Benoit Mojon

Interest rates tend to move together. In Figure 1, we report interest rates on Treasury bonds of five-year maturity for the Eurozone member states that have the best ratings, and for the US, the UK, and France. It is striking for US and UK interest rates throughout the last decade.

In continental Europe, interest rates tend to swing with their US and UK counterparts only up to 2013. Diebold et al. (2008) show that the yield curves of the US, Japan, Germany, and the UK move together. In addition, the level and slopes of each country’s yield curve is highly correlated with a global level and a global slope of interest rates. The importance of international co-movements between interest rates is confirmed by Pegoraro et al. (2014). These stylised facts on interest rates may reflect both international arbitrage by investors and a high degree of real (Kose et al. 2003) and nominal (Ciccarelli and Mojon 2010, Ferroni and Mojon 2014) international co-movements in business cycles.

Figure 1. Five-year interest rates (Eurozone AAA, US, UK and French treasuries), in %

Sources: Bloomberg and ECB

The common wisdom is that US rates lead and Eurozone rates follow the movement. However, the picture has changed since 2014, when the ECB expanded its unconventional monetary policy.

Larger decoupling between US and Eurozone rates after Donald Trump’s election

After the election of Donald Trump, the spillover of the sharp increase in US interest rates has been very limited on the Eurozone. This is true both in nominal terms as well as for ex ante real interest rates. Indeed, long-term inflation expectations, as measured by surveys of professional forecasters, have remained very stable over the last 10 years.

From the month prior to the US election on November 8, 2016 to January 2017, the interest rates on US five-year treasury bonds have increased by about 70 basis points. This is mainly because investors expect both economic growth and inflation to accelerate if the new administration cuts taxes, boosts investment, and even raises tariffs on imports. Meanwhile, Eurozone five-year interest rates have increased only by 20 basis points. Since mid-January French rates have increased above Eurozone AAA as they frequently do before important elections.

By contrast, during the ‘Taper Tantrum’ (from April to June 2013), when US Treasury yields surged because investors believed that the Federal Reserve would soon raise policy rates, a comparable increase (of about 70 basis points) in five-year US interest rates coincided with an increase of 45 basis points in the five-year French rate.

The role of the Eurozone monetary policy

Short- to medium-term interest rates are mostly influenced by monetary policy. They mainly reflect expectations of future monetary policy decisions. The significant decoupling of Eurozone rates from its US counterparts, which started in 2014, has been striking, especially when compared to the absence of decoupling for the UK (except very recently). Through its monetary policy actions, the ECB has managed to largely shield Eurozone financial conditions from the forces that determine US and global financial conditions.

In December 2016, the Federal Reserve raised its policy rate and is expected to raise it further in 2017. By contrast, ECB non-conventional measures are still in place and investors expect Eurozone interest rates to stay much lower than their US counterpart for several quarters.

The stance of the ECB’s monetary policy is the most likely reason why Eurozone rates of up to five years’ maturity have been decoupling from their US counterpart.

Longer-term recoupling when the monetary policy impact fades away

As seen in Figure 2, interest rates at longer maturities (five to 10 years), which we measure by forward (five years in five years) interest rates have kept swinging together throughout the last decade. There are some differences here and there. For instance, the French forward rate increased above the US rate during the Eurozone sovereign crisis in 2011-2012, fell below in 2014, and then rebounded at the end of 2016. However, variations in forward rates have remained remarkably parallel across the Atlantic, including after the election of Trump. The same forces seem to move US, UK, and Eurozone interest rates up and down. At such long horizons, interest rates are likely to reflect common real factors, such as oil prices, or longer-term ones, such as shifts in productivity trends, rather than domestic monetary policies.

Figure 2. 5Y-5Y forward interest rates (Eurozone AAA, US, UK and French treasuries), in %

Sources: Bloomberg and ECB
Note: 5Y-5Y forward interest rates reflect the market perception of the 5-year maturity interest rate that will prevail 5 years from now. For instance, in January 2022, the French treasury should be able to borrow at about 2% and the US treasury at about 3%.

How does the ECB’s monetary policy contribute to decoupling?

The ECB’s non-conventional monetary policy is currently based on three main instruments: forward guidance, asset purchases, and long-term liquidity provisions (Targeted Long Term Refinancing Operations, or TLTROs). First, through forward guidance, the ECB commits its key policy interest rate “to remain at present or lower levels for an extended period of time, and well past the horizon of [its] net asset purchases”.

Second, through the asset purchase programme (commonly called quantitative easing), the Eurosystem buys government bonds, thereby pushing interest rates down at different maturities. The programme was announced in January 2015 and is intended to last until at least the end of 2017.

Third, since June 2014, the ECB TLTRO has offered liquidity to banks at a four-year horizon. The final operation will take place in March 2017. For banks that meet the criterion, the interest rate can be as low at -0.4% for a funding instrument that they will pay back as late as March 2021.

Those three instruments reinforce each other and work efficiently to keep Eurozone nominal interest rates low (or negative) for horizons of several years. Thus, monetary policy is powerful and effective in setting monetary conditions that are adapted to the Eurozone situation. These exceptionally low rates facilitate deleveraging while stimulating investments. They reduce the interest bill of member states and hence taxes. As shown in Banque de France (2016) and in Andrade et al. (2016), the sequence of non-conventional measures undertaken since June 2014 steer up inflation expectations, stimulate credit, foster the recovery of the Eurozone and help the sustained adjustment in the path of inflation closer to 2% than has been the case since 2013.

Thus, the reinforced decoupling between US and Eurozone nominal interest rates up to five years, following the election of Trump, provides some evidence of the ECB’s ability to pursue a policy fully tailored to internal macroeconomic conditions and not unduly sensitive to external influences and spillovers. By that standard, the non-conventional monetary policy put in place by the ECB has confirmed and strengthened the monetary sovereignty of the Eurozone.

This article originally appeared in VOX EU – CEPR (Centre for Economic Policy Research) Policy Portal (http://www.voxeu.org).

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IFM Correspondent

November 14, 2016: Mortgage rates have quickly surged ever since Trump was declared the victor of the US presidential election. Rates modestly changed, with the benchmark 30-year fixed mortgage rate rising to 3.73 percent, according to Bankrate.com’s weekly national survey.

After results of the elections came out, financial markets expected turmoil. However, Trump’s acceptance speech soothed investors who were previously sceptical about a Trump victory.

The prospects of higher government spending and more government borrowing for infrastructure improvements sent long-term Treasury yields racing higher. The 10-year Treasury note yield soared above 2 percent on November 8, closing at 2.07 percent, the highest since January 22.

The benchmark 15-year fixed-rate mortgage rose to 2.97 percent from 2.96 percent while the benchmark 5/1 adjustable-rate mortgage rose to 3.15 percent from 3.14 percent.

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IFM Correspondent

November 14, 2016: Investors endured a rocky day of trading after the shock election of Donald Trump as the next US president sparked a bout of unusual volatility that rocked financial markets around the world.

Shares and bonds whipsawed violently as initial concerns about a Trump presidency gave way to cautious optimism that the businessman-turned-reality-television-star would be less divisive than originally feared.

The FTSE 100 dropped as much as 146.8 points at the opening of trade, only to recover remarkably and close up 68.71 points, or 1pc, at 6,911.84, a rally mirrored in Europe and the US. While futures on the Dow Jones Industrial Average at one point plunged more than 800 points, the US benchmark index was up 1.4pc, or more than 256 points, by the end of the day, just 0.25pc off its record high set in August.

Mark Haefele, global chief investment officer at UBS Wealth Management, said Mr. Trump’s acceptance speech, in which the Republican outsider with no government experience struck an unexpectedly conciliatory tone, soothed some investors’ worst fears.

“We clearly saw the market turn when Donald Trump began speaking and rather than continuing with divisive campaign rhetoric, thanked Hillary Clinton, said he would reach out to all Americans and the Democrats for guidance,” said Mr. Haefele.

In the early hours, before his speech, markets initially panicked as it became apparent he would win, with Japan’s Nikkei 225 stock index slumping 5.4pc and the dollar sharply weaker.

“We had a knee-jerk reaction,” said Phil Poole, head of research at Deutsche Asset Management. However, hopes that Mr. Trump will pursue pro-business policies that will stimulate economic growth, along with his overtures towards the Democrats, helped to spark a rally in the dollar and equities, and saw gold fade.

“He spoke about jobs, he spoke about lower taxes, he also spoke about infrastructure,” said Mr. Haefele. Investors are now betting that Mr. Trump’s focus on infrastructure spending and tax cuts will be inflationary. Treasuries, which had earlier been in demand, were sold-off and 10-year yields spiked as high as 2pc.

Stock markets were also buoyed by expectations among some investors that global central banks will keep monetary policy loose amid the uncertainty caused by Mr. Trump’s victory, although the consensus was still for the US Federal Reserve to hike rates in December.

“People have taken a view that this doesn’t change the over-riding importance of monetary policy and that monetary policy is going to remain extremely loose,” said Mr. Poole.

As the shock waves from the election rippled through the business world, JP Morgan boss Jamie Dimon warned employees in a memo that “we need to listen to those voices” that elected the Republican. Analysts also urged caution that investors should not be over-optimistic.

“If we look at all his pronouncements around policy, they’re not necessarily consistent, they’re not well fleshed out,” said Mr. Poole. “Investors need to watch very closely who Trump appoints, what his team’s going to look like and the extent to which that team is experienced. These are all going to be very important signals in determining just what kind of Trump we’re going to get.”

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Ken Taubes

September 26, 2016: As expected, the Federal Reserve Board left interest rates unchanged following the September meeting of the Federal Open Market Committee (FOMC). In its statement following the meeting, the FOMC said, “The Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives.”

The Fed appears to be moving its targets. Chair Janet Yellen cited the need to wait for further improvement in the economy, even though there is evidence that the Fed’s goals have been achieved. She indicated that Committee members will continue to assess economic conditions but made no commitment on the timing of a rate increase. According to Bloomberg, the futures market places a 59% probability on a December hike, but the Fed’s shifting views make that uncertain.

Full employment?

The US unemployment rate is at 4.9%, which meets the Fed’s mission of full employment. While Chair Yellen said the labour market has been improving, she also said there is “room for further improvement.” She said, “The fact that unemployment measures have been holding steady while the number of jobs has grown solidly shows that more people, presumably in response to better employment opportunities and higher wages, have started actively seeking and finding jobs.” She added, “This is a very welcome development, both for the individuals involved, and the nation as a whole.”

But Chair Yellen also said there continues to be slack in the labour force and cited the need for further evidence of improvement in the labour market as one reason for leaving rates unchanged. This raises the question of whether the Fed is giving more importance to the broader measure of unemployment, the U6 rate published by the Bureau of Labor Statistics, which includes not only the total unemployed but part-time underemployed workers as well. This rates stands at 9.7%. The market is left guessing how much further the labour market needs to improve before the Fed will raise rates.

Mixed inflation signals

The Fed also cited inflation below its 2% target as another reason for holding rates steady. But it is becoming increasingly clear that inflation indicators are being impacted in part by government policies and factors beyond the Fed’s ability to affect the outcome with monetary policy. One such area is healthcare.

The core personal consumption expenditures index (Core PCE), which is the Fed’s preferred inflation index, and the consumer price index (CPI), use different methods to track healthcare expenses, resulting in sharply different data. CPI tracks what American consumers spend out-of-pocket (including insurance premiums) on healthcare, while PCE takes into account all healthcare spending, including costs paid by insurers, Medicare and Medicaid. Under Obamacare, Medicare and Medicaid have been aggressively pushing down reimbursement rates to healthcare providers while consumers are shouldering higher out-of-pocket costs for healthcare-related expenses.

This government-engineered cost shifting has resulted in significantly different inflation data between PCE and CPI. PCE healthcare inflation was up only 1.1% year-over-year based on the most recent July report, while CPI healthcare jumped 1% in August alone, to 4.9% year-over year. It’s worth noting that healthcare has twice the weighting in PCE vs. CPI, at 19.1% vs. 8.5%, reflecting the fact that healthcare providers pick up most healthcare costs. Monetary policy has little influence over the effect of government-mandated healthcare reimbursement rates built into Obamacare, which are holding down Core PCE inflation, while pushing up CPI inflation.

Investment outlook

Following the Fed’s decision to hold rates steady we expect further gains for risk assets. In fixed income, we expect yields to drift, with little change in the yield curve until there is a shift in the economic data or a change in Fed policy. We continue to believe that developed markets sovereigns, including most US government debt, look unattractive. Investors are being poorly compensated for duration risk as a result of negative nominal yields and negative real yields. Corporate credit is generally more desirable than Treasuries, however even here values are well below historical averages, with an upward bias on leverage. Floating rate securities, including structured securities and event-linked (catastrophe) bonds, may be attractive to hedge interest rate risk without too much yield give-up. With yields so low and a flatter yield curve, shorter duration positions have become less costly.

In equities, we favour large cap stocks over small cap stocks, and see opportunities in mid-cap stocks, many of which are benefitting from secular growth.

Ken Taubes is US Chief Investment Officer at Pioneer Investments

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