Homo economicus

We all know £2.99 is a bargain and £3.00 is a scandal. Whoever first realised the incredible value hidden in that one pence made a lot of money on our irrationality. Brokers are now probably making that much money again with investors trading feverishly as the 10-year US Treasury broke the 3.00% milestone for the first time in a bit over four years.

14 May 2018

We all know £2.99 is a bargain and £3.00 is a scandal. Whoever first realised the incredible value hidden in that one pence made a lot of money on our irrationality. Brokers are now probably making that much money again with investors trading feverishly as the 10-year US Treasury broke the 3.00% milestone for the first time in a bit over four years.

The benchmark yield has since fallen back below 3% after its sharp rise in late April. The spike in the 10-year yield helped increase its spread over the 2-year, taking it above 52bps for a couple of days before it slumped again to 47bps. This measure is important because if the spread falls to 0 or below – the yield curve inverts – this virtually always signals a recession is coming. We think a recession is unlikely and so we don’t expect the spread to turn negative; however, we are continuing to keep watch, given how low the spread has gotten.

With the US economy running smoothly and the Federal Reserve raising rates steadily (if extremely slowly), yields were going to continue rising. The average 10-year US yield between 1990 and today was 4.6% and going back to 1962 it was 6.2%. Three full percentage points is not a doomsday scenario. Yes, borrowing costs are rising, but US companies appear in pretty good shape. Some are over indebted and will topple as rising interest payments erode their cash flow, but most are posting strong numbers. Half of the S&P 500 has released first-quarter results, with almost 80% of them topping analysts’ expectations, according to FactSet. The blended growth rate is a whopping 23% with nine of 11 sectors boasting double-digit expansion in earnings. Energy companies have done extremely well, reporting earnings that are almost 90% higher than a year ago, while the materials sector has increased earnings by 41%. Technology remains the rocket ship powering the index higher, with its earnings up 32% on 12 months ago. Financials and industrials are also posting good numbers, with their earnings rising, roughly, by a quarter.

Companies are cautious about future earnings, however, citing the uncertainty of new tariffs with China and the general protectionist moves by the US government over the past few months. Some hope of a deal remains, hanging on Steven Mnunchin and his team who are said to be travelling to China this week to iron out a deal on trade. It is impossible to say what the outcome will be.

Higher borrowing costs will be most worrying for the US government. Having just splurged $1.5tn over the next decade on tax cuts, the Congressional Budget Office expects the US deficit to balloon to more than $1tn by 2020. With total US government public debt totalling roughly $16tn, back of the envelope math tells you that every 50bps increase in the 10-year yield adds an extra $70bn to its borrowing costs. The rough total for 3% interest payments is $480bn each year, or 14% of the $3.4tn tax revenue forecast for the coming year.

 Index  1 month  3 months  6 months  1 year

FTSE All-Share

6.4%

1.1%

2.1%

8.2%

FTSE 100

6.8%

1.1%

2.3%

8.5%

FTSE 250

4.7%

1.0%

1.5%

6.2%

FTSE SmallCap

5.2%

0.2%

1.9%

9.1%

S&P 500

2.2%

-2.9%

-0.2%

5.8%

Euro Stoxx

5.2%

-0.8%

-0.7%

10.1%

Topix

2.7%

0.8%

2.0%

13.5%

Shanghai SE

-1.9%

-9.5%

-8.7%

-0.4%

FTSE Emerging

1.0%

-4.6%

1.2%

11.5%

Source: FE Analytics, data sterling total return to 30 April

Bait and switch

Another month, another twist in the Bank of England’s (BoE) forecast. Just a month ago Governor Mark Carney was sending strong signals that the BoE would start hiking interest rates. By the end of April he had reversed course, distancing himself from a near-term rate rise and sending sterling tumbling.

Mr Carney blamed Brexit talks, weaker economic data and lower-than-expected (but-still-much-higher-than-target) inflation. To be fair, wages and retail sales weren’t the best, but they’ve been pretty lacklustre for some time. And economic growth has been trending downwards since the first quarter of 2017. As for Brexit negotiations, well they’ve always been a bundle of uncertainty so it’s odd that Mr Carney saw a recent change worthy of altering the Bank’s interest rate path.

Central bankers shouldn’t act just because the market thinks it will. But this is long-running form for Mr Carney. There is a school of thought that says monetary policy has to shock to be effective. This argument usually harks back to 1979 when Paul Volcker took the reins at the Federal Reserve (Fed) and aggressively raised interest rates against the market’s expectations. Within six months, the US prime lending interest rate had almost doubled to 21.5%. Inflation, running hot at 14% when he took the job, was below 3% three years later. Markets didn’t see it coming and many investors – particularly bondholders – were routed. It was painful, but by getting control of the money supply inflation was tamed.

This is not the perfect strategy! The country suffered two recessions and unemployment ballooned to 10% in the early 1980s. It almost broke the nation. You would rather avoid getting to the point where you have to throw a tenth of your people out of work to restore balance to your money supply.

The lesson from Mr Volcker’s term wasn’t that you have to trip up financiers and speculators to make central banks powerful. The lesson was that central banks have to be credible: markets have to trust them. Throughout the 1970s Fed chairmen talked tough on busting inflation, but when it came to the crunch, they always relented and kept interest rates relatively low. So when Mr Volcker turned up saying he was going to strangle inflation with very high interest rates, markets thought it would be more of the same. People soon realised he was deadly serious; Mr Volcker made the Fed credible again.

Nowadays, central bankers’ interest rate forecasts and market expectations tend to be broadly in synch. This is driven by two things: firstly, central banks are open about their aims for inflation, unemployment and money growth and all sorts of other measures; secondly, the market trusts that the bank will do what it has said it will to get there.

We grumble about Mr Carney’s “unreliable boyfriend” ways not because he made an informed decision to change the expected path of interest rates. It’s because the more he backtracks at crunch time, the less credible the BoE becomes. And the more drastic his successor may have to be to win back the market’s respect.

Bond yields
Sovereign 10-year Apr 30 Mar 31

UK

1.42%

1.35%

US

2.95%

2.74%

Germany

0.56%

0.49%

Italy

1.78%

1.78%

Japan

0.05%

0.04%

Source: Bloomberg

 

Julian Chillingworth, Chief Investment Officer

The value of investments and the income from them may go down as well as up and you may not get back your original investment. Past performance should not be seen as an indication of future performance.

Rathbone Unit Trust Management Limited is authorised and regulated by the Financial Conduct Authority and a member of the IA. A member of the Rathbone Group. Registered office: 8 Finsbury Circus, London, EC2M 7AZ. Registered in England No. 02376568