Scott Mather, CIO U.S. Core Strategies and a managing director at Pimco, thinks that monetary policy normalization will be a game changer for financial and expects the return of volatility.
The bond market is on the move. The economy is gaining steam and interest rates are rising. This week, the yield on ten year Treasuries climbed to the highest level since the summer of 2014. Despite that, Wall Street doesn’t’ seem to care much. The Dow Jones chases record after record and investors take on more and more risk.
“So far, they have been rewarded. But it’s dangerous,” says Scott Mather. The veteran Chief Investment Officer of U.S. core strategies and managing director at the Californian bond giant Pimco expects that inflation will become a key topic this year. He cautions that the global normalization of monetary policy is going to be a game changer and volatility will finally stage a comeback.
Mr. Mather, bond yields are rising. It this a sign that the economy is getting better?
I think this year is going to be the best year in terms of growth that we have seen in a while. For the first time in a long time, there’s not one major region in the world that is underperforming. The outlook for Europe looks pretty good. In the US, we are going to get fiscal spending which is going to bump up growth to probably 2,5% with risk to the upside. That’s versus 2% for many years in the past. Japan’s growth looks pretty good, too. Also, in the emerging markets almost all the problem cases have recovered. Putting it all together that means you have to bump up your growth forecast for the world by a quarter to half of a percentage point versus what people were thinking a year ago.
That’s sounds encouraging. How sustainably it this pick up in US?
We have some concerns that the US is going to slow back down again because much of the growth this year is fiscal stimulus. There’s the corporate tax cut which is structured to pull the activity forward: The incentive for corporations is to do all the spending and investment this year and then push the profits out to the future when they’re taxed a lower rate. So investment spending could bump up this year because of that. You also have another $ 100 billion of fiscal spending from the hurricane relief and raise in defense spending. But that’s just kind of a onetime shot because it won’t be repeated the following year. Also, we’re pretty close to full employment. At some point, if you can’t put more and more people into the labor force you are going to slow down unless they become more productive and there is no reason to think that we are going to see some productivity miracle. So after the boost this year there will be some sort of a gravitation that will us pull back down.
How does filter into your outlook on inflation?
Inflation is a factor that will come into play this year. It’s sort of unique that we haven’t had wages rebound and inflation come back sooner. But we don’t think the laws of supply and demand have been repealed. If we start to see wage inflation, that’s sort of an omen for future generalized inflation and we know that the Fed pays a lot of attention to wages. So inflation will probably head closer to the Fed’s 2%-target which means the Fed will have reason to move. It’s not as if they want to slow the economy down. But they have reason to move to try to at least get back to a neutral Federal Funds Rate. And if we get a little bit of acceleration in terms of inflation as we head through the year they will probably even think about what they should be doing with respect to overshooting. Having inflation overshoot a little bit might be ok. But they could start to get nervous.
What does this mean with respect to monetary policy?
We are getting into an environment where monetary policy around the world starts to reverse course. I think that’s one of the big themes this year which is a global movement towards normalization. In US, we will get two or three more rate hikes this year. That takes the Fed Funds Rate back in the 2% to 2,5% range and that’s the level that starts to slow the economy down. At the same time, the ECB tapers and will be done with QE by the end of the year. Elsewhere, it looks like that the Bank of England will hike once this year. The Bank of Japan is likely to tweak its balance sheet expansion and yield curve control. The Bank of Canada has moved, and the Reserve Bank of Australia will probably be moving this year as well. So everybody starts moving.
Right now, everybody is focusing on the ECB. Will the European Central Bank be able to follow through with its plans to normalize monetary policy?
Growth in Europe has been good which has surprised them. I think we have seen the lows in inflation. So there is reason for the ECB to think the same way the Fed has which is to take advantage when you have the opportunity to start normalizing. The big priority would be getting away from negative rates. If that goes well, then they will make a judgment if they want to shrink the balance sheet first or hike rates. Probably they want to hike rates a bit further. So it’s the same playbook as the Fed and we think that economic growth will allow for this.
It’s been almost four years since the ECB became the first major central bank to push rates to negative territory. Are they at risk of falling behind the curve?
If the ECB could do it over, they probably would be tapering faster because growth has surprised them. If you’re a Martian and you landed on earth you would be like: “What in the world are these central banks doing?”
This expansion has been going on for a long time and I don’t see any risk really on the economic horizon that are very challenging. And yet they have zero and negative rates and huge central bank balance sheets. So central banks are being very cautious, maybe too cautious about normalizing. But this year is the big change and we think people may be underestimating it.
What does the normalization of monetary policy mean for the bond market?
One of the biggest unknowns is what this normalization does to financial markets. No one really knows. The balance sheet reduction at the Fed and the tapering of the ECB will be a big change for the bond market. We are going to get a lot more net supply. If you’re looking back on the past two or three years, we had two trillion dollars in global quantitative easing by the major central banks every year. But this year that all changes: We go from a two trillion run rate to flat lining. I’m not so worried about it having a major impact on the real economy. But it will potentially slow down inflation in financial assets. It probably has an impact on risk premiums in general and will bring back a little more volatility. Basically, what we are describing is a more normal market environment. But it’s been so long that people have forgotten how that feels like.
In the US, the yield on ten year treasuries climbed to the highest level since June 2014. Will this trend continue?
There are major forces at work here. Normally, when the Federal Reserve is tightening the yield curve flattens. On the other hand, you have the balance sheet reduction and you have a fiscal expansion which at this point of the cycle is very unusual. Both factors are steepening forces with respect to the yield curve and they begin to prevail. This doesn’t mean that yields have to continue to go up dramatically. Ten year yields can edge up into the 2,75% range this year but they probably can’t get much over 3%. The long end could be 50 to 75 basis points higher than that.
Outgoing Fed chief Janet Yellen said that the balance sheet normalization would be a very quiet and almost boring process, like watching paint dry. Is it really going to be so painless?
That’s the way central banks want to frame it. But they know that can’t be true. You can’t go from a two trillion dollar QE run rate down to zero and not expecting an impact. But central banks also see that the costs and risks of doing nothing are growing by the day. So it’s time to stop and push the responsibility back to the fiscal agents. In that sense, the Fed is kind of lucky that they have President Trump and this fiscal expansion because it will allow them to normalize without much risk. Europe needs the same sort of thing probably: There is a little bit of fiscal expansion in Europe, but it would be helpful if it was more because then the ECB could stop quicker.
At the beginning of February, Jerome Powell will take over as Chairman of the Federal Reserve. In what respect will that impact monetary policy in the US?
Normally, there are all sorts of uncertainty that comes when you get a new Fed chair. But I think the new Fed chair looks a lot like the old Fed chair – and the old Fed chair looks a lot like the previous Fed chair, Ben Bernanke, who we talk to all the time since he’s an advisor to Pimco. Based on our understanding, Powell is unlikely to change the Fed’s reaction function. So I wouldn’t expect anything dramatic. He’s a well-known entity and his thoughts and beliefs are recorded by the Fed board for a long period of time. There is no reason to expect that he’s going to change the way the Fed reacts. But it will be interesting to see who the Vice Chair is going to be and who fills the other spots. The real question however, is what happens if the unexpected happens. What if they have an inflation problem? Or what if growth slows down? What if some sort of strange thing happens?
The last time the Fed got caught by an ugly surprise was when housing prices in the US were tanking. How will higher rates impact the mortgage market this time?
We think that private mortgages are pretty attractive. They have been great and they’re in a lot of ways safer than corporate credit because normally you don’t see the housing market that closely linked to the economy. Yes, a recession causes housing prices to slow down. But the last recession was unique because we never had this generalized price decline in the US. So people are still sort of viewing in through that lense but that’s not the right way to view it. The next recession won’t be caused by housing or mortgage problems, it’s likely caused by something else.
So what’s the biggest risk for financial markets in your view?
The biggest risk that we worry about is a geopolitical event. That could really change the economic outlook and it certainly could impact the markets. It’s a higher risk than it has ever been because we have new leadership which is completely an unknown: How would the US respond? How would other countries respond to one another? It’s a completely changed world from where we were ten or twenty years ago. We have a lot of friction globally, so it doesn’t take much at this point. It could be a terrorist event or an accident. The US, Russia and China are always playing with each other in the skies and on the ground. And there’s the one risk that everyone is focused on which is North Korea. That’s bad enough in itself but when you look outside of that, there is a lot of instability.
How can investors prepare for that?
It’s very hard to plan for and it’s very hard to price. You can’t just go and put a trade on because you don’t know how it will unfold. But it’s another reason to say that now is not the time for investors to be counting on asset price inflation to infinity and low volatility. It’s a reason to start betting the other way.
What does this mean in terms of investment strategy?
One mistake market participants are making is they’re sort of looking what the Fed has done in the past two years and they say: “Well, it didn’t seem to cause any issues, there’s no volatility. So why does it matter if the ECB and the Bank of Japan do the same thing?” But people are ignoring the fact that the Fed could do it with having seemingly no impact only because the other central banks were offsetting it with monetary expansion. The difference is, this year nobody is offsetting. Everybody is going into same direction. That’s why investors should not underestimate the very likely scenario that volatility returns to normal. It doesn’t have to be dramatic, but it will look a lot different than the past few years and people need to prepare for it. It’s time to be a bit more defensive.
So what should investors do?
You should look what you are doing now and think about what your asset allocation should be. Most people take on more risk than they should, and they know that. But they feel that they have no alternative. But now is the time to just say: “I’m not going for that last 1%. I’m not going to try to play it to the end here”. What you should do is to give up a little bit of carry, go up in quality, go up in liquidity and gown down in maturity. Just be safer and wait. There will be some opportunities. But there won’t be opportunities if you’re already in the risk. So it’s a good diversifier to have bonds in your portfolio.
Where do you find such kind of safe, high-quality investments in the bond market?
One the things we are focused on is that increasingly people will look for US high quality bonds because the US is normalizing monetary policy faster than other countries. The US is about the only real bond market in the world. You are not going to get that kind of yield in Japan and you are not going to get much yield in core Europe. So investors should look at their portfolios and be comfortable holding more US high quality bonds than they would normally because they can’t get that anywhere else until other countries get further along on the path of normalization.
And what about high yield bonds? How will they react when the Fed is normalizing rates?
It means probably some pressure. We’ve seen a little more of that in the pasts months and it does worry us a bit. Also, the underwriting standards have declined. You have all sorts of companies issuing at relatively tight spreads which should be sending off alarm bells because this is always sowing the seeds for the next big problem. In addition to that, you’ve had a record push from retail investors into the high yield space. You’ve had an explosion of things like ETFs and untested sorts of structures. You’ve had an explosion in low quality loan issuance which is another warning sign. People buy just tons of bank loans and this market has been getting riskier every day for the past several years. So it won’t take much to set off the next bit of high yield spread widening which will spill over. At these yield levels it’s not going to take much at all.
So how risky are junk bonds?
There is sort of a mirage of liquidity out there. No one really knows what happens if you get a big shift of a lot of people trying to get out at the same time because we haven’t had a major widening in the credit market when we’ve had so much money in daily liquidity mutual funds and second by second by liquidity in ETFs. But behind the scene there is not that liquidity, we know that. That means that spreads can widen pretty fast and prices can decline a lot faster than people think.