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G10 Macro Rates Blog – Take away the punchbowl

Thursday, May 16, 2019

Latest G10 Macro Rates Blog
With Shayne Dunlap, Co-Portfolio Manager

Take away the punchbowl/Kill the Zombies!
At a recent meeting with a respected economic research firm, they alluded to the fact that the quick back track by the Fed earlier this year may have avoided yet another recession and lengthened the economic cycle by a few more years – To which I questioned – “Are Central Banks meant to avoid recessions or depressions?”

My thought stemmed from the idea that their economist was right! The outlook for the Fed and the world was for a flatline of the business cycle – a long drawn out period which has lost its beginning, middle and possibly, end.

This flatline is priced to perfection in the USD OIS curve, which has barely 75bp difference for the next 30 years. (I didn’t calculate any further). What this means is that the implied overnight yield is priced to be between 1.75% and 2.50% for any day, week, month, year or combined period of those until 2049, and possibly beyond.

This current market pricing is something I find hard to rationalise. Is the USD interest rate curve really going to do almost nothing for the next 30 years? I doubt it! I understand how we got here. Central banks have taken upon themselves to fight recessions – via their inflation and / or employment targets. This outcome can be viewed as politically motivated or a by-product of always trying to attain these targets combined with any number of background factors ranging from globalisation, automation, ageing population to maturing economic development.

What is harder to understand, and what was behind my question, is why is the world so sanguine that any future US policy manoeuvre is going to be contained to a 75 bp range?

This range looks at odds with history, especially when considering the range over the previous 30 years. The current range of pricing seems to be more in-line with Japan and it’s so-called “lost decades”. In that economy, free money perpetuated a “zombie economy” – where uneconomic companies could refinance debt for long periods and effectively retain market share and suffocating healthy companies. In the US this easy credit availability has driven a similar outcome. In 2018, 16% of all US companies were categorized as “zombies” (outmoded or financially unviable business models) by the BIS, up from just 2%, 20 years ago. The explosion of capital via QE and other liquidity programs means the excess “free” money has been used to buy back shares, free money for VC’s to force up asset prices, free money being sucked into “Unicorn” business models. (Do I hear “but the emperor isn’t wearing any clothes”?). Free money to drive all credit spreads down to historically low levels, in a never-ending chase for yield.

However, I believe the free market economy only works effectively if it’s allowed to work freely, and that freedom is an environment where a business cycle can work to its conclusion. That cycle includes a recession, as unwelcome a thought as this might be. The economy needs a full business cycle, it needs speculators to lose money on bad investments, it needs zombie business and zombie business models to be removed, and an avoidance of completing this process is to the long-term detriment of everyone.

How this eventuates, who knows?! I have faith that markets generally find the most efficient, but not necessarily the best, way to allocate capital. So, if that capital is harder to acquire then the less deserving allocations will disappear. Which implies that regulators, in the absence of any other means, need to encourage a tightening in lending standards and capital availability.

Unfortunately, in recent times the trend has been the opposite, access to capital was loosened after the GFC. Yet when the underlying economy was looking strong earlier this year, the Fed backed away from a further tightening of liquidity via suspending QT and any further rate rises. Many suspect the Fed back traction was linked to a fear of potential further equity weakness.

As the 9th fed governor William McChesney Martin famously once said - the Job of the Fed is
“to take away the punchbowl when the party gets going”.

I worry they only like parties now... even long and boring ones.

Source: Pacific Asset Management. Note: Recent US rates rally has extended OIS yield range from 60bp to 75bp

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