The consensus among market watchers last September was that, with US interest rates so low and the US Federal Reserve about to withdraw stimulus, interest rates would trend higher. I took a different view, writing in a commentary that “10-year rates may be heading back to 2.25 per cent or lower”.
When 10-year Treasury yields ended 2013 at 3.02 per cent, some may have thought I had taken the wrong end of the bet. But in early August, 10-year Treasury yields went as low as 2.35 per cent and I believe the path of least resistance on interest rates is still lower.
A number of factors have helped push Treasury yields lower. With yields on German 10-year bonds at historic lows of about 1 per cent and Japanese government bonds yielding around 50 basis points, Treasuries look comparatively attractive. Add to that the perception that both the yen and euro are a one-way bet towards depreciation and it is reasonable to expect that international capital will continue flowing towards the US, pressuring Treasury yields down as quantitative easing draws to an end.
Tensions from Ukraine to Iraq have added to a flight-to-quality trade, boosting demand for Treasuries. With the size of incremental US government borrowing also expected to decline because of shrinking federal budget deficits, Treasury yields could move lower.
Reduce rate risk
My original forecast of 2.0-2.25 per cent still seems reasonable. Nevertheless, markets do not move in straight lines, so yields could retrace to 2.5 per cent in the near term. Ultimately, as rates head back towards 2 per cent portfolio managers should use the rally to reduce interest rate risk.
As anyone experienced in investing in the US mortgage market knows there is a phenomenon that traders call the “refi bid”. When interest rates fall, a larger percentage of mortgages becomes economically attractive to refinance at a lower interest rate.
Whenever a threshold is breached where a large amount of mortgages make attractive refinancing candidates, prepayments spike up dramatically and portfolios that own mortgages have a sudden surge in cash. This causes portfolio duration to shorten and leads to a need to buy longer duration assets in order to maintain the target portfolio duration. This demand surge can result in a sudden and dramatic decline in rates.
Currently, I estimate that the next “refi level” will hit when the 10-year Treasury yield drops to about 2.25 per cent.
An unusual feature of this potential wave of mortgage refinancing is that the vast majority of US mortgages are on the cusp of being candidates for refinancing, given the relative stability of mortgage rates over the past year or so.
Additionally, there is one dominant holder of these mortgage securities that has vowed to reinvest in new mortgages as prepayments come in – the Fed.
Traditionally, in a refinancing rally, spreads on mortgage-backed securities widen due to increased prepayment risk and expected increases in supply. Spreads will not widen on this occasion to the same extent as during previous refi rallies for a number of technical reasons.
Among those reasons is that the Fed, the biggest mortgage investor on the block, has made clear it will reinvest principal repayments dollar for dollar. Normally, the widening in mortgage spreads mutes the impact of the rate decline on mortgage rates, slowing the pace of refinancing.
This time, advertised mortgage rates are likely to fall more rapidly than in prior refi experiences.
Selling opportunity
Given the likely rapidity of the interest rate decline, the potential for shortening in the duration of fixed income investment portfolios could further intensify the current rally and lead to a more extreme decline in rates than would normally be anticipated.
Declining mortgage rates will also give a lift to housing affordability, which could help clear unsold inventories of homes and support new construction activity. This would further support the US economy.
Ultimately, this expected run-up in bond prices and the associated decline in interest rates should prove unsustainable once the refinancing bid is past. For the near term, risks favour lower interest rates – perhaps sharply lower. In the medium term, as the economy strengthens further, this rally will reverse itself and will have proven to be a selling opportunity.
It is premature to sell now, but as 10-year Treasury yields approach 2 per cent it should provide an opportunity to rebalance portfolios. In other words, don’t chase the rally, but don’t fight it either. The opportunity to sell bonds is coming – but not just yet.
Source: http://www.ft.com/intl/cms/s/0/ece5bb60-22e0-11e4-9dc4-00144feabdc0.html#axzz3AkAuS7S0
Monday, August 18, 2014
Friday, August 1, 2014
QE and ultra-low interest rates: Distributional effects and risks
There is widespread consensus that the conventional and unconventional
monetary policies that world’s major central banks implemented in
response to the global financial crisis prevented a deeper recession and
higher unemployment than there otherwise would have been. These
measures, along with a lack of demand for credit as a result of the
recession, contributed to a decline in real and nominal interest rates
to ultra-low levels that have been sustained over the past five years.
The impact that ultra-low interest rates have had on banks has been mixed. They have eroded the profitability of eurozone banks, resulting in a cumulative loss of net interest income of $230 billion between 2007 and 2012. But banks in the United States experienced an increase in effective net interest margins and a cumulative increase in net interest income of $150 billion. The experience of UK banks falls between these two extremes.
Life-insurance companies, particularly in several European countries, are being squeezed by ultra-low interest rates, so much so that if this environment were to continue many of these insurers would find their survival threatened.
Theoretically, ultra-low interest rates may have resulted in higher asset prices, and this effect may have offset lost interest income for households and other investors. But we find a mixed picture.
Rising bond prices are the flip side of declining yields, and the value of sovereign and corporate bonds in the eurozone, the United Kingdom, and the United States increased by $16 trillion between 2007 and 2012. Investors that mark the value of their assets to market have therefore seen a significant gain on their fixed income investments, at least on paper.
Ultra-low interest rates are likely to have bolstered housing prices by lowering the cost of mortgage credit. This effect is most clearly seen in the United Kingdom, where the majority of mortgages have variable interest rates that have automatically adjusted downward. The impact is less clear in the United States, where the recovery in housing prices has been dampened by an oversupply of housing, high levels of foreclosures, a predominance of fixed-rate mortgages, tightened credit standards, and the prevalence of homes with negative equity whose mortgages cannot be refinanced.
We found little evidence that ultra-low interest rates have boosted equity markets. We cannot discern a large-scale shift into equities as part of a search for yield by investors, and price-earnings ratios and price-book ratios in stock markets are no higher than long-term averages. Although stock prices do react to announcements by central banks, these are transitory effects that do not persist.
If one accepts that housing prices and bond prices are higher today than they otherwise would have been as a result of ultra-low interest rates, then the increase in household wealth and the possible additional consumption it has enabled would far outweigh the income lost to households. But we are skeptical about whether increases in wealth have translated into higher consumption in today’s environment, given that housing prices in the United States remain far below their peak. Moreover, it is more difficult for today’s households to borrow against any increase in wealth because of tighter credit standards.
Ultra-low interest rates do appear to have prompted additional capital flows to emerging markets, particularly into their bond markets. Purchases of emerging-market bonds by foreign investors totaled just $92 billion in 2007 but had jumped to $264 billion in 2012. Emerging markets that have a high share of foreign ownership of their bonds and large current account deficits will be most vulnerable to capital outflows if and when central banks begin tapering current policies.
There are likely to be risks ahead whether asset purchases are tapered and interest rates rise or, alternatively, if current monetary policies continue and interest rates remain low. In the first scenario, the benefits gained or losses incurred could be reversed. Government interest payments on debt, for instance, could rise up to 20 percent. Amid anecdotal evidence that some investors have increased their leverage to amplify returns in some markets, rising interest rates could lead to a collapse in leveraged trades and could pose a threat to some financial institutions. Capital flows to emerging markets could reverse. Investors in bond markets forced by accounting rules to mark to market could face large write-downs. Eurozone countries could be caught in a crosswind if rates increase in the United States before they do in Europe, leading to a shift in foreign capital from Europe to the United States. In the second scenario, life insurers and banks in Europe would experience continued erosion in their profitability. A continuation in ultra-low interest rates could also prompt higher leverage and the return of asset-price bubbles in some sectors, especially real estate.
Source: http://www.mckinsey.com/insights/economic_studies/qe_and_ultra_low_interest_rates_distributional_effects_and_risks
MGI’s
Richard Dobbs and Susan Lund discuss the economic impact of QE and
ultra-low interest rates and the problems that may arise, depending on
future conditions.
A new report from the McKinsey Global Institute examines the
distributional effects of these ultra-low rates. It finds that there
have been significant effects on different sectors in the economy in
terms of income interest and expense. From 2007 to 2012, governments in
the eurozone, the United Kingdom, and the United States collectively
benefited by $1.6 trillion both through reduced debt-service costs and
increased profits remitted from central banks (exhibit). Nonfinancial
corporations—large borrowers such as governments—benefited by $710
billion as the interest rates on debt fell. Although ultra-low interest
rates boosted corporate profits in the United Kingdom and the United
States by 5 percent in 2012, this has not translated into higher
investment, possibly as a result of uncertainty about the strength of
the economic recovery, as well as tighter lending standards. Meanwhile,
households in these countries together lost $630 billion in net interest
income, although the impact varies across groups. Younger households
that are net borrowers have benefited, while older households with
significant interest-bearing assets have lost income.The impact that ultra-low interest rates have had on banks has been mixed. They have eroded the profitability of eurozone banks, resulting in a cumulative loss of net interest income of $230 billion between 2007 and 2012. But banks in the United States experienced an increase in effective net interest margins and a cumulative increase in net interest income of $150 billion. The experience of UK banks falls between these two extremes.
Life-insurance companies, particularly in several European countries, are being squeezed by ultra-low interest rates, so much so that if this environment were to continue many of these insurers would find their survival threatened.
Theoretically, ultra-low interest rates may have resulted in higher asset prices, and this effect may have offset lost interest income for households and other investors. But we find a mixed picture.
Rising bond prices are the flip side of declining yields, and the value of sovereign and corporate bonds in the eurozone, the United Kingdom, and the United States increased by $16 trillion between 2007 and 2012. Investors that mark the value of their assets to market have therefore seen a significant gain on their fixed income investments, at least on paper.
Ultra-low interest rates are likely to have bolstered housing prices by lowering the cost of mortgage credit. This effect is most clearly seen in the United Kingdom, where the majority of mortgages have variable interest rates that have automatically adjusted downward. The impact is less clear in the United States, where the recovery in housing prices has been dampened by an oversupply of housing, high levels of foreclosures, a predominance of fixed-rate mortgages, tightened credit standards, and the prevalence of homes with negative equity whose mortgages cannot be refinanced.
We found little evidence that ultra-low interest rates have boosted equity markets. We cannot discern a large-scale shift into equities as part of a search for yield by investors, and price-earnings ratios and price-book ratios in stock markets are no higher than long-term averages. Although stock prices do react to announcements by central banks, these are transitory effects that do not persist.
If one accepts that housing prices and bond prices are higher today than they otherwise would have been as a result of ultra-low interest rates, then the increase in household wealth and the possible additional consumption it has enabled would far outweigh the income lost to households. But we are skeptical about whether increases in wealth have translated into higher consumption in today’s environment, given that housing prices in the United States remain far below their peak. Moreover, it is more difficult for today’s households to borrow against any increase in wealth because of tighter credit standards.
Ultra-low interest rates do appear to have prompted additional capital flows to emerging markets, particularly into their bond markets. Purchases of emerging-market bonds by foreign investors totaled just $92 billion in 2007 but had jumped to $264 billion in 2012. Emerging markets that have a high share of foreign ownership of their bonds and large current account deficits will be most vulnerable to capital outflows if and when central banks begin tapering current policies.
There are likely to be risks ahead whether asset purchases are tapered and interest rates rise or, alternatively, if current monetary policies continue and interest rates remain low. In the first scenario, the benefits gained or losses incurred could be reversed. Government interest payments on debt, for instance, could rise up to 20 percent. Amid anecdotal evidence that some investors have increased their leverage to amplify returns in some markets, rising interest rates could lead to a collapse in leveraged trades and could pose a threat to some financial institutions. Capital flows to emerging markets could reverse. Investors in bond markets forced by accounting rules to mark to market could face large write-downs. Eurozone countries could be caught in a crosswind if rates increase in the United States before they do in Europe, leading to a shift in foreign capital from Europe to the United States. In the second scenario, life insurers and banks in Europe would experience continued erosion in their profitability. A continuation in ultra-low interest rates could also prompt higher leverage and the return of asset-price bubbles in some sectors, especially real estate.
Source: http://www.mckinsey.com/insights/economic_studies/qe_and_ultra_low_interest_rates_distributional_effects_and_risks
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