The dangers of safety

Much of the focus on central bank deliberations in the past month has been on the US Federal Reserve Governor’s comments at Jackson Hole around the prospect and timing of an imminent hike in the federal funds rate; it appears that a 25 basis point lift is a forgone conclusion, whether it is at the September or December meeting of the Federal Open Market Committee.  

The main measure of inflation tracked by the Fed – core PCE inflation – remains below the central bank’s 2% target.  Ms Yellen and her colleagues clearly remain faithful to a Phillips curve view of inflation dynamics; in the short run, low unemployment is associated with rising inflation.  With the unemployment rate below 5%, the internal view at the Fed is that the US economy at or close to full employment which offers confidence that core inflation lifts back towards the 2% target once the transitory effects of lower energy prices and a stronger US dollar wear off.

Differences of opinion amongst economists around whether the Fed should tighten policy at a time when inflation continues to undershoot the target therefore hinge on whether the short run Phillips curve is the right model.  If it is, then the central bank is justified in giving weight to strong labour market conditions.  Evidente has previously suggested that the unemployment rate has increasingly become an unreliable gauge for inflation.  Prior to the crisis, the Phillips curve was steep; since then it has flattened considerably.

The bond market remains at odds with the Federal Reserve.  With the yield to maturity on 10 year Treasuries at less than 1.6%, it is sending a powerful signal that it doesn’t buy into the short-run Phillips curve view of the world.  And for good reason; surveys and market based measure of inflation expectations remain well anchored. 

Perhaps the current cohort of central bank governors have under-estimated just how successful their predecessors had been in slaying the inflation dragon over the past two decades, as well as the scale and persistence of the global glut in saving.  The world has been awash with excess financial capital, driven primarily by a strong appetite to save at a time when profitable investment opportunities have apparently diminished.  No wonder that the global price of money is at a record low.

The global glut in saving was cited recently by the Governor of the San Francisco Federal Reserve as one of the key reasons for the decline in the neutral rate of interest; the interest rate that is consistent with the economy growing at potential output.  The theory goes that entrepreneurs and companies will be encouraged to invest when the actual interest rate is below the neutral rate, and conversely will be discouraged when the actual rate is higher than the neutral rate.  Weak business investment since the financial crisis suggests that the prevailing interest rate – even at these low levels – lies above the neutral rate. 

To the extent that the neutral rate of interest remains low going forward – some estimates point to close to zero – this points to a world where the Federal Reserve and other central banks will be hitting up against the zero lower bound to deal with the next downturn and beyond.  Ms Yellen in her Jackson Hole admitted as much when she explained at length that the Federal Reserve could continue to rely on forward guidance and large scale asset purchases, if necessary.

For fixed income managers, the timing of a US rate hike in September or December matters.  More importantly, they will be looking for hints that reveal the likely trajectory of the fed funds rate over the course of 2017.  If the recent history of the dot plots of the Fed’s own internal projections is any guide, the central bank’s senior officials continue to under-estimate the powerful effect of the drop in the neutral rate of interest and the associated powerful disinflationary forces. 

Much has been made of the rise in bond duration to a record high globally; the sensitivity that bond prices have to changes in the yield to maturity (YTM).  A decline in the YTM is associated with an increase in a bond’s price.  Governments around the world are clearly taking advantage of record low interest rates and issuing more bonds at longer maturities.  Much in the same way that some CEOs take advantage of their stock price being at a record high to issue equity to fund an acquisition and/or capital investment.  With the US 10 year Treasury bond price to coupon ratio pushing beyond 60x, Treasuries are clearly vulnerable at some stage to a lift in the YTM (in the same way that a glamour stock is vulnerable to a lift in the discount rate used by investors).

For equity managers versed in financial statement analysis, and forecasting net cash flow and dividends, the timing of the next rate hike in the United States matters less.  What is more relevant are the reasons underlying the drop in the neutral rate of interest and why animal spirits in the corporate sector remain dormant when corporate profit shares across many developed economies are high by historical standards.  Economists I believe have over-simplified the investment implications of the neutral rate of interest.  Companies just don’t look at the rate of interest, but their cost of equity capital, which is the sum of the risk free rate and equity risk premium (ERP), however measured.  In the past, Evidente has suggested that stocks have not re-rated despite the lower risk free rate because of the offsetting effect of a rise in the ERP.  The decade long widening in corporate bond spreads in the United States and survey evidence that hurdle rates remain sticky is also highly suggestive of a higher ERP.

The higher ERP would help to explain a number of empirical phenomena. 

  • First, a higher risk premium has probably reduced expected risk adjusted returns of prospective capital projects despite high expected profitability, which would account for why there is little appetite for risk taking.  This represents a more coherent thesis for persistent under-investment than Larry Summers’ view that the capital light firms dominate stock indexes globally. 
  • Second, low beta stocks ought to trade on a higher multiple than normal due to the interaction of their beta and the ERP.  In the CAPM, the relationship between the two variables is multiplicative so that a rise in the ERP and a fall in the risk free rate reduces the cost of equity capital.  The math is not so kind to a high beta stock because the interaction of a higher beta and higher ERP overwhelms the effect of the lower risk free rate.  Low beta stocks have also benefited from the bond like attributes of a stable dividend stream.

Much research needs to be done to understand the causes of the higher ERP.  A good starting point is to better understand the dynamics around households’ stock of human capital, what Milton Friedman called permanent income; the stream of expected discounted future cash flows.  Specifically, economists need to better understand why households are assigning higher risk premia to their expected cash flows, which has led to a substantial drop in permanent income.  This is fertile ground for those looking to understand the sources of timing of a reversal of the rising ERP.  This will lead to a tectonic shift in the relative performance of 'safe' assets: low beta stocks, low volatility stocks, high grade corporate bonds and sovereign bonds. The dangers of safety will re-emerge, but not just yet.

* Charts accompanying the analysis are available on request.