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FIXED INCOME MARKET OUTLOOK
POLICY CONFUSION, CROWDED TRADES, AND A RISE IN
VOLATILITY… ALL REQUIRE AN ATTEMPT AT PERSPECTIVE
OCTOBER 2014
Highlights
 The fear of a global growth slowdown and some confusion over policy direction has
helped to reintroduce markets to more elevated volatility levels. Still, while there are
genuine concerns, the recovery in the U.S. remains on track.
 A fascinating dynamic of U.S. dollar strength and commodity price weakness is
having a profound influence on inflation in the U.S. and even threatens to impact
monetary policy decision making in unhelpful ways.
 For some time now, we’ve seen excessive rates policy and a virtually insatiable
demand for income combine to produce crowded trades and limited opportunity
sets, so investors would do well to tread carefully with popular positioning.
Last month in these pages we raised the question of whether we had reached an
inflection point for markets, largely brought on, we argued, by a monetary policy
regime in the United States that appeared to be transitioning toward normalization.
The story told by recent asset price performance and rising volatility levels, however,
appears to be more complex. Indeed, a series of economic data disappointments
over the past month, both in the U.S. and around the globe, have increased fears of a
global slowdown, have raised the likelihood of further divergence between U.S.
growth and that of other major economies, and have also, some believe, placed U.S.
growth itself at risk. These concerns have also led to a set of official and unofficial
comments from Federal Reserve Federal Open Market Committee (FOMC) members
that we believe have confused market participants as to the current state of the
central bank’s policy reaction function.
Undoubtedly, the global economy is facing some downward pressure. For instance,
the growth rate of industrial production in Japan has been sliding since early in the
year, and recently turned negative. Further, Germany’s Purchasing Manager Index
(PMI) levels have declined over the same period and now sit just below the ‘50 point’
demarcating expansion versus contraction. In the U.S., PMIs have declined from the
high-50s to the middle-50s, suggesting that growth rates are moderating, but as we
argued extensively last month, a set of secular tailwinds combined with cyclical
improvements are likely to allow U.S. growth to continue at a sold rate. Still, despite
our thinking that the case, the Fed appears less willing to normalize rates based on
domestic economic considerations, and its recently released meeting minutes
specifically mention slowing global growth (particularly that of Europe) and a strong
dollar as risks to the Committee’s economic outlook.
We think these concerns are being overplayed by the Fed, and in this month’s
outlook we explore the slowdown in global growth in more detail, examining the role
of credit growth in this dynamic, and judging what recent U.S. dollar strength implies
for commodities markets and inflation. Finally, we analyze the investment implications
that stem from these evolving economic and market dynamics and suggest that the
near-term volatility has opened up some opportunities for investors.
The opinions expressed are those of Rick Rieder as of October 23, 2014 and are subject
to change at any time due to changes in market or economic conditions.
FOR USE WITH INSTITUTIONAL AND PROFESSIONAL INVESTORS ONLY  PROPRIETARY AND CONFIDENTIAL
Rick Rieder, Managing Director,
is BlackRock's Chief Investment
Officer of Fixed Income,
Fundamental Portfolios, and is
Co-Head of Americas Fixed
Income. He is a member of
BlackRock's Fixed Income
Executive Committee, and also a
member of its Leadership
Committee. Mr. Rieder holds a
bachelor's degree from Emory
University and an MBA from the
University of Pennsylvania.
Dramatic Financial Market Disruptions Distract
From Diverging Growth and the Role of Credit
Before turning to the global growth slowdown, a brief
discussion of recent moves in rates markets is in order,
particularly since a great deal of the financial press mistakenly
attributed October 15 market drama to fears over the growth
slowdown, but we think that explanation is incomplete. For
context, 10-Year Treasury yields began the day at roughly
2.20%, plunged dramatically to near 1.87% shortly after the
market open, and finally reverted back to about 2.09% at day
end. The dramatic nature of the moves should not be
minimized, as the intraday trading range ranked among the
widest seen in the past thirty years. At one point, U.S. 10Year yields were 36 basis points lower on the day, and 2016
and 2017 Eurodollar futures prices traded nearly 50 basis
points higher.
That said, the dramatic decline in Treasury rates was largely
the result of large (and in some cases leveraged) market
players unwinding crowded trades in Treasury futures
markets. The extremity of the move strongly suggests that it is
unlikely to have been caused by a wholesale reevaluation of
fundamental economic conditions, despite the weaker U.S.
retail sales data release that morning. Thus, technical market
factors, and not fundamentals, were largely at play. Still, we
think it is important for investors to recognize that there is a
good chance of further market volatility, as both seasonal
factors and technical unwinds of crowded positions play out in
the weeks ahead.
We have often advised our readers to keep perspective
regarding distracting headlines and daily market fluctuations,
which is key when attempting to discern those factors that are
truly important to markets in the long run from mere noise.
Thus, we continue to think that critical factors, such as
demographic change, technological innovation, the energy
revolution, and economic leverage, liquidity and cash flows
will all continue to be hugely influential in determining the
course of economic growth, alongside evolution in monetary
policy. As we’ve also discussed, while the U.S. growth
trajectory has diverged from that of Europe (and to a degree
other parts of the world), and as the Fed moves closer to
policy transition, previously synchronized monetary
accommodation will diverge as well, with central banks
seemingly working at cross purposes.
The European periphery is, unfortunately, still struggling with
the troubles of debt levels that are too high, nominal GDP
growth that is too low, and real rates that are still positive
(alongside low inflation), which is a mixture of economic
conditions that threaten the frightening possibility of a
deflationary debt trap. This concept, largely associated with
the economist Irving Fisher, posits that under deflationary
conditions debt becomes increasingly difficult to pay down, as
nominal income declines while debt levels remains steady,
thus increasing debt loads in real terms. This dynamic can
take the form of a vicious cycle, or spiral, which traps an
economy in an ever-deteriorating situation, and it is the
eventuality that many central bankers fear most. It is not
surprising, then, to see the European Central Bank’s focus on
getting real rates closer to negative territory in an attempt to
help many economies deleverage and try to raise growth
rates.1 As an example, while nominal rates in Italy have
declined quite a bit in recent years, economic growth has
stagnated, and real rates have remained well above the
stimulative levels reached in places like the U.S., where
obviously greater deleveraging has taken place and economic
recovery remains on stronger footing (see Figure 1).
Figure 2: TOTAL U.S. CREDIT GROWTH (LESS GDP
PRICE DEFLATOR) VS. GDP
Figure 1: ITALY GDP VS. COST OF DEBT
Source: Bloomberg
1
Source: Bloomberg, BlackRock
For a comprehensive view on European Central Bank monetary policy, see: Glossop, Adam. “The Evolution of ECB Monetary Policy,” in BlackRock’s By The
Numbers: Perspectives on Capital Markets, October 2014.
Note: Historical yields are not indicative of future levels.
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[2]
What is needed to help spur growth in Europe is a greater
currency revaluation in the euro, which is happening to an
extent, but not to the degree required. As Europe continues to
struggle, it raises the question of whether fiscal policy might
be used to aid the recovery there, although there are
significant political constraints that must be overcome with
this. Overall, we think that markets have grossly
underestimated the importance of an economy’s “balance
sheet,” which is to say its aggregate level of leverage relative
to cash flows (and liquidity), in an overemphasis on growth
per se. The two concepts are married in a sense and further,
as we intimated previously, while credit expansion is
important, so is whether the cost of that debt remains above
the level of GDP. If it does, then added debt can merely serve
to increase volatility and financial stress. Indeed, aggregate
demand in a highly leveraged ecosystem has to exceed the
cost of the debt, and has to be able to cover (or reduce) that
debt, as an increase in the debt-stock usually will not increase
aggregate demand, but it can sustain it for long periods of
time.
The U.S. actually serves as a good example of this dynamic.
Based on our examination of the data, in the post-war period,
the U.S. economy has required at least 2.3% to 2.5% overall
credit growth (adjusted for inflation) to sustain decent
economic growth and not slip into recession (or stagnation).
Since 1952, total credit growth in the U.S. has only fallen
below this threshold in eleven years, and five of them have
been since 2008 (see Figure 2). Still, once inflation-adjusted
aggregate credit growth does break above the threshold level
(as it appears it is now) it has historically tended to increase
for multiple years, suggesting that as this channel recovers in
the U.S., it can help sustain a more durable recovery. Europe,
however, appears to be in a position whereby mere credit
expansion is not likely to foster persistent growth. We think
the strengthening of aggregate demand in the Eurozone will
likely require a combination of fiscal initiatives, expansive
monetary policy, and currency devaluation.
The Risk Posed by Slowing Global Growth
In its latest World Economic Outlook publication, a thoughtful
evaluation of the state of the global economy, the
International Monetary Fund’s Chief Economist, Olivier
Blanchard, identifies three main risks to the global economy
today: 1) the extended period of low interest rates, 2)
geopolitical risks, and 3) the (admittedly unlikely) possibility
that the stalling Eurozone recovery turns into a full
deflationary scenario. While geopolitical risk can be inherently
unpredictable, the reaction functions of central banks will help
guide the likely paths of the first and third of these risks.
Therefore, as global growth risks have become more
apparent in recent weeks, and the Fed has displayed a
reticence to commit to rate normalization, confusing some
market participants, volatility in markets has unsurprisingly
spiked. Moreover, as we long argued, one of the major
impacts that quantitative easing has had on financial asset
markets is a dulling of volatility, and as QE has receded and
ends in October, it is only natural to expect a reassertion of
market volatility. Still, while U.S. equity and rates markets are
likely to be more volatile in the year ahead than they have
been in recent years, this should not be taken as a sign of risk
for the economic recovery, and it should not delay a return to
a more normal rate environment, in our view.
Indeed, virtually all indicators of slack in the U.S. labor market
have dropped precipitously in recent years, while indicators of
future wage growth are pointing higher. In fact, we think an
argument can be made that the gains in nonfarm payroll data
could serve as a proxy for judging the timing of the Fed’s first
step higher in rates, while the average hourly earnings metric
should mirror the pace of rate normalization and the eventual
terminal policy rate. Thus, if we look at six-month average
nonfarm payrolls data (currently 245,000 jobs) alongside
historical Fed funds rate levels (run with a six-month lag), we
see that payrolls today stand very close to levels seen at
other moments of rate hike initiations (specifically, the past
four major hiking cycles: June 2004 to August 2006, June
1999 to July 2000, February 1994 to March 1995, and April
1988 to April 1989). That suggests to us that from a labor
market perspective the Fed should be moving. When the
same exercise is repeated with average hourly earnings as a
gauge, we find that we are only halfway back to levels that
would historically correspond to rate tightening, which implies
that while rate hikes can begin, their pace need not be
hurried, and the terminal rate level should likely be lower than
in prior cycles. Finally, from the standpoint of the Fed’s other
mandate objective, core inflation has averaged 1.9% at the
start of every Fed tightening cycle in the past 20 years and we
are below that level.
Nevertheless, inflation dynamics today are such that the Fed
can begin raising policy rates even before achieving its
unofficial 2% target rate, and attempting to artificially stimulate
higher levels of inflation makes little sense and could serve to
further confuse market participants as to the Fed’s objectives.
There are tangible signs of wage pressure building in various
regions, and in many skill sectors, while simultaneously we
would contend that goods inflation is likely to run lower than
historically has been the case. Indeed, in higher-skilled
positions we continue to see decent wage gains, and in
specific regions of the country, such as the Dallas, Texas
area and San Francisco, California, we are seeing wages
trend higher. This gets to the bifurcated nature of employment
markets today, where certain skills are much more in demand
than others, and certain regions are flourishing while others
languish. Of course, as we have long believed, this is
suggestive of the kind of structural labor market headwinds
that monetary policy can do little to aid and fiscal policy is
required to help.
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[3]
Further, the economy is running more strongly than many
have been willing to admit. Indeed, real U.S. GDP is growing
at a 3.6% rate over the past four quarters, if one excludes the
first quarter of this year with the impact of unusually harsh
winter weather. Also, the latest real GDP print came in at
4.6% and we’re expecting the third quarter to run around 3%,
so this is solid growth. That is particularly the case when
looking at the past decade of average real growth, which
comes in at a surprisingly low 1.6% level. Thus, when one
juxtaposes the European economic situation with that of the
U.S., the divergence becomes clear, as does the genuine
improvement seen in the U.S.
Figure 3: THE U.S. IS A RELATIVELY CLOSED
ECONOMY AND FACES LESS CURRENCY RISK
(Sum of Exports and Imports as % share of GDP)
Dollar Strength and the Commodities Complex
As we begin to see nascent signs of wage inflation, there are
also secular dynamics at play (in the energy sector, in
particular) that are creating what might be termed “positive
disinflation.” Specifically, since mid-2014 we have seen
commodity prices decline across the board, resulting in an
effective “tax cut” for consumers at a time when static fiscal
policy has been unable to deliver such a boost through
legislation. Importantly, this trend produces a tremendous
benefit to lower-income households, which have a tendency
to spend money saved at the pump or in lower utility bills.
Indeed, according to Bureau of Labor Statistics data,
households in the bottom quintile of the income spectrum will
spend more than 15% of their total expenditures on utilities
and fuel, while the top quintile spends a third less at under
10%. Furthermore, while the impact of currency change is
also at play (most major commodities are priced in U.S. dollar
terms), the dynamic is still benefitting other regions. For
example, since its July peak, Brent crude oil prices have
dropped by nearly 25%, as measured in dollars, but still
dropped 20% in euro terms, helping to benefit the Eurozone
consumer as well, according to Bloomberg data.
Beyond currency dynamics, what factors are at play in the
recent commodities price slump? Vitally, the influence of
China’s economic growth cannot be overstated in generating
the so-called commodity “super cycle,” which now appears to
be contracting along with China’s slowing GDP. In fact, some
of the data are staggering in this regard: China accounts for
more than one third of global incremental petroleum demand
growth over the past 20 years, it also accounted for the
majority of global copper demand in 2013, as well as an
astounding 96% of the incremental copper demand growth
since 1995. So as China GDP growth has slowed to 7.3% in
the third quarter, and property/infrastructure sectors appear
unlikely to rebound anytime soon, we can expect further
downward pressure on energy and industrial commodities.
Still, from the standpoint of the U.S., this imported disinflation
should not be viewed as “not enough inflation in the system,”
as some at the Fed appear wont to do, but rather it serves as
Source: Bank of America Merrill Lynch
a tangible benefit to persistent consumption growth,
particularly for lower-income cohorts.
In addition to slowing global growth, a strengthening U.S.
dollar was the other main risk cited by the Fed in its recent
meeting minutes. And while it’s true that the 5% gain in the
Trade Weighted Dollar Index (DXY) over the past three
months places a headwind in front of exporters, making U.S.
exports less competitive abroad, the economic importance of
that obstacle is largely overstated. Indeed, unlike the
Eurozone, the U.S. derives a very small amount of its
economic growth from export activity (exports represent only
13% of U.S. GDP), making it a relatively closed economy that
faces less currency risk from dollar appreciation (see Figure
3). Moreover, many analyses that worry about dollar strength
fail to fully account for the corresponding reduction in the cost
of imports (particularly commodities), which clearly benefit a
consumption-led economy.
Figure 4: THE USD HAS STRENGTHENED EVEN AS
LONG RATES HAVE DROPPED
Source: Bloomberg
INDEX PERFORMANCE IS SHOWN FOR ILLUSTRATIVE PURPOSES ONLY.
IT IS NOT POSSIBLE TO INVEST DIRECTLY IN AN INDEX. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RETURNS
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[4]
Interestingly, over the past three months we have witnessed a
significant rally in the dollar at the same time that longTreasury rates have dropped, but while these moves appear
particularly dramatic lately, it may be more useful to think of it
as a continuation of a longer-term trend operative for the past
three years (see Figure 4). What the dynamic suggests to us
is that there is a shortage of both U.S. dollars and Treasury
paper relative to demand. The U.S. Treasury shortage is
perhaps best explained by the ‘stock effect’ of the Fed’s
balance sheet (which is to say that there are fewer bonds in
the market after years of Fed purchases). Likewise, one
explanation for the dollar shortage may, fascinatingly, be
found in a shale-energy-revolution-driven decline in
petrodollar supply. In fact, a stock of “withheld” petrodollars
may be having a similar “scarcity effect” on the USD as the
increased Fed balance sheets is on Treasury securities. With
dramatically increased domestic energy production comes
significantly reduced oil imports from abroad, which
essentially implies that the U.S. is “withholding” the export of
these dollars from the rest of the world. What is the extent of
this development? Judging by U.S. trade balance data, the
global supply of dollars is roughly 30% lower in the five-year
period from 2009 to 2013 than it was in the five years prior to
that. By this metric, we can estimate that more than $1 trillion
in dollars were “withheld” as a result of this dynamic, which in
our view presents something of a structural bid for the dollar.
Investment Implications: Crowded Positioning
and the Opportunity Set Today
Thus, we find ourselves in a position today where monetary
policy has clearly been driving financial asset inflation, labor
markets have begun to recover more rapidly, economy-wide
goods inflation remains low, as do rates, and the dollar is well
bid due to global scarcity. It is at this stage when it might be
worthwhile to recall the first risk to global growth outlined
recently by the IMF, namely the extended period of
excessively low interest rates. It is clear to us that financial
asset price distortions (such as seen in front-end yield curve
assets) are likely to continue to proliferate in the context of
excessively easy monetary policy, and that this situation leads
to crowded positioning, a more limited investment opportunity
set, and potentially, a higher risk of volatility and risk to the
financial system.
We have long discussed the imbalance between fixed income
supply and the tremendous demand seen for yielding assets.
Indeed, it is this imbalance that is likely to keep rate levels
fairly contained, even when the Fed does begin the process
of rate normalization. This supply/demand imbalance, in the
context of excessively easy policy, is also the root cause of
“crowded trades,” whereby in many cases very sensible
trades are put on by a huge proportion of the investment
Figure 5: INVESTORS HOLD HIGHEST NET LONG
PERIPHERALS EXPOSURE SINCE 2010 IN SIGN OF
CROWDING
Source: JP Morgan, Bloomberg
community, which invariably results in periods of extreme
volatility as the trades come under pressure and are
unwound. This type of dynamic was largely responsible for
the market action seen on October 15, as discussed at the
beginning of the outlook, and it’s also present in the
extraordinary increase in net long peripherals exposure
(versus core Europe) seen over the past year (see Figure 5).
Of course, we must also recall that we have just passed
through a period of difficult seasonality for risk asset markets,
which historically have tended to do better in the early and
latter parts of the year.
In our estimation, fair value on the 10-Year Treasury is
roughly between 2.65% and 2.75% at this point. Further, as
we work through the market duress and get into
November/December, we will likely see rates drift higher
again, but for now their cap is probably lower, around 2.5% to
2.6%. In this economic and financial market environment, we
think back-end interest rates still look attractive, largely due to
the fact that the long-end is likely to hold in better than shorter
rates once the Fed starts moving, and Treasuries continue to
appear more attractive that other sovereign nominal rate
markets. Further, we think long-end municipals still appear to
be attractive, on the tax-exempt side, particularly should their
rates back up further from here. Finally, we have also begun
to think high-yield markets look more attractive than earlier in
the year, when yield levels sat at 5%, relative to a 10-Year
UST at 2.5%. Today, yields in this market are closer to 6% to
6.5%, with 10-Year Treasuries at 2.25%, clearly indicating
that meaningful spread widening has brought about some
better values, particularly as default rates should remain low.
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