Overall low interest rates have become a permanent feature of the developed world markets. Last week on Sep. 21, Yellen failed to raise interest rates again in six consecutive meetings. Her message was rather mixed, lacking in any real direction: “The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.” In terms of the market reaction, the dollar was lower and gold was higher, US stocks climbed during and after Yellen’s conference. All of these market reactions indicate a more dovish interpretation of the FOMC meeting.
Meanwhile, the Fed was split. The decision to hold interest rates unchanged was rejected by three of ten voting members on the Federal Reserve’s monetary policy committee, indicating how the central bank is growing increasingly divided on when to increase borrowing costs from crisis-level lows. Three officials, the most since December 2014, voted in favor of a quarter-point hike.
According to Fed Fund Futures, currently markets are pricing 17.1 percent implied probability of interest rate hike in the next two months, and 56 percent odds by December. We find these probabilities to be too low based on economic drivers, but it is still possible that the Fed doesn’t raise interest rates at all this year. More interesting, however, is the pricing of interest rates over the medium term. Currently the market expects only 40bps of tightening over the next 3 years. To believe this pricing is reasonable is to believe that there is a substantial probability that the US economy turns down in the short term. A quick look at growth statistics such as consumer demand and the latest production numbers tells us that this is unlikely to be the case. That is, growth is currently high enough to continue to cause economic slack (proxied by the unemployment rate) to tighten. If we were seeing these levels of growth three years ago, the story would be different, but currently you can see from the economic fundamental data that the economy is a least neutral if not on the tight side. Indeed, aggregate inflation is clearly rising.
But more so, the services and housing components of core CPI are rising the fastest. These components, as opposed to the goods component, give the best read on domestic pressures in the US economy because they are only minimally impacted by external factors such as USD strength, commodity prices and trading partner inflation.
Nonetheless, our base case view is that only moderate tightening will be required to normalize the economy. The economy doesn’t call for strong tightening but still, the market pricing of the interest rate hike probabilities is too low.
Some experts believe that the Fed should continue to keep interest rates low as tightening too fast and too early will hurt a fragile economy. However, there are meaningful risks related to living in a consistently low rate environment. These are the top four risks we see:
- The savings and productivity paradox:Historically rates have been used by central banks in order to impact economic growth through the usual levers of consumer spending and saving, and investments for example. However, the assumptions behind the efficiency and adequacy of those levers have been based and constructed over periods of relatively high interest rates, and might not apply in the current situation. Japan and some major European economies are now struggling in negative rate territory, and the US has only seen one interest rate increase since 2008 when the Fed lowered rate to near-zero level. These policy actions have fallen short of producing the effects that were expected. Monetary easing seems to have reached its limits. With rates still at depressed levels, many major central banks have run out of options.In fact, many economists are now talking about the productivity paradox, and about the savings paradox. In our minds, it is a reflection that low interest rates are currently a consequence of the economic malaise as opposed to a driver of the economy. It is also possible that, lowering interest rates further will not reduce the savings rate and increase consumer spending, as this move would be perceived by the public opinion as a sign of ongoing deterioration of economic conditions.
- Traditional equity/bond portfolio risk:Since early June, the Fed actions and the market anticipation have driven down bond yields and flattened the yield curves even further. The lower and flattened yield curves have introduced dramatic risk on the investments.First, equities are discounted future cash flows and interest rate volatility is a large driver of their value. Though not directly observable, in a period of financial contraction, interest rate compression provides a cushion for PE ratios, lessening the price impact of a market sell-off. However, with the never-seen low interest rates, these discount rates have less room to fall, resulting in a historically high amount of downside for equity investment.There are also dramatic risks on the portfolio level. Traditionally, a simple 60/40 stock-and-bond portfolio provides a cushion on the adverse economic shocks. When markets crash, equities suffer, meanwhile, the bonds prices increase as longer-term interest rates fall. Thus, the portfolio reduces the market risk through diversification. However, in the low interest rate world, as the one we are living in, there is less room for bonds to provide this balance, and even a “diversified” portfolio can suffer substantial losses. A more hawkish signaling from Yellen will also lead to a sell off, and has negative impacts on both equities and bond investments.
- Operational risk:Negative interest rates also created for the financial system, and for banks in particular, extreme operational risk, covering all aspects of trading, from pricing and front office valuation systems breaking down all the way to back-office and collateral management system. For example, most rates valuation and risk management systems are based on the assumption of lognormality of rates, and those break down when rates cross zero, even if you are not pricing options or complicated derivatives. Another maybe more obscure but quite dramatic example has to do with collateral management, as a lot of CSA (Credit Support Annex) are not yet aligned to the ISDA negative rates protocol, and still contains clauses allowing for non-native currency collateral or even worse floors.If the CSA has an embedded floor, the accrued interest will not be allowed to be negative. This is now turning into quite a nightmare for two reasons. First in many cases collateral management systems are not able to calculate correctly the amount of collateral including the floor properly, resulting in erroneous transfer of cash and incorrect credit exposure across the street. The second reason is a little subtler but equally important: valuing a portfolio of even simple derivatives like swaps with an embedded floor in the CSA, requires a sophisticated option model, taking into account the volatility of funding, as well as correlation between rates and funding, and values all products at once, since CSA are netted across products. As a result, dealers and counterparties would at times disagree on the valuation of the swaps they are holding against each other by amounts in the order of billions of dollars, which became quite apparent once dealers started deleveraging or unwinding legacy books. Solving those discrepancies is a major undertaking that is currently being worked out, but in many cases has not been fully taken into the books and records of the dealers.
- Global liquidity risk:Growing international trade increased the integration of the global financial system since the financial crisis. A feature of the financial integration is that most funds flows are from ‘financial center’ economies, including US, Eurozone, UK and Japan, to the rest of the world. International banks in these big economies intermediate much of global credit. Thus, their monetary policy has large impacts on the international credit and funding conditions. With the current low interest rate, there is no more room for these countries to boost global liquidity. That is, the next downturn will likely compound on itself due to the adverse impacts on global borrowers of developed world liquidity and the feedback to global trade and developed world wealth.