Reviewing the policies of central banks across the world remains crucial in understanding the trajectory of major investment markets – both bonds and equities.
A cursory look at these policies suggests there are two camps of central bankers undertaking two starkly different approaches. The aggressive camp includes the US Federal Reserve (the Fed), the Bank of England (the BoE) and Australia (the RBA), whilst the passive camp includes the European Central Bank (the ECB) and the Bank of Japan (the BoJ). The former is aggressively lifting cash rates, trying desperately to get “in front of the curve,” whilst the latter are only reluctantly moving rates or seemingly doing nothing at all.
However, there is more to monetary policy than official cash rate adjustments. A primary policy action is central bank balance sheet management and how it adds or subtracts liquidity to asset markets. When the balance sheet increases, through purchases of Treasury notes, bonds and mortgage backed securities, it is called Quantitative Easing (QE). When assets are sold and the balance sheet is reduced, we refer to Quantitative Tightening (QT). In effect, QE increases liquidity in markets while QT reduces it. More importantly, QE supports highly indebted governments by holding down the interest rates on bonds, thereby reducing their debt servicing costs. QT should do the opposite.
Managing the yield curve has become another policy objective for the central bankers. The analysis of yield curves across different periods should in normal circumstances provide valuable insights into the way markets are forecasting future interest rate trends. But at present, it appears that the yield structure of government bonds across the world has seemingly decoupled from inflation expectations. This implies that the historic predictive power of bond pricing – for inflation risk, for default risk, for recession or currency risk – has fallen away. Across the world, central banks continue to intervene in bond markets so that the yields of government bonds are set well below both the actual and expected level of inflation. This creates “negative real rates” for bond yields that help fund debt-bloated governments and actually encourages them to borrow further as inflation rages on.
To examine this in more detail, I delved into recent statements in the US by the Fed and by the Congressional Budget Office (CBO).
The Fed has declared its intentions regarding QT and how it will reduce the size of its US$8.9 trillion balance sheet. It has stated that it will not be selling bonds outright, but will rather adjust the level of reinvestment of maturing bonds. From early June through September, it will reinvest proceeds of maturities that exceed $30 billion per month. From September through 2023, it will reinvest proceeds above $60 billion per month of received maturities. At this rate of reinvestment, the balance sheet will merely reduce to $8 trillion by the end of 2023. This will still be 100% higher (i.e. US$4 trillion) than it was in March 2020. Therefore there remains abundant liquidity in markets even though it is being marginally reduced.
But what is the Fed reinvesting its excess cashflows into? Are these mainly longer dated bonds?
If the Fed is buying long dated bonds and redeeming short dated ones, this may explain why short dated US bond yields are higher than longer dated ones, creating an inverse yield curve. The widely held view that the inverse yield curve portends recession may be a false signal.
Indeed, long dated yields that are set well below current inflation (10 to 20 year maturities) support the equity market in two ways. First, they help government fund expansionary fiscal policy. Second, lower bond yields are a tailwind for PER expansion in the equity market.
The recent US budget forecasts emanating from the CBO paint an outlook (see chart below) for persistently high US fiscal deficits and rising interest bills as a percentage of GDP.
Source: US Congressional Budget Office
The Biden Administration is proposing an expansionary US budget deficit of 4.2% of GDP (US$1 trillion) before “one off” outlays (eg. support for Ukraine) increases it further. Looking ahead, the US deficit is projected to be at around 4% of GDP until a rising interest bill (more debt and higher bond yields) pushes the deficit towards 6% in ten years’ time. That of course assumes that future US Administrations do not lift taxation rates on corporates or high earning individuals to reign in the deficit.
Putting the monetary settings together with the fiscal outlook in the US suggests that stimulatory tailwinds for risk and growth markets will persist. However, here is the rub in this outlook: the budget and debt situation of the US government is not sustainable without some form of QE or the maintenance of only a very mild QT policy. The Fed will need to continue to manage the yield curve. Therefore, whilst QT has begun, it will be managed to achieve a yield curve structure that keeps long dated yields down as the US government issues more debt.
From an asset allocation perspective, the policy of compressing bond yields well below inflation for the foreseeable future suggests that investors should tilt their portfolios towards assets that can match or outgrow inflation. The risk of an economic slowdown is noted, but with fiscal stimulation occurring and monetary authorities adroitly limiting the negative consequences of Quantitative Tightening, any downturn in the US and Australia is more likely to be mild rather than deep. The hoped-for soft landing just might be achievable.
What does this mean for our forecasts?
At our recent presentations to investors we made the following forecasts and noted the significance of Central Bank policy and potential to pivot.
The significant issue for equity markets is the prevailing level of long dated bond yields – particularly focused around the 5 to 10 year maturities.
We must remember that 10 year bond yields are often sighted as the “risk free rate of return” from which other required returns for riskier assets are derived. This is fundamental to our monitoring of the “rule of 20” that determines the fair value of the equity market against prevailing bond yields.
Given our research into the Fed policy (see above) we are of the view that longer dated bond yields will weaken steadily but not aggressively. We would suggest that 10 year bonds in the US could reach 3.5% (from previous target 4%) and Australian bonds target 4% (previous target 5%).
Those yields suggest weakness in the bond market (low actual returns) and acknowledges that inflation will come down dramatically in 2023 to around 3% to 4% in the US and Australia.
Those bond forecasts support the equity market through maintenance of market PERs of 15 to 16 times. Therefore from an asset allocation perspective we remain positive to tilting to growth assets (equity and property), inflation hedges and targeting yield in corporate debt markets.