An unstable equilibrium

We have been living in a low-vol world for a while now, driven by a massive alphabet soup of central bank liquidity, which have been delivered globally. If it’s not the Fed engaging in QE’s 1, 2 and 3, it’s the ECB’s PSPP and CSPP bid, BoJ’s QE and yield curve control, or simply the massive stimulus delivered by PBoC. But the persistence of low volatility and low yields is also thanks to what seems like a Goldilocks global growth picture.

The US economy has put in a sufficient recovery over the last year such as to allow the Fed to have hiked three times without much ado from the markets. Similarly, European growth hasn’t been this stellar since the Eurozone sovereign crisis, which put most of the continent into a coma for the last five years. And of course, against all devaluation expectations, the Chinese Yuan and economy have both charted a firm and steady course so far this year.

Economy is both too hot and too cold

Put it all together, and you have a global economy probably past its peak but not yet falling over, and activity levels that are holding up but not so strong as to warrant a sharp rise in interest rates. But what lies beneath may not be so Goldilocks. The economy is both “too hot” (US labour market) and “too cold” (global inflation), and it is precisely such opposing forces that currently result in a benign macro backdrop. In the tug-of-war between a Fed determined to pursue monetary normalisation and a stubbornly weak (or at least weakerthan-expected) inflation picture, the yield curve has flattened and low-flation has won.

Certainly after five disappointing US inflation prints, a belief has set in that we are now in a structurally lower inflation world, perhaps as a result of the success of inflation-targeting central banks.

Regular readers will know that I am strongly of the view that low inflation is a structural phenomenon, but given the extent to which inflation expectations have adjusted, there is perhaps a more even chance of some positive surprises in the next few months. There are also those who argue that the Fed’s balance sheet tapering will necessarily result in an imbalance in Treasury supply and demand dynamics, which ought to send yields higher. While we agree with this view we believe it will be a slow-burn with the cumulative effects (stock) much more important than the monthly flow.

At some point the market will wake up to a large net issuance problem, but we don’t expect that to be a factor in the short-term. In any case, it is all too simplistic to argue that QT is just the opposite of QE, and even if that were the case, bouts of QE have generally resulted in higher yields, and prior attempts to taper have resulted in lower yields. Ultimately, to produce a sustained sell-off in US yields, the debt ceiling storm clouds need to part, and positive economic momentum needs to grow some legs.

It was only 18 months ago when the world was convinced that the US was headed into recession. By the start of 2016, WTI crude oil had found new lows in the mid-$20s, US GDP growth had more than halved in less than a year, and ISM PMIs were firmly in contractionary territory. Between mid-2015 and early 2016, US high yield credit spreads had almost doubled to 600bps. Concerns over the US being “late-cycle” had quickly escalated into fears of the next US recession, and no investor wanted to touch US retail with a ten-foot barge pole.

The equilibrium may not be as stable as you think

Then in what felt almost like an overnight move, things started to improve. We all know very well by now that the Chinese credit stimulus of late 2015 “made America great” by delivering the impulse needed to avoid the next dip. Soft and hard data based as commodity prices lifted off their lows, and however “late-cycle” the US might have been then, the economy had once again peered over the edge but stepped back from the abyss. Asset volatility, risk premia, and credit spreads globally followed the US recovery, and the rest is history.

So now here we are, with volatility and credit spreads at, near or through their cyclical tights, and so far no catalyst has managed to cause a significant enough shift in fundamentals to disrupt the ecosystem. This is a market conditioned to buy the dips and ignore high stakes. We are therefore in an equilibrium of sorts, although this equilibrium may not be as stable as you think.

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