The Silver Bullet | Perpetual Motion

In Leonardo’s times, the debate on achieving perpetual motion was heated. Those seeking perpetual motion aimed at creating machines able to function continuously and effortlessly, relieving men from their daily fatigues.

Leonardo recognised this to be an unfeasible project, and compared perpetual motion-seekers to alchemists who tried to transform lead into gold in the middle ages.

What would Leonardo think of today’s central bankers?

To counter the negative impact of Brexit, the Bank of England unleashed a combination of lower interest rates, a QE programme expansion including corporate bond purchases and a new Funding-for-Lending-Scheme. 10-year Gilts are now approaching 0.5%. With another potential rate cut before year-end, the UK may soon join the zero interest rate club.

This is good news for markets, which are breaking record highs as investors from Britain, Japan and other QE countries move away their capital to preserve it from currency depreciation. The main beneficiaries have been $-denominated assets: not only US Treasury bonds, which now yield flat to German bunds after hedging currency risk, but also stocks and high yield bonds.

Yet if QE boosts markets, the question remains open on the effectiveness of loose monetary policy and the collateral effects caused by it. It is a question that not only investors like us – but policymakers too – are starting to ask loudly.

While easing policy during a recession has provided clear advantages, continued stimulus comes with collateral effects. In the case of Britain, lower interest rates are likely to cushion a deflating housing bubble, and the FLS/QE combination will improve credit conditions. But they won’t improve sluggish productivity or wages, nor will they address the record-high wealth inequality. And with household leverage already heading towards pre-crisis highs, cheap credit could make consumers and banks even more vulnerable to a future downturn (see also The Silver Bullet | We are still dancing).

Are central bankers today just a modern version of medieval alchemists who sought perpetual motion?

For the first time after eight long years of implementing non-standard policies, policymakers are starting to question their actions. Mr Draghi and Mr Constâncio of the ECB have repeated that monetary policy only creates the conditions for growth, not growth itself. Mr Rajan, former Governor of the RBI, questioned the feasibility and effectiveness of helicopter money earlier this year at LSE. Mr Kuroda of the BOJ called for a meeting to discuss whether the measures taken are effective. Finally, Glenn Stevens of the RBA, in his final speech as governor, said:

“I have serious reservations about the extent of reliance on monetary policy around the world. It isn’t that the central banks were wrong to do what they could, it is that what they could do was not enough, and never could be enough, fully to restore demand after a period of recession associated with a very substantial debt build-up. […] The problem now is that there is a limit to how much we can expect to achieve by relying on already indebted entities taking on more debt.”

But although central bankers are being more vocal about the insufficiency of monetary policy, it is becoming increasingly harder for them to stop using the same tools they are blaming. Every time a central bank timidly deviates from the beaten path of policy easing, market forces push it to step back in line. We saw this with the two tantrums in 2013 and 2014, and last week when a move higher in JGBs triggered a sell-off across bond markets.

In their experiment to find perpetual growth, central bankers have created a monster that constantly needs to be fed, to prevent it from turning upon them.

This monster is the bond market.

Low policy rates encourage investors to look for higher-yielding assets, supporting demand for treasury bonds in positive interest countries like the US, Australia or New Zealand. But after currency rises and FX-hedging costs negate the positive yield, investors move to stocks and riskier bonds. The result – in theory – is higher consumption and investment. In practice, QE ends up exporting demand for risk from zero to positive interest countries.

If all developed markets lower interest rates, the result is self-defeating: lower rates of return discourage investment and push consumers to save more. Corporate investment also stalls, as companies remain uncertain about economic conditions, absent policies other than monetary easing. Banks earn less on loans and are not encouraged to lend, as the IMF discussed recently. Finally, lower interest rates mean debt can be refinanced and resources allocated to sectors and industries with low productivity. But as debt levels remain high, the result is once again persistent low interest rates. This means low interest rates can become self-validating, and in the medium term, deflationary.

Investing in today’s bond markets is like riding on the back of the monster, knowing it could wake up any moment. Should investors avoid duration, missing out on further potential QE gains? Or should they still buy bonds, exposing themselves to the risk that central bankers may eventually run out of credibility, or ammunition?

US duration represents the most dangerous area in bond markets, in our view. Even though US Treasuries still offer positive yields vs most government bonds globally, they are nearing zero after including currency-hedging costs. Markets appear complacent about the chance of a further hike this year, with only a 20% probability priced in for September. International capital flows have moved into US bonds and stocks recently, keeping yields low.

Meanwhile, US labour markets have improved, even though many signs of structural slack still remain under the headline numbers. Low-paying jobs still make up for a large part of new employment, wages remain stagnant and broader measures of unemployment are still well above pre-crisis lows. We believe one hike is on the table before year-end, but market expectations still price it as a 50-50 outcome.

But even for the Federal Reserve, room to normalise interest rates could be limited. Debt burdens have been reduced in the US, thanks to efficient bankruptcy frameworks and the ability to restructure bonds in capital markets. This allowed a restructuring of over $500bn of corporate debt and a reduction of 20% in household debt to GDP.

Today, US households and corporates are able to borrow, and banks bear little non-performing loans in their balance sheets. Looking at the US economy in isolation, interest rates should be already over 1-2%. Yet bringing interest rates up poses additional challenges, in a global context where other central banks are pushing towards zero.

Can the Fed lean against the rest of the world? We believe not. Here is a simple example: normalising interest rates from 5% to 6% in a world where everyone else is at 5% is easy. But going from 0% to 1% in a world where every other central bank is at zero, means attracting disproportionately higher capital flows and suffering from a stronger currency. Even if the US economy is stronger, the Fed does not want that yet. The same is true for balance sheet operations: the Fed is now smaller than other major central banks.

Where can bond investors hide then? In the Eurozone, the ECB is likely to extend duration and increase flexibility on its QE programme over the coming months. Yet, markets already price this outcome, with Spain 10-year bonds now yielding less than 1% and Italy nearing the same level. These look tight in light of upcoming political risks: Spain is likely to form a government, in our view, but Italy will face a controversial referendum in November. In the UK, where the BoE will likely cut rates once again, and upsize QE to avoid pushing short-term rates to negative territory. And in Australia and New Zealand, where central banks are behind the rate-cutting cycle, facing economic pressures from over-investment in property and commodities. Finally, there are bonds from businesses which benefit from rising rates, like banks and insurance companies.

Eventually, the monster may wake up. We see three risks for bond investors: fiscal stimulus, political unrest and a change of tack by central bankers. First, the new US administration may deploy fiscal stimulus post elections, taking some weight off monetary policy and boosting wages and inflation. Political risk could also rise across European countries, where protest parties are funnelling years of frustration from high unemployment and low growth. This would increase risk premia on sovereign debt. But the major risk is that one central bank may eventually grow reluctant to increase stimulus once again.

Conclusions

1.Perpetual motion, as well as perpetual growth, are not achievable. We have lived in the illusion that monetary easing would re-start growth globally.

2.Instead, we find ourselves stuck in a trap of zero interest rates, persistent debt levels, higher savings and growing asset-price distortions.

3.Central bankers are being increasingly vocal about the problem, but there is no alternative policy in sight.

4.Bond investors have few places to hide.

5.A diversified portfolio combining directional and relative value strategies can provide superior returns in this environment, while alleviating the risk of future sell-offs when monetary policy and rates eventually turn.