Dont' be
fooled by
Jackson Hole

Luc Synaeghel, CIO 2016-09-09

Jackson Hole, a remote mountain valley of West Wyoming, used to be roamed by fur trappers in the 19th century. Over the past decades, it has come to be known as the annual central banking late summer retreat. Every August, central bankers, policy experts and academics gather there to discuss « a topic that is not necessarily of immediate concern, but instead looks into the future at emerging issues and trends »1.

It is said that good trout fishing spots were what initially led the Federal Reserve Bank of Kansas City to select Jackson Hole as the location for its annual economic policy symposium, in a bid to attract Paul Volcker, then Chairman of the Federal Reserve and a keen fly-fisherman. Thirty five years later, we are not sure about how much there was actually to fish from the symposium.

no longer only lenders

Instead of seizing the opportunity to debate possible new approaches to monetary policy, the major central banks simply stood their ground: current policies will be pursued, end of discussion. Worse, central bankers stubbornly refused to acknowledge the collateral damage caused by these very policies. ZIRP (Zero Interest Rate Policy) was already tough, but NIRP (Negative Interest Rate Policy) is proving just too much – for the banking system, for savers, indeed for society at large. Like it or not, central banks are no longer only lenders of last resort, with defined economic growth and inflation targets.
By maintaining interest rates below the economically required level, they are driving (unwanted) changes in behaviour and thereby finding themselves increasingly engaged in politics (more here)

A test for the capitalist system

We strongly feel that by next year’s summer retreat, central banks will be thinking, talking and acting differently – that the 2016 edition of the Jackson Hole Symposium will be the last “more of the same” one. It could be that some central banks (read: Bank of Japan) go even more radical, implementing so-called helicopter money and putting the capitalist system to test.
More realistic though, certainly from a European perspective, is a scenario in which monetary policy reverses course and central bank rates are gradually lifted to a more normal level. For longer-dated paper, taking into consideration projected inflation as well as term and risk premiums, this would imply considerable adjustment (more here).

If – or rather when – this adjustment in bond markets does occur, it is unlikely to prove a smooth process. Which is why, regardless of the seemingly reassuring Jackson Hole tone, we feel comfortable having little outright long term bond exposure. As hinted to in last month’s Letter, we recently sold fixed income positions posting large capital gains and replaced them with floating rate bonds whose capital will be protected in the event of rising yields.

THE UNINTENDED CONSEQUENCES OF NIRP

With general elections scheduled next year in both France and Germany, we feel that the ECB will have little choice but to backtrack on NIRP during the course of 2017.
Negative interest rates are not only a concept that is difficult to apprehend but also, indeed mainly, a terrible reality for savers across the globe – financial repression at its worst.

Faced with what they are coming to realize as the theft of their money, savers are no longer behaving just as central bankers would like them to. Instead of ploughing their savings into ever riskier asset classes, in a mad dash for yield, a number of them are choosing to save more. And when corporate bonds in their portfolio reach maturity, they are increasingly prefering to keep the capital « safe » in their current account rather than reinvest it.

Two concomitant factors help explain such a hoarding behaviour. First, true European inflation is probably not as low as official indexes would have us believe. Many of the items on a typical middle class household’s shopping list are becoming costlier, however inadequately this may be reflected in the composition of the CPI (Consumer Price Index) basket. Second, people are ever more worried that come the time of retirement their pension will not prove sufficient. Pension systems are reeling from years of low to inexistent yields, with rising public indebtedness adding to the vulnerability of those that are state-funded.

What all this boils down to is a circular process by which money injected by the European Central Banks (ECB) is largely returned there, in the form of banking system excess reserves. As such, most of the monetary creation does not find its way into the real economy, anihilating European policymakers’ hopes of markedly boosting growth. Meanwhile social unsatisfaction is mounting, with voters increasingly attracted to extremist parties. Like it or not, central banks are finding themselves entangled in politics. Surprising financial markets by not extending the timeframe for its current policy from March to September 2017 could be the first step in this reversal process.

Germany’s relatively strong economy and very low unemployment rate certainly do not warrant negative (even zero) rates. But what of the weaker Eurozone economies, Italy in particular?

There too politics will play a large part, with a crucial vote on labor laws in October – potentially sealing the fate of Prime Minister Renzi. That said, goverments across Europe have been given ample opportunity over the past few years to borrow cheaply and/or extend debt maturities. A rate hike by the ECB would thus not have a huge immediate impact on their debt servicing costs.

TOWARDS A BOND MARKET CORRECTION?

The fact that most countries’ public finances could withstand a return to positive interest rates does not mean that financial markets would adjust seamlessly to the ending of ZIRP/NIRP. We seriously doubt the central banks’ ability to control the bond markets’ reaction, particularly in the event that inflation (finally) picks up just as rates are being normalized.

The table on the right shows 10-year government bond yields and year-to-date performance for a selection of countries, as of the end of August.

Assuming 2%+ inflation and “normal” term and risk premiums, we could easily imagine 10-year government bonds yielding around 4%, a far cry from current prevailing rates. And the adjustment is unlikely to be a gradual process. As soon as bond investors at large embrace such a scenario, they could make it happen extremely quickly by all heading for the exit simultaneously. Bond markets look very vulnerable to even a small change in central bank rates. We have no doubt that a correction lies ahead, the only question is when.

The impact on equity markets is more debatable

The normalization of monetary policy could of course be interpreted as a sign of a stronger economy, boding well for corporate revenues and earnings and offsetting the potential contagion from bond markets. But that is forgetting that equity markets are also currently priced for perfection. Their elevated valuations, most extreme in the US, leave little room for negative surprises. Having been yet again fed the “more of the same” message in Jackson Hole, investors only stand to be more disturbed when central banks do announce that they are changing monetary policy gear.