By Michael Temple
Like a teenager caught between the decision of going to college and leaving friends behind or living in the comfort of home and going nowhere, debt markets have been reeling between taper angst and infinite quantitative easing (QE) euphoria.
And like that teenager, investors are wondering, “Where should I go from here?” The problem is the cues we have been trained to watch for. Unemployment, was that a 6.5% or 7% target? Inflation, or, wait . . . no, it’s housing prices, right? We are now all confused, adrift without anchorage.
What the Federal Reserve says really matters to the markets these days so much so that even experienced investors are spending an inordinate amount of time trying to interpret the minutest of changes in phraseology. After the market’s horrified response to the idea that QE was in fact not infinite, the Fed is now backpedalling, possibly fearing the negative feedback loop that was created by its taper discussions – a loop it constructed itself in the first place by committing to “buying everything the Treasury would issue”.
So what is an unanchored, unsure and unsteady fixed income investor to do? Perhaps it’s time to sit back, take a deep breath and think about the things that matter to interest rates over the long run: economic data. When we compare economic data today to that during the anxious times of the QE announcements starting with QE2 (QE1 was responding to a liquidity crisis, not economic malaise), it’s clear that conditions are dramatically better.
We have previously argued the need for QE to support an economic recovery is over. The question, therefore, is – where do rates go from here? One simple, yet effective rule of thumb is to turn to the “Golden Rule”. Over time, interest rates should be equal to nominal GDP. This generally accepted rule of thumb links productivity and population growth to the direction of interest rates – which, not coincidentally, are the long-term drivers of GDP growth. Nominal GDP also happens to be the sum of real economic growth plus inflation. Thus we link interest rates to GDP growth and inflation.
Given the fuzziness around the Fed’s guideposts, the key questions for investors are: 1) what is the ability of the US economy to produce real GDP growth; and 2) what is the path of inflation? Inflation is the easier number to get agreement on: it’s low – currently around 1.5%. For 2014 the median expectation is for 2%. Real GDP is another matter. The debate is whether or not given structural deleveraging and deteriorating demographics the long-term ability of the US to grow real GDP at around 3% is permanently impaired.
We don’t think so and would point to the dramatic improvements in the US oil and gas production as evidence of this country’s ability to innovate in the face of structural headwinds. But the debate here is extensive and we are also willing to concede that the path towards reaching 3% real growth could be a long one given the aforementioned headwinds, and we therefore think 1.5-2% is a reasonable expectation for 2014. Maybe it’s time to grow up and say goodbye to the parents (the Fed).
Michael Temple is director of credit research, US, at Pioneer Investments
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