindsight basis, we can certainly say that buying Amazon and selling Franklin would have worked brilliantly if you had executed them five years ago. This is how Amazon, Franklin, and the S&P have fared over the last five years:
Anyone who made a Long Amazon-Short Franklin trade five years ago would by now have gained 867%, before trading costs and interest charges. It seems wildly optimistic that brokers’ analysts still think that the trade has a long way to go, and that Long Amazon-Short Franklin is still the best pair trade available from S&P 500 stocks today.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the author of this story:
John Authers at jauthers@bloomberg.net
To contact the editor responsible for this story:
Beth Williams at bewilliams@bloomberg.net
