Most equity markets drifted lower all week as the situation in the Middle East progressively worsened. For the week the developed market indexes were down between -0.2% and -0.7%, with the notable exception being Japan, which notched a +0.1% gain. Emerging equities were also pretty resilient with a +0.2% gain. As you would expect, oil prices jumped on the Iraq news. Crude closed at $106.84, up +3.9% for the week.
Bond yields finished the week flat, and as you would expect, intermediate-term government bonds were unchanged on the week. Interestingly, high-yield bonds added +0.3% despite the losses in the equity market. Credit spreads continue to contract. Probably the biggest news in the bond market was the development in Europe. For the first time since 2010 the yield on Spanish 10-year government bonds dipped below comparable U.S. government bonds (see red line in the chart below).
The fact that Spanish (and soon Italian) bond yields are lower than U.S. yields highlights a couple things: 1) inflation is simply much lower in Europe than the U.S., as are inflation expectations. This explains why German and Japanese bond yields are so much lower. 2) Investors believe the European Central Bank will “do whatever it takes” to prevent peripheral Europe from being pushed towards default. The Greenspan/Bernanke put has become the Draghi put.
The IMF Warns About Housing Bubbles…
The International Monetary Fund made a big splash this week after they released their latest study on global home prices. They made a strong case that select markets are moving into bubble territory and that regulators must take steps to address the problem. As you can see below, global home prices, especially weighted by GDP, are moving firmly back towards all time high levels.
Min Zhu, the IMF’s deputy managing director, said the tools for containing housing booms were “still being developed” but that “this should not be an excuse for inaction”. For example, prices relative to both income and rents have moved well above average in several countries. The first chart shows prices versus incomes:
The next chart shows prices versus rents:
On both measures the U.S. looks to be in line with historical average, while Canada, Australia, and the U.K. are large economies with serious overvaluation issues.
The IMF’s goal with their study is to alert policy makers and regulators to the risks of a housing bubble. But how much can they do? Korea and Indonesia have set loan-to-value limits in recent years while Ireland, Norway, and Spain have imposed higher capital requirements for banks that make high leverage loans. But in some countries, such as the U.K., the problem stems as much from a lack of housing supply as anything else. As the Bank of England (BofE) Governor Mark Carney said last month, more housing “would help us out, (but) we’re not going to build a single house at the Bank of England.”
…And Policy Makers Start to Feel the Heat
So central banks are left with the tool they have always used to try and dampen speculation – interest rate hikes. Mr. Carney took the opportunity to hint at just such a thing on Thursday. In his annual Mansion House speech (similar in profile to Jackson Hole) he warned households, companies and financial markets to prepare for an interest rate rise, saying the first increase “could happen sooner than markets currently expect”. The market immediately went from thinking rate hikes would happen in the second quarter 2015 to betting the first hike will come in November 2014.
Governor Carney tempered his more hawkish comments by emphasizing that the BofE “has no pre-set course [and] the ultimate decision will be data-driven”, but the message is clear. The BofE will become the first major central bank to tighten policy since 2008.
The British pound immediately rallied on the news while the yield on the policy-sensitive two-year UK government bond jumped 12bps to 0.86%, the highest level in three years (as you can see below). 2-year yields are up 80bps from the low back in 2012.
The U.K. may prove to be something of a template for the U.S. in the months to come. A central bank growing increasingly worried about froth in certain sectors of the market (housing in the U.K., maybe the credit markets in the U.S.) moves to let some air out of the balloon. In the U.K. they are also seeing hints of inflationary pressures. Similarly in the U.S. there are some early signs that wage growth is picking up. (see chart below).
While not exactly taking the punch bowl away, the BofE is attempting to switch party goers over to low alcohol beer. It will be interesting to see how the U.K. markets adjust to the new regime.
The Budget Deficit and Bond Yields
There are a number of reasons why bond yields remain low in 2014, but one factor is likely the federal deficit picture this year.
On Wednesday the Treasury released the May monthly Treasury Statement. The deficit in May came in at $130 billion, down from $138 billion in May 2013. For the fiscal year through May the deficit was $436 billion compared to $626 billion for the same period last year. The chart below shows the actual (purple) budget deficit each year as a percent of GDP as well as an estimate for the next ten years per the CBO.
The 2014 deficit estimate is less than 3%. The decline in the deficit from almost -10% to under -3% would be the fastest decline since the demobilization following WWII.
We are seeing progress on two fronts. First, revenues are up. As Ed Hyman at ISI notes:
“Federal receipts through May have increased almost +45% from their recession low. Personal income and corporate profits are both up significantly, as are capital gains and, more importantly, tax rates. Receipts in May were up +9% year-over-year (see chart below).”
Secondly, Federal spending continues to trend lower. Outlays are down -4.7% year-over-year, as you can see below.
Mandatory spending cuts are playing a large role in this, and the cuts are very evident when you look at the Federal government’s payroll. Employment has dipped sharply the last few years at the Federal level.
What this all means is that the Treasury is issuing fewer bonds every month to finance itself. While the total stock of debt issued is huge (over $17 trillion on the latest reading), rates are set at the margin. Less supply, all things being equal, means prices go up and yields fall. A Deutsche Bank analysis noted that the net issuance of Treasury debt has fallen 59% so far this year. An RBS Securities report estimates that the demand for high-quality bonds for 2014 will amount to $1.2 trillion while actual net supply is roughly $600 billion.
While the supply picture is only one part of a complex puzzle, it is likely playing an important role in 2014 in setting bond yields globally.