Tapering and UK banks
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On 22nd May, markets started to price in a higher probability that the Fed will start tapering its asset purchases and begin the shift towards policy normalization, and most investors now expect that tapering will be announced at the September Open Market Committee (FOMC) meeting. Of course, markets didn’t wait until September to price in higher yields, and since 22nd May, US Treasury 10 year yields have risen by about 100bp, and this has brought some collateral damage in what was an eventful summer, especially for emerging markets (EMs).
With tapering now largely priced and rates normalization under way albeit very slowly, we need to think through what the new macro environment means for investors.
First, we can expect a gradual shift up in rates, accompanying slow but persistent recovery in developed market economies. US rates have adjusted sharply to the prospect of Fed tapering, after experiencing a prolonged period when yields were below what macro fundamentals would justify. Thus, normally the level of yields on US Treasury 10 year bonds can be explained by the yield on US Treasury two year bonds, CPI inflation and macro economic prospects, which can be proxied by the ISM PMI. Looking at the data and data relationships, it is apparent that actual yields de-linked from their fundamental drivers around mid-2011 and stayed at historically low levels until May this year. That gap now appears to have closed following Fed tapering expectations and had reflected significant compression of the term premium, driven by concerns about severe global financial stability risks, such as the Euroland debt crisis, US fiscal issues, and the risk of a hard-landing for China. These concerns started dissipating in H2 2012, and this development coupled with improved prospects for the US economy, led to a sharp back-up that started even before Mr Bernanke hinted at tapering.
It looks likely that now that rates have adjusted to levels that are more in line with fundamentals, cyclical data will become more important drivers of yields, and we may see US Treasury 10 year yields up to around 3.10% in the fourth quarter this year, and 3.75% during Q3 14. This is a faster back-up than discounted by forwards and is grounded on several factors: continuation of the US labour market recovery, a tighter link between Fed policy and the labour market, and financial conditions not having deteriorated significantly, despite the back-up in yields.
Overall, this environment should be supportive of higher US yields, underpinned by positive activity data. US equities will face a tougher environment, grinding higher at best, in our view, in H2 as yields rise in this new macro environment. We can be more constructive on UK and European equities, given the early growth recovery and still-attractive valuations, but the main victims of the tapering debate to date have been Emerging market (EM) assets. Thus, the rise in global and US rates has been sharp, but the EM rate rise has been sharper, and has been the third-worst period for local market EM rates on record. Despite the recent EM stress, the persistent underperformance of EM equities looks to be stabilising, and within EM currencies, despite the aggressive sell-off, the KRW and CNY have fared well and highlight the significant differentiation between those emerging market economies that have current account surpluses and deficits.
The flattening of the yield curve between 10 years and 30 years in the US and Euroland in the context of rising yields is also interesting and likely reflects the low inflation environment and an improved fiscal environment. We will keep these developments under review, as the outlooks for oil and fiscal finances remain fluid.
Decompression of the term premium in ‘safe rates’ in the US and Europe, coupled with stronger data, have led to much steeper yield curves in the US, UK and Euroland, and whilst the Fed has managed to communicate effectively that it won’t hike rates soon even if it tapers, in Europe, central banks (BoE and ECB) have not contained the back-up at the front end. It seems that BoE guidance has been watered down by its knock-out clauses, while the ECB has yet to flesh out a strategy to implement guidance, and the back-up in yields at the front end of the EUR curve vs. the US is difficult to reconcile with the relative business cycle. For now it look likely that US yields will eventually rise further on the back of improving macro data, but Euroland’s cyclical recovery is way behind. This suggests that the ECB will need to use guidance and perhaps another LTRO to contain the front end, with the longer end of the curve likely more correlated with the US and more susceptible to a sell-off if Euroland data continue to improve.
Importantly forward guidance has worked in the US in terms of keeping front end-rates expectations anchored, but also in terms of helping US banks which have also benefited from the recovery in housing. Bank equities have outperformed the broad S&P500, but in the UK, bank equities have not outperformed. Banks in the UK should however benefit from the improving macro backdrop, and Governor Carney’s first speech help bank equities with reduced liquidity buffers that support bank lending, whilst his dovish message on the outlook for rates keeps the UK curve steep.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
