Submitted by Michael Lebowitz of 720 Global
What deadly summers, Sandy Koufax and lucky golfers can tell us about bonds
In 1918 and 1930, Washington D.C. set daily record high temperatures with readings of a sizzling 106 degrees. The observed temperatures on those two days are statistically defined as 3 standard deviation (sigma) events. Now imagine the nation’s capital enduring a 119 degree day, because that is what a 5 sigma event would entail. That is a lot of hot air even from the seat of our federal government. (Data from NOAA)
Since 1900 there have been over 185,000 major league baseball games played yet amazingly only 21 perfect games pitched – 27 batters up, 27 batters down, no walks, no batters hit by a pitch and not a single player reaching first base. The odds of a perfect game being thrown are approximately 1 in 18,000 or .005%. (Keep in mind there are two pitchers so there are two chances per game). Pitching a perfect game is approximately a 4 sigma feat. To be labeled a 5 sigma phenomena a perfect game would only occur once every 400+ years! (Data from baseballreference. com)
Lastly for all of you golfers, according to Golf Digest, there are an estimated 150,000 holes in one per year out of an estimated 490 million rounds of golf. While a hole in one is rare event indeed, it merely measures as a 3 sigma achievement. If a hole in one were a 5 sigma event there would only be 290 per year.
As you can see in the examples above, a five sigma event signifies extreme conditions, or an extremely rare occurrence. To bring this discussion from sports and weather to the financial world, we can relate a 5 sigma event to the stock market. Since 1975 the largest annual S&P 500 gain and loss were 34% and -38% respectively. A 5 sigma move would equate to an annual gain or loss of 91%.
With a grasp of the rarity of a 5 sigma occurrence, let us now consider the yield spread, or difference, in bond yields between Germany and The United States. As shown in graph #1 below German ten year bunds yield 0.19% (19 one-hundredths of one percent) and the U.S. ten year note yields 1.92%, resulting in a 1.73% yield spread. This is the widest that spread has been in 30 years.
Graph #1: German and U.S. Ten Year Yields
To put this spread into its proper perspective due to the various levels of interest rates over time, it is appropriate to normalize the yield spread. For instance, a 1.75% spread at 7.00% nominal yields is very different in magnitude than the same spread at 2.00% yields. To normalize the differential we calculate a ratio dividing the yield spread by the nominal U.S. yield. Currently, the resulting ratio is 0.90 (1.73%/1.92%) while the historical average since 1990 is 0.08. Statistically the normalized spread is nearly a five sigma deviation as shown on graph #2 below.
Graph #2: Normalized Ten Year Yield Spread in Standard Deviation Terms
The media, economists and other market professionals are leaning on two rationales to explain this differential; inflation rates and European Central Bank (ECB) Quantitative Easing (QE). We do not put much stock in either.
The preferred methodology to compare interest rates is on a real basis and not a nominal one. By adjusting for inflation, the real basis provides a measure of the true cost of borrowing and true return on lending. At first glance inflation rates partially explain the abnormally wide spread as the difference in the year over year core CPI between Germany and the U.S. is over 1%. To expose the inadequacy in this theory we stand on the shoulders of Albert Edwards of Societe Generale. According to Edwards, when U.S. consumer price inflation is calculated using the same inputs and weightings as the Eurozone, U.S. inflation figures are nearly identical to those in Europe. His graph below provides a compelling illustration.
The second justification, to explain abnormally wide spreads between U.S. and German government debt are the actions of the ECB. The ECB recently announced a 19 month QE program in which they will purchase €1.14 trillion of European bonds. Embedded in this amount are an estimated €214 billion or 31% of all German bunds outstanding. As a consequence, dealers and traders are front running the ECB and forcing bund prices higher (yields lower). This is one of the oldest tricks in the book and it seems reasonable that some of the recent spread widening is a result. However, what’s left out of the conversation is the Federal Reserve (Fed) and its QE programs. As a result of their policies the Fed owns almost 20% of the stock of outstanding U.S. Treasury bonds. The ECB just started QE and it will take them at least a year to buy as large a percentage of German bunds as the Fed already owns of U.S. Treasuries. So while we agree that ECB actions explain some of the spread, we don’t think it accounts for anywhere near the current amount.
We believe the biggest reason for the massive yield differential is that Europe is in the grips of “Japanification”. In other words, they are suffering from a combination of very low economic growth, deleveraging, demographic headwinds and resulting deflationary pressures. Japan’s economy has been gripped in this same dynamic for over 20 years. Similar to Japan’s experience, European yields are pushing towards zero percent and in some cases below zero. Adding to the immense pressures pushing yields lower is what is known as a “flight to quality”. When investors are risk averse they tend to buy assets that provide safety. European investors are anxious about Greece as well as the aforementioned European economic situation and some are likely flocking to the safety of the debt of the Eurozone’s strongest constituent, Germany.
Mean reversion in financial markets is like gravity to physics, a fundamental law. We have no doubt this law will re-assert itself and the German-U.S. yield spread will revert to the long-term trend. The question, of course, is how the spread corrects. Will durable economic growth and inflation emerge in Europe causing German rates to rise or will the U.S. remain in a secular economic stagnation causing U.S. rates to converge lower with those currently seen in Europe and Japan? Our view is that there are a multitude of forces that will drive rates lower in the U.S. thereby collapsing the spread.
It is generally taken as a statement of fact that interest rates in the U.S. have been manipulated lower purely by the Fed’s zero interest rate policy and the various QE measures they have undertaken. On one hand, we do not argue with that assertion as the effects on the short end of the yield curve are self-evident. On the other hand, QE3 “taper” began at the end of 2013 and was completed in October 2014. Although the Fed continues to buy securities in order to maintain the current size of their balance sheet, there are no longer expansionary purchases taking place. Counter-intuitively interest rates have fallen dramatically since the beginning of the Fed’s “taper”. We argue that disinflation and deflationary forces in play around the globe are the primary factor driving U.S. longer-term interest rates down. These forces dwarf the policy actions being taken by the Fed and other global central banks.
Listed below are the main factors we believe will keep economic growth stagnant, fuel disinflationary pressures and ultimately drive U.S. yields lower:
Deleveraging of financial institutions globally is on-going through declining shadow banking systems (securitizations and repos) and rising capital requirements which reduce profitability and lending Deleveraging of consumers (increased savings rates and debt reduction) reduces consumption and impairs U.S. GDP growth Increased government regulation and interference in the U.S. economy raises uncertainty and reduces businesses willingness to invest in the future U.S. federal spending and current account deficits are declining, reducing the amount of U.S. dollars in circulation Commodity prices have been falling since early 2011, reflective of slowing global demand and rising inventories Protectionism in the form of competitive currency devaluations is disrupting foreign trade and further damaging global economic growth The ratio of working age people to total population is falling in every major country (except India) which creates a major demographic headwind for global economic growth
Deflationary forces around the globe are legion. Despite the battalion of seemingly gargantuan efforts by central bankers to prop up inflation and restart growth, those stated objectives remain elusively out of reach. Ignoring the truth of these circumstances will not diminish their impact on U.S. yields.