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The Federal Reserve has announced a programme for the reduction of its balance sheet, and a potential normalisation of global short-term rates looks closer to becoming a market reality, as Andrew Baron of Butterfield Asset Management explains.
Higher interest rates are something that captive owners have been hoping for since the end of the credit crisis. It is hard to put a date on how long that is, but certainly it has been at least seven years since there has been some degree of stability in the US economic recovery, post-crisis and recession.
Despite reasonable economic growth, intermediate and long-term interest rates in the US have failed to move higher at all. In fact, the 10-year US Treasury note currently trades nearly 1 percent LOWER than the prevailing rate at the end of 2010. The US Federal Reserve has moved short-term rates very gradually higher, away from the zero bound, in four 25 basis point increments over the course of the last 22 months.
While this has been welcome and has helped cash yields somewhat, buying a five-year US Treasury at under 2 percent still seems pretty unexciting. Despite the four rate increases, the five-year Treasury is at a similar yield as at the end of 2010. Is there a trigger point, as
a result of which longer-term rates will move higher? Although we don’t have a working crystal ball at the moment, we can think of a plausible scenario under which interest rates in the US can move materially higher.
The rise of QE
In order to lay out the conditions for a material move higher in rates, we need to go back to the credit crisis and its aftermath. In order to inject liquidity and stability to financial markets during the recession, global central banks eventually set interest rates at ultra-low or even negative levels. Although interest rates were never set below zero
in the US, around the world, negative short-term interest rates remain a feature to this day in the eurozone, Switzerland, Japan, Sweden
In most of these places, discussion of raising rates to zero has barely even begun, much less a contemplation of positive rates. In addition to setting rates at very low or negative levels, itself an experiment rarely attempted in the history of modern central banking, global central banks also embarked on another method of injecting money into the monetary system called quantitative easing (QE). QE is a simple concept, if highly experimental and previously unprecedented, and in practice is just the process of buying low-risk or sovereign debt, using the notional balance sheet of the central bank.
As the central bank buys the bonds from investors, those investors must seek another use for the capital they have received from the sale of their securities. Economic theory holds that some of that money should wind up being put to productive use in the real economy, stabilising the economic system and fostering an environment of high liquidity, and low long-term interest rates. This article is not set up to judge that effectiveness, but notes only that it happened and at a staggering scale.
In the US, the Federal Reserve increased its balance sheet from roughly $900 billion of securities to over $4.2 trillion, buying US Treasuries and Agency Mortgage-Backed Securities over the span of the last 10 years. The Fed was actively buying new bonds to increase its balance sheet through 2013 and has since held in place a policy to maintain the current balance of securities at its high level by reinvesting all maturities and principal repayments. In US dollar equivalents, the Bank of Japan (BoJ) owns more than $4.5 trillion of securities (not only bonds, but equities as well) and the European Central Bank (ECB) owns more than $2.6 trillion.
Both central banks increased their holdings at a similar pace and scale as the Fed, spread across slightly different timelines. The ECB and the BoJ, unlike the US Fed, have not levelled off purchases and have continued to grow their respective holdings. Numbers like these can barely be comprehended and definitely do not fit into any contextual relationship with economic history. Whether or not bond purchases by central banks have had a direct causal effect on global interest rates, interest rates have nonetheless remained suppressed.
Since the US never got to a place where short-term rates of interest were negative, one of the features of the period of balance sheet expansion, outside the US, was that it has caused investors to seek yield-producing assets outside their home nations and currencies. The US has been the beneficiary of these investment flows to the tune of hundreds of billions of dollars.
Some portion of that investment flow finds its way to US Treasuries, US corporate bonds and other dollar-denominated fixed income assets, systematically pushing interest rates lower by constant demand for dollar-based assets. The Investment Company Institute records data for cumulative flows to US bond mutual funds and exchange-traded funds and in the last eight years, cumulative net assets have risen by over $2 trillion. To gain some perspective on that figure, net assets grew by only $1.4 trillion over the previous 19 years.
Higher rates closer?
This phenomenon can operate in reverse as well and here is where you get the possibility of higher interest rates. Just as QE and balance sheet expansion on an unimaginable scale had unknown effects, so too would balance sheet reduction and a potential normalisation of global short-term rates. This process is looking like it is coming closer to becoming a market reality.
In September 2017, the Federal Reserve announced that it would begin its programme for the normalisation of its balance sheet, beginning in October 2017. While the reduction of the balance sheet will begin extremely slowly, and will be reduced only by slowing the pace at which maturities are reinvested, it is nonetheless a dramatic change. Thus far, as of this writing, the markets have taken this initial step in stride, but future reductions in central bank demand for Treasuries can provide the impetus for an upward bias in longer-term rates.
In addition to the US Fed announcing its reduction in stimulus, the ECB has been reassessing its QE programme and balance sheet size. In the wake of its own September meeting, the ECB announced that its October meeting would feature a discussion on how to reduce the pace of their bond purchases.
In conclusion, no-one really knows what the net effect of the reversal of QE programmes and moves away from a negative rate regime will be to financial markets, particularly interest rates. If one follows the money flows, however, a reasonable argument can be made that long-term interest rates, particularly in Europe and the US, could be poised to rise, perhaps substantially, from current levels.
The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. The Bank accepts no liability for errors or actions taken on the basis of this information.
Andrew Baron is the chief investment officer of Butterfield Asset Management. He can be contacted at: email@example.com
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