For a Return to the 'Old Normal,' Real Rates Must Tick Higher
With inflation back around 2 percent in the U.S. and the Federal Reserve moving away from its years-long policy of monetary accommodation, something like economic normality is beginning to return. But to truly get back to the “old normal,” real interest rates must play catch up, and that’s likely to take a while.
Although President Donald Trump initially signaled quick implementation of new tax, trade and regulatory policies and, most importantly, infrastructure spending, his focus has turned to social and foreign issues, leading to a shift in options prices, which convey important information about changing risks.
Using option prices for insight into future risks is like harnessing the power of crowdsourcing. And, like insurance contract prices, option prices provide extremely efficient estimates of the market’s price of the risk of different possible near-term future outcomes.
After Trump’s election, option prices signaled greater inflation risk, which no longer seems to be the case. Options indicate that gold and other assets that do well when inflation looms are not being priced with great upside, while nominal Treasuries are now viewed more favorably.
The selloff in bonds after the U.S. election put inflation expectations at the Fed’s target of 2 percent. Option market signals are now implying that real rates need to rise to finish the “normalization.” This second step has barely started, with U.S. real rates sitting just above 50 basis points, well below real GDP growth, which economists would consider abnormal.
The good news is that central banks have more control over real rates than they do over inflation, which often takes the form of a tail event, rising sharply over a compressed period of time. This is not the case with real rates, unless the “hawks” take over, and Janet Yellen’s team isn’t taking an overtly hawkish stance, instead continuing with its preference for real rates closer to zero. Even if a surprising four hikes were to unfold in 2017, surpassing the market expectation of 2.5 increases and likely sending the 10-year Treasury yield closer to 3 percent, that pace is still moderate. The downside risk now appears to be a slow increase in real rates, as opposed to a rapid rise in inflation, which can shock the markets.
However, by no means is sovereign debt a screaming buy. Option prices indicate that the holders of government bonds are likely to go largely unrewarded for some time, and because the risk is now in real rates, yields on inflation-protected bonds would be expected to rise with those on nominals.
But very low real rates along with normalized inflation create a stimulative environment. Benign inflation encourages spending and investment, while low real rates allow such consumption to be financed at near zero real cost. Options are pricing such a scenario, with the expected upside potential for U.S. equities far greater than their downside risk in coming months. So while the option market no longer sees the inflation element of the “reflation trade,” it continues to see rising growth accompanied by gradual increases in real rates -- the “real growth” trade.
Option prices also point to good near-term growth in emerging markets and for equities in China and Mexico. Signals indicate they are compelling buys, despite Trump’s bombast about reining in nations that benefit from “unfair” trade practices. Signals indicate that changes to trade deals won’t necessarily be punitive, which suggests that Trump doesn’t plan to stifle global trade.
An equally interesting dynamic is unfolding in Europe, where Italy’s signals are more attractive than France’s, which are more attractive than Germany’s, suggesting that defeat or victory in the French presidential election for Marine Le Pen of the right-wing Front National is less of a threat than is imagined. Win or lose, the rise of the populist right could be a trigger for growth as witnessed in the U.K. and the U.S. Option prices reflect this view.
Of enormous significance was the news late last month that executives from BlackRock Inc., Barclays Plc, UBS Group AG and others have met with Le Pen’s team to try to better understand her plan to take France out of the euro. This suggests that, having been caught by Brexit and Trump’s win, members of the crucial banking sector won’t be surprised again and, if need be, will mitigate the risk of extreme losses.
So while worries abound about equities trading at all-time highs, the Fed removing accommodation, political uncertainty and a divided population, short-term option signals are optimistic about a return to a much missed “old normal” of healthy growth and contained inflation.
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