By John Abernethy, Chief Investment Officer at Clime Asset Management Wednesday, 4 December 2013
This week we will scan across some interesting charts which will give us an insight into the direction of interest rates in 2014. These charts will show the perversion of international bond markets, the requirement for more central bank intervention and the risk of inflation in Australia that emanates from China. To conclude, we will look at inflation a little more closely as we note the rapid increase in energy costs across the developed world.
The first chart (Figure 1) is a forecast of the financing needs of the major economies in the Eurozone over the next two years. The financing need can be described as the amount of bonds that a government will need to issue to meet maturing debt and expected fiscal deficits. Immediately obvious is that Italy, which is the Eurozone’s third largest economy, has a mountain of debt to refinance. At 55% of GDP this is probably beyond the capacity of capital markets to negotiate and so European Central Bank (ECB) assistance is required.
To understand the level of Italian bond issuance, think of it in Australian economic terms. If Australia was Italy then we would be issuing and negotiating about $850 billion of government debt over the next two years. Of this, about $200 billion would be deficit funding and $650 billion would be maturing debt.
Clearly, this amount of debt would require a massive borrowing campaign from offshore capital markets and interest rates across the economy, government and private, would spiral upwards. A substantial part of Australia’s superannuation assets would need to be invested in bonds. Alas, Italian interest rates remain remarkably low and belie the supply and demand mismatch – or do they?
Figure 1. Government’s estimated financing needs (2014 & 2015, % of GDP) Source: Capital Economics, IMF
We can see from Figure 1 that Greece, Portugal, Spain, Belgium and France also have significant debt negotiations in coming years. Each member of the Eurozone continues to run high fiscal deficits with both low economic growth rates (sub 1%) and high unemployment (average of 12%).
What is indeed strange and illogical, from the above observations, is shown by the next chart (Figure 2). It shows the extraordinary rally in sub-prime European bonds that has occurred in 2013, even as German bonds weakened. How could it be that countries that have both large government debt loads (on average 100% to GDP) and large refinancing commitments, benefit from lower bond yields? Further, how could Italian, Irish and Spanish 10-year bonds yield below those of Australia? Is our AAA credit rating worth anything?
Figure 2. 10-year bond yields (%) Source: Capital Economics, Thomson Datastream
The Eurobond markets are operating in a perverse manner, similar to the way they did prior to the GFC. In 2007, Eurobond managers struggled to differentiate between a German and a Greek bond with a mere 0.5% (or 50 basis) sitting between them. The best capital managers and bank treasurers in the world could not see the risk of a potential Greek default. Today we may well ask – is there a risk of an Italian default that is not priced into Italian bonds? Or have the policies of the ECB acted to take the risk of default away?
The following chart (Figure 3) shows the massive growth in central bank balance sheets as a result of quantitative easing (QE). Notably, the ECB balance sheet has declined in the last year as it has not undertaken QE but rather recycled bank deposits and loans across Europe. Indeed it is worth comparing the growth in balance sheets of the Federal Reserve and Bank of England with that of the ECB. The growth rates of the US (circa 2%) and the emerging recovery in the UK suggest that the ECB may have erred in not undertaking aggressive QE.
Figure 3. Central bank balance sheets (2008=100) Source: Bloomberg, Capital Economics, ECB, Thomson Datastream
In August 2012 the ECB decreed that it would provide unlimited and cheap funding to European banks to ensure the viability of the Eurozone. The defacto underwriting of European banks also effectively underwrites large European countries. European banks currently borrow from both the ECB and from European household sector as credit growth outside the government sector is non-existent.
Bank retail deposits are rising across Europe and the cost of these is negligible. Therefore, the purchasing of bonds by banks is an easy way to make margin or profit from assets with “limited risk”. This is a wonderful position for weak European banks that are in the process of recapitalising, with their biggest risk being the re-emergence of both growth and demand for credit. This is a similar risk for highly indebted European governments who simply could not service higher bond debt yields that will result from sustainable growth.
It is truly perverse that European governments are striving for economic growth and inflation, yet a general economic recovery may well tip their fiscal situations into chaos. This is why the ECB with the support of Germany may be forced to introduce QE in 2014. Without it, Europe seems destined for a deflation cycle similar to that seen in Japan for the last decade.
At this point economic growth in Europe cannot be seen on the horizon and therefore bond yields are stuck at ridiculous levels. The general feeling that governments are too big to fail permeates across Europe unless you are small like Cyprus!
As for the direction of Australian bonds that have weakened dramatically in the last six months, it could well be ultimately determined by the likely and inevitable emergence of inflation from China.
To this point we draw on the next chart (Figure 4) that plots the methodical revaluation of the Chinese Renminbi and the US dollar. This year we have witnessed a 3% revaluation of the Chinese currency and this translates into a 15% revaluation against the $A. Arguably the days of cheaper consumer imports from China are over as the $A devalues against the $US and therefore the Renminbi.
Figure 4. Renminbi/US Dollar Exchange Rate (inverted) Source: Bloomberg, Capital Economics, CEIC, Thomson Datastream
In retrospect, the last five years have been a wonderful period for Australian consumers as our terms of trade reached record levels. Record export prices were matched by lower import prices emanating from China, Korea and Japan. However, this period is now over and in coming years Chinese imported inflation will replace the deflation that did result from a grossly undervalued Chinese currency. Therefore a slowing economy and a weakening currency are in store for Australia in 2014. With this outlook we perceive that the Reserve Bank of Australia (RBA) is reticent to cut cash rates further, fearing the stimulation of investment asset bubbles that have been seen overseas.
The risk of imported inflation is real and this must be added to the forecast of a sharp lift in energy prices. Indeed the projected lift in Australian energy costs (particularly gas) is bringing us into line with the last decade of energy price rises seen in overseas developed countries.
Figure 5. Change in energy prices, 2003-2013 (%) Source: Capital Economics, Eurostat
The projected sharp rise in gas prices forecast for Australia as we develop massive LNG exports is a growing concern for our dwindling manufacturing base. Across the developed world, it appears to be only the US that has an active policy that attempts to hold down energy costs. It does this with a positive gas exploration program and the reticence to allow gas exports. The US in contrast to Australia has determined to drive down energy costs to support manufacturing and maintain a low cost of living for households.
In conclusion, it is important to understand that “free” bond markets determine bond yields by reference to inflation, currency and default risk. Of all the developed economies in the world, it is arguable that the Australian bond market is free from central bank intervention. Therefore, whilst our bonds do benefit from the spill over of low perverted yields in offshore markets, they are not subjected to tampering by RBA activities.
Therefore, we believe that interest rates settings, determined by the RBA, are certainly stuck at current levels for the next 6 months. From the middle of next year, a weakened currency may well see inflation emerge rapidly and require the RBA to change course. Indeed, that is what the weakening Australian bond market is telling us: interest rates will likely rise in 2015.