While it may come as a surprise to the current crop of 17-year-old hedge fund managers, the current period of persistently low long-term interest rates and plunging, near reocrd volatility in the face of a hawkish Fed and rising short-term rates, is hardly new: exactly the same happened from 2004 through 2006, despite the Fed's continued rate hikes and jawboning. Alan Greenspan, the Fed's Chair at the time, called this phenomenon a "conundrum" and blamed it on many things, including the global savings glut.
And, as the latest FOMC minutes demonstrated, the current period of especially loose financial conditions despite a projected 3 rate hikes in 2017 coupled with a balance sheet rolloff is likewise confusing the Fed. Deutsche Bank has called this "Conundrum 2.0."
So, in an attempt to explain what the Fed is missing as it stubbornly hopes to push LT rates higher and risk prices lower, Deutsche's financial strategists believes the causes of long-term rate decline to be as shown in the chart below: they think that rate declines are largely being caused by four factors:
- disappointment over policy of the Trump administration (pink),
- geopolitical/political risk outside the US (orange),
- increased demand for and decreased supply of bonds (yellow) and
- concerns about slowing US and Chinese economies (grey).
At the same time, Deutsche believes the causes of rising share prices in a time of declining long-term rates, are shown in the bottom right quadrant on the chart below. The first of these is
- an “excess liquidity spiral”. In the absence of risk-off factors, declining long-term rates (with the added impact of a weakening USD) give rise to excess liquidity. Pension funds/individuals/insurers strengthen their risk-taking stance to compensate for reduced income from government bonds and the like. Strengthening of the risk-taking stance brings about decreases in long-term rates through aggressive acquisition of term risk.
- Strengthening of the risk-taking stance acts to reduce the risk premiums required by investors, boosting stock market valuations (P/Es).
- Naturally, 3) a reduced risk-free rate acts to increase P/E (Note: theoretically, P/E = 1/ (discount rate – growth rate). If the growth rate is zero, P/E is 10x based on a discount rate (risk-free interest rate + risk premium) of 10% and rises to 20x when the discount rate falls to 5%.)
- USD weakness acts positively on US-listed companies' profits (EPS).
DB also believes that these conditions, which lead to "excess liquidity" markets, also explain the dramatic moves in FAANG stocks in 2017.
Looking at the transition from "low-volatility, high-dividend shares to high-volatility, low-dividend shares", the German bank says that in recent months, shares with low volatility and high dividends are seen as alternatives to bond investment. Amid falling interest rates, risk-taking money had not been satisfied with investing only in defensive stocks as an alternative to bonds, but had also been investing in technology stocks.
Interest rates (investment yields) have trended back downward since 2H of last December, prompting greater risk-taking (see chart above), and "amid the slowdown in corporate earnings growth, the market focused on technology stocks like FAANG with robust fundamentals."
As a result, the implied volatility of technology stocks in January-May had dropped to the level of defensive stocks in early 2016. Investors who had bought defensive stocks as an alternative to bonds when yields were in decline at the start of last year could buy technology shares in terms of risk volume.
This is whay tech shares offered the best return in the Jan-May period, something which as Bank of America showed yesterday has led to the best outperformance for the mutual fund industry since 2009. As shown in Figure 32, the volatility of excess returns in US technology stocks was around one-third that of defensive stocks. Technology shares had lower dividend yields than defensive stocks, but the difference was tiny, comparing with the scale of excess returns in line with price movements (Figure 32). We see that technology shares had the lowest risk and highest returns this year through May. The financial sector largely underperformed due to the low interest rate.
Inversely - and obviously - rising long-term rates have an adverse effect on excess liquidity, damaging the P/Es of US technology shares, which were in the front-line of risk-taking (Figure 31).
The first verbal intervention in two years by Fed Chair Janet Yellen and other members of the FOMC, whose de-risking comments in the last week of June sent yields higher and risk lower...
27 June 2017, Yellen, Fed, Chair, “Look high, but there’s no certainty about that.”... “Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn’t try to comment on appropriate valuations, and those ratios ought to depend on long-term interest rates.”
26 June 2017, Dudley, New York Fed, President, "Monetary policymakers need to take the evolution of financial conditions into consideration.", "When financial conditions ease, as has been the case recently, this can provide additional impetus for the decision to continue to remove monetary policy accommodation
27 June 2017, Fisher, Fed, Vice Chair, “So far, the evidently high risk appetite has not led to increased leverage across the financial system, but close monitoring is warranted.”
... also had an adverse impact on the sector. In a turnaround from Jan-May, return on risk for technology shares has deteriorated greatly from June (Figures 32 and 33).
As such keep an eye on tech for the market's interpretation of just how serious, and credible beyond the already loose financial conditions, the Fed's tightening threat truly is.