Friday, May 16, 2014

Of Secular Stagnation and Other Worries

We have seen quite a bull run in the bonds market since the start of the year. Which has caught many people off the guard. The usual suspects are flow chasing yields after equity peaking off the tops, and risk off from Ukraine crisis. But perhaps something more at play here, and we take a look about the secular stagnation and a global japanification that is priced in the rates markets now. After the good rally this week

The peak nominal equilibrium rate priced in is maximum for USD. This is in spite of the recent difference between GBP and USD. This prices in a convergence of UK and US inflation and a higher long term real GDP for US. The recent bullish phase has been less about re-pricing the pace of rate hikes, and more about the terminal rate, i.e. estimate of natural rate of interest. Except in GBP where there is a large re-price of peak rate time (by 3 years!)

This, in my opinion, reflect a much less optimistic re-assessment compared to last year. The terminal rates should be determined by the potential output of the economy, and the pace of hike is an estimate of central bank’s degree of dovishness. This re-pricing of terminal  rate shows a possible shift downward of potential output itself

This brings us back to the pricing of a possible secular stagnation and Japanification. We run a simulation assuming 1) a further 50bps reduction in the maximum future rates (secular stagnation) and 2) as mentioned under 1, but also the maximum rate is attained 8 quarters from the current priced-in pace of hikes. The effect of these on long end rates are obvious, both depress the long end further, and 2) is more severe than 1). 

However, the interesting point to note is how the curve slopes get re-priced. From current level, scenario 1) shows a flattening, while scenario 2) shows a steepening. Indeed the curve slopes in JPY are in general steeper than G3. I think any re-pricing of pace of hike is less likely, especially if inflation has indeed bottomed out (for USD and GBP). We still have a chance for re-pricing of pace of hike for EUR. So as I see it, flattening to continue in USD and GBP, and expect further steepening in EUR.

Oh, and there is this interesting piece from FT Alphaville. Do check the link. 

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