In recent weeks the debate about the significance of the flattening yield curve has reached fever pitch. Does a flat curve spell curtains for the US/UK economic expansion – and by extension, the global economic expansion? Can we hear the distant strains of the amply upholstered diva? Is this a golden moment to acquire bargain basement long-dated bonds?
My answer is no, no, thrice no! We have insufficient evidence that global economic momentum is faltering, especially in the light of the latest US national accounts data and the stimulatory policy announcements from China. As I argued in a previous article, past relationships suggest that US bond yields have further to rise to adjust to a strengthening nominal environment. Part of that is compensation for faster inflation, and part reflects an improvement in real economic growth. It would be quite extraordinary for an economic expansion to end with real interest rates – short and long – little above zero. The typical real interest rate achieved at the end of a post-war US tightening cycle has been 2, 3 or even 4 per cent. How can we be sure that US real interest rates – short and long – will not revisit positive territory before this economic expansion ends?
The alternative scenario, which we favour, is that the entire US yield curve has further to travel to adjust to an environment of 6 per cent to 7 percent nominal GDP growth. Not only could the FOMC extend its planned normalisation, in the light of positive economic surprises, but bond yields could create the room for that normalisation to occur in the context of an upward sloping curve. (Just imagine the Trump tweets that would ensue). As a bond investor, how would you wish to be positioned in the long-dated Treasury futures market if you entertained this suspicion? Or if you took the New York Fed’s underlying inflation gauge (figure 1) seriously? Or the Atlanta Fed’s wage tracker?
Figure 2 provides a rough-and-ready answer. Aggregate net positioning, in terms of numbers of contracts, has never been as negative as it is today, with these positions concentrated in the longer maturities. Tariff talk has diverted financial market attention from the here and now. Flatter yield curve natter has obscured the longer-term perspective on the determination of long bond yields and exposed bond investors – and property investors – to the risk of significant capital loss over the coming year.
Properly understood, central banks contain a branch of the intelligence services. They hold secrets, conduct covert operations, exact silent retribution on miscreants and facilitate invisible transactions. In extremis, they curate the rise and fall of domestic political regimes and individual careers. Occasionally they destabilise tyrannical regimes in far away places. (Should you ever be offered a job in a central bank, you should take it.) The only real difference between the US Federal Reserve and the Central Intelligence Agency, or between the Bank of England and MI5/MI6 is that central banks hold press conferences and publish information.
You might consider that to be a fatal flaw for a clandestine organisation, but clever people always find solutions. For central banks, the solution is the Script. The Script is a rolling narrative about economics and finance, that is plausible, memorable and technical. Plausible, because it has to fool journalists and other commentators and compel them to hang on every word of the chief communicator. Memorable, because it is important that the communicator can recite the message in his/her sleep and so that it becomes familiar to the journalists and commentators. Technical, because it must maintain a gap – sometimes a chasm – between the consumers of the information and the providers. This gap is invaluable when it comes to the Q&A sessions at press conferences and accountability hearings. Questioners must be made to feel inferior and inadequate in the presence of Great Minds.
There’s just one more thing about the Script. It bears almost no relationship to the actual internal policy discussion or the underlying motivation for the decisions made. Hence, after reaching an important decision, there follows a further round of discussion to consider the necessary amendment to the Script. The cornerstone of the prevailing Script is that the long end of the yield curve (embracing the 30-year and 10-year yields) is anchored by the central bank. Long-dated bonds are frequently described as ‘safe assets’ and their yields as ‘risk-free rates’. This is a major achievement of the Script. For when shorter-dated (2-year or 5-year) bond yields approach the anchored rate, it creates an appetite for government bonds. The apparent upside (from falling yields) is large, while the apparent downside (from rising yields) is small. This is the investment equivalent of the television show, “Play your cards right”.