Top of Mind(2014.09.19) - Exploring Exit

Investors are left grappling not only with the implications of US and UK rate hikes, but also with the effects of global divergence in monetary policy.

1.     Interview with Hildebrand and Hatzius

1)     Interestingly, If you look at the start of past hiking cylces – in 1994, 1999 and 2004 – the eventual adjustment was more significant and happened more rapidly than what was priced in at the beginning of the cycle (Hildebrand)

2)     There has been a clear tendency to underestimate the speed and ultimate peak for short-term interest rates during past hiking cycles. (Jan)

3)     The first few hikes are likely going to be slow, but if the economy continues to do well enough and financial conditions do not tighten too much in response, there is a high probability that the pace would eventually accelerate (Jan)

2.     Divergence in the monetary policy exit

1)     Although the current divergence is striking, differentiation in the timing of hikes is not itself unusual. ( G10 monetary policy easing tends to be quite synchronized but tightening is much less synchronized as the differential impact of those global shocks, the policy responses to them, and fresh local shocks play a larger role )

2)     Changes in the unemployment rate have been the single best indicator of this differentiation in the past, with changes in inflation also playing some role.

3)      We continue to think that the fed funds rate may move more quickly than the 100bp per year that is currently priced and that the terminal rate is likely to e higher(at 4%) than many now believe.

4) The differentiation in monetary exits is important in three major ways

1. The first is its impact on the currency markets.
2. The second is its impact on global bond yield and the US Treasury market.

• Longer-dated yields in particular are, increasingly, globally not locally determined.
• US longer-dated bond yields are likely to remain lower than they would otherwise be if they were priced off a US growth and policy profile alone.

3. The third issue is the impact on the global policy stance

• While a desynchronized monetary exit does not remove the risks of over-tightening, it is one reason why we think those risks are lower than the market believes.

3. It’s not just about when, but how

• The effective fed funds rate : The price banks pay to other banks for borrowing reserves on an overnight basis.
• Target fed funds rate : FOMC’s goal for the average level of the effective fed funds rates over time.
• The key to the fed fund rate is therefore the level of reserves

1. Pre-QE : The level of reserve balances in the banking system fairly low
2. Post-QE : The degree of excess reserves in the banking system has risen to a substantial $2.7trillion → As a result, the scarcity value of reserves today is close to zero and the effective fed funds rate has generally traded at the lower end of the target range of 0 to 25bp

• At a high level, when the Fed wants to hike the fed funds rate, it can (A) create scarcity of reserve balances, (b) rely on interest paid on excess reserves(IOER), or use some combination of the two.

4.  Independence day for ECB rates

1. During period of “Taper tantrum”, Euro short-term rates rose and became more volatile in concert with those in the US
2. Ultimately, on 4 July 2013 the ECB attempted to break the shackles of Fed influence by adopting a qualitative form of forward guidence of its interest rate decisions
3. Mr. Draghi stated : “ The Governing Council expects the key ECB interest rates to remain at present or lower levels for an expended period of time”
4. One ambition of the ECB’s forward guidance was to assert independence from Fed policy. This would ensure that shorterm interest rates would remain under the ECB’s full control and be approate for the Euro area’s weaker cyclical situation.
5. The evolution of 3-year fowards of 1-month monetary market rates offers some insight into the impact of the ECB’s announcement. ( These rates represent a simple proxy of market expectations of the future course of monetary policy.)
1. For all the idiosyncrasies in the economic and financial situations on each side of Atlantic over the course of the financial crisis, Dollar and Euro foward rates have moved essentially in lockstep
2. after, the ECB’s foward guidance in July 2013, a more substantial and persistent widening of the spread between US and Euro area forward rates proved possible. This spread has now reached 200bp

5. Is “limited and gradual” credible?

1. The BOE emphasizes that, when it raises rates, the pace of tightening is likely to be “gradual” and that the level to wich rates rise is likely to be much lower than was typical of past cycles. Our forecasts imply that this expectation is reasonable, but if the economy requires a faster pace of tightening to higher level, we expect the Monetary Policy Committee’s communication to adjust accordingly.
2. UK official rates tend to rise more slowly than US rates during tightening cycles in part because, with relatively high levels of gross household borrowing and a shorter average duration of that borrowing, changes in official rates typically have a bigger effect in the UK than in the US
3. If there is one main sesson from the UK’s experience with foward guidance, it is that guidance will change quickly if the circumstance dictate.

6. A quater century of rate-hike cycles

1. History suggests that rate-hiking cycles do not typically end in recession, leading instead to moderately slower growth and easing economic constraints. In this context, markets may well be able to ultimately adjust to rising rates without much loss of momentum.
2. Equity market
1. Equity markets typically pause for the first two or three months after the first hike. Vut equity markets quickly regain their footing, posting 12% returns on average in the full year after the first hike. This is consistent with the fact that very few past rate hiking cycles have led to spell of negative economic growth.
3. US marekt
1. 1998, 1994, 1999 and 2004
2. Yield curves flattened shortly after the start of policy rate hike
3. S&P 500 rallied into the start of all four rate-hiking cycles, traded sightly lower during the first few months of rate hikes, and then regained its footing.
4. Some exceptions in 1999 and 1994
1. 1999
1. The 1999 hiking was followed closely by the onset of a recession, economic growth deteriorated more dramatically than in other episodes, and longer-term equity market performance was for weaker.
2. 1994
1. The rate hikes of 1994 which were desgined to suprise markets, led to a much sharper rise in yields, and a more negative and lingering initial equity market sponse.
4. The unprecented nature of the current cycle suggests that comparisons to past experiences should be treated cautiously
5. While the approach of a rate-hiking cycle naturally creates uncertainly, history suggests these cycles need not be a major roadbloack to ongoing ecnonomic and market progress

7. A hiking-cycle roadmap for US equities

1. US stocks tend to perform well in the year before tightening cycles, which is consistent with an improving economic backdrop
2. While equities tend to perform well heading into rate hikes, they typically stall in the aftermath
3. Once tightening began in the three previous rate-hiking cycles, a shift in investor focus on the dampening effect of tighter financial conditions led to a modest pulback in equity prices. On average, the S&P 500 fell 4% in the three months folowing the first hike.
4. The fed funds rate rises to constrain growth, which increases the discount on future flows and lowers valuation. Lower equity valuations as raties rise fits with the search for yield which lowers the demand for equities. But we are likely to experience the reverse in coming years.
5. A year-end 2018 DDM-implied S&P 500 value of 2300 is consistent with a 4.0% netural fed funds rate, a neutral 10-year bond yield of 4.5%, and 2.0-2.5% trend GDP growth. So while US equities may not be so exciting at face value, they are likely to be one of the most attractive investments around

8. EM: In between Fed exit and ECB entry

1. As the first expected hike in US rates approaches, a key question is: how will EM assets cope?
2. This is most clearly the case for EMs with significant external imbalances as investors fear that rising US rates will draw capital flows away from these economies, leading at best to economic weakness and at worst financial crisis
3. While we still think that EM FX is the most valnerable of EM asset classes, at least in this limited extent, specific EM currencies should be better poisitioned than before to withstand the threat of rising US rates
4. The divergence in growth, inflation and policy outlooks between the two regions(EU and US) suggests that the potential for significant EUR weakness (Both against the USD and also several EMs). This implies that EM FX reactions to impending US rate hikes should be a bit more nuanced in the near-to-medium term. (INR looks good but TRU looks not good)
5. The advantages of holding EM FX longs against the EUR versus the USD today are already playing out’ since mid-july, an index of EM FX has fallen about 3% against the USD, but is about 1% higher aganist the EUR. By contrast, during the first couple of months of the 2013 taper tantrum, EM FX losses were about 5% against both the USD and the EUR
6. EUR-funded EM longs generally offer decent risk/rewards against these risks. This is because EUR absorbs some of the downside risks associated with a strong USD, and is itself expected to depreciate on a trend basis. The currencies that offer the best returns against the EUR relative to the risks include NJA currencies - the MYR, PHP, INR and CNY. Lower-yielding LatAm currencies, such as MXN and COP, also ofer decent upside relative to the potential risks. In contrast, the risks for the TRY,BRL and ZAR are high relative to the expected returns aganist the EUR and, toghter with the CEE(HUF,FLN,CZK), do not offer compelling risk/reward if the Fed exit proves to be unfriendly.