William De Vijlder

 In recent months, the dollar has weakened versus the euro although the real bond yield differential between US Treasuries and Bunds has increased. Amongst the factors that may explain this development, Federal Reserve policy is particularly important through its impact on capital outflows from the US and currency hedging behaviour of eurozone investors. The biggest risk for a change in direction of the dollar would be a repetition of the ‘taper tantrum’ of 2013 with the Federal Reserve starting to point towards a possible beginning of the normalisation of its policy. However, such a change in guidance is not to be expected anytime soon.

Yields on US Treasuries and German Bunds tend to be highly correlated but since the end of August, Bund yields have been essentially stable whereas treasury yields have increased.This spread widening is explained by a rising real rate differential, to a large degree due to a decline in German real yields. This could reflect a more gloomy view of bond investors about the growth outlook in Germany and, by extension, the Eurozone. Another, more likely, interpretation is that the real rate risk premium has declined in Germany due to the asset purchases of the ECB. In such case, investors will become increasingly nervous about the prospect that in a post-pandemic world the ECB will eventually have to stop the net purchases under its PEPP.

It is quite likely that, going forward, fighting recessions will be the remit of governments with central banks facilitating this task by creating cheap financing conditions. As a consequence, public indebtedness may very well remain high.One should wonder whether this could end up having negative consequences. A possible transmission channel is the pricing of government debt via a sovereign risk premium. Another factor can also play a role. Since 2015, when German bond yields increased, the rise in Italian yields has been even bigger -so the spread widens- whereas French yields have increased in line with German yields. These results suggests that, even in an environment of public sector securities purchases by the ECB, the high level of Italian debt influences the reaction to movements in Bund yields. Clearly, in the absence of QE, one would expect this effect to be at least as powerful.

In the US, the behaviour of the equity market versus the level of employment is very different in the current recession compared to previous recessions. The recession this year stands out because of its sudden, enormous job losses, which were quickly followed by a significant albeit very incomplete recovery. The equity market, after a huge drop, has rebounded swiftly and made new highs although earnings –on a 12 month moving average basis- still have to rebound. For 2021, more than anything, earnings growth matters.

The very good performance of stock markets since the announcement that an effective vaccine was under development, may surprise. If GDP growth in 2021 is expected to be less dynamic than anticipated (before the announcement of a vaccine), how to account for equity markets rally?

The publication by the ECB of different economic scenarios illustrates the extent of uncertainty which at present surrounds the forecasts for key macroeconomic variables. As a consequence, companies may hold off investing, preferring to wait for better visibility. While understandable at the micro level, such a wait-and-see attitude could act as a drag on growth and reinforce the view of companies that their caution was warranted.The large increase in the dispersion of earnings forecasts points to huge uncertainty at the individual company level. However this has not stopped the US equity market from rallying. Although several factors help to explain these different reactions to uncertainty, such dissension cannot last forever. At some point company cautiousness or investor bullishness will have to give in.

Fed Chair Powell’s comment about what would happen in case of a prolonged recession has weighed heavily on equity markets. Historically, recessions are accompanied by major equity market drawdowns. The year-to-date decline is more limited, which stands in stark contrast with the plunge of activity. Massive monetary and fiscal policy support has led to a reassessment of the distribution of risks, which goes a long way in explaining the rebound of equity markets. The focus is now shifting to the outlook for corporate earnings, hence the importance of the debate on the shape of the recovery.

In theory, and all other things being equal, an increase in uncertainty results in a fall in the price of risky assets and an increase in the price of safe haven assets. In a way, this can be considered as the “price of uncertainty”. The reality is rather more complex. Greater uncertainty also affects growth prospects, which in their turn influence asset valuations.

Economic sciences teach us that financial markets fear uncertainty as it introduces volatility in prices of financial assets. Based on the reaction of markets since the beginning of the year, one could conclude that economic textbooks need to be rewritten. In spite of a high level of commercial and geopolitical uncertainty, markets have recently set new records.

There is a considerable gap between what are considered to be the geopolitical ramifications of the escalating tensions between the US and Iran since the start of the year and the subdued reaction of markets. The market reaction probably reflects the investors’ view that the probability-weighted impact on growth should be very limited because the risk of a major escalation is considered to be small and/or because of an expectation that the impact of higher oil prices on the economy is limited. What also may play a role in the market reaction thus far is that, leaving the geopolitical uncertainty aside, the economic environment is considered to be conducive to taking risk: stabilisation of survey data, reduction in trade-related uncertainty and accommodative monetary policy.

The ECB’s monetary policy meeting account illustrates the dilemma it is facing: inflation is subdued and risks to growth are tilted to the downside, yet the financial stability implications of the very accommodative policy need to be closely monitored. These implications are covered in sobering detail in the ECB’s Financial Stability Review. A possible side effect of very low to negative interest rates is that borrowing and spending become more procyclical. Quantitative easing (QE), by modifying the risk structure of investment portfolios (less government bonds and more exposure to assets with a higher risk), will probably increase the sensitivity of portfolio returns to the business cycle.

In recent weeks, equity markets performed well. Focussing on the US, it is hard to argue that this reflects an improvement in the earnings outlook or a perspective of more rate cuts than hitherto expected. This would imply that a decline in the required risk premium was the key driver. US treasury yields also increased significantly, which probably reflects to a large degree an increase in the term premium. The decline in the equity risk premium and the increase in the bond term premium were driven by a common factor, namely a reduction in economic tail risk on the back of progress in the trade negotiations between the US and China and a stabilisation of certain survey data.
The reduced likelihood of very negative economic developments, which has boosted equity markets, has also reduced the attraction of bonds as a hedge against equity risk. As a consequence, bond yields have moved up in sync with equity markets.

Asset prices can play a useful role when assessing the economic outlook. The big drop in treasury yields during August has raised concern although a nowcast points to satisfactory third quarter growth in the US. This would mean that increased uncertainty about the trade dispute has caused a flight to safe havens and a decline in long term interest rates. Swings in the communication about the trade dispute cause swings in investor uncertainty and hence in risk premiums. This reduces the signal quality of asset prices, which may end up weighing on the real economy.

Based on historical experience, the recent increase in equity volatility may end up weighing on future growth.

US long-term rates rose sharply in early October, which brings to mind the sudden rise in early February. Upside surprises in terms of wages and inflation triggered February’s upturn, while the catalyst in early October was a strong rise in non-manufacturing ISM, an indicator that is usually not monitored very closely. That this indicator should have such a big impact already shows how nervous the markets are.

In Wall Street stock market fell sharply again, pursuing a bearish trend initiated several weeks earlier. For an economic understanding of these trends, it is worth comparing equity market behaviour with that of the other asset classes, an exercise that is all the more difficult given that the correlation between asset classes tends to increase as pressures rise.

Equity markets continue to be particularly volatile. Understandably this has weighed on government bond yields. The volatility of high yield bonds remains low however. This could indicate that recent equity market swings are driven by other factors than worries about the outlook for GDP growth or monetary policy.

The eruption of US equity market volatility, with global spillover effects, is a delayed reaction to a rather significant increase in bond yields since the second part of August. Market-implied inflation expectations didn’t move that much so the rise in long term rates reflects an increase in real yields which in turn is related to strong growth numbers. Historically the relationship between weekly changes in yields and stock market performance is weak. This implies that one should focus on drivers of investor risk appetite and in particular signs of slower growth.