Our friend John Roque, one of Wall Street’s great technicians, often talks to us about the importance of visual affirmation. Let pictures talk. He is speaking of the importance of perspective in analysis and not losing sight of it.
The bond market has been getting a lot of attention since the Great Financial Crisis. Many market watchers have been complaining about ZIRP (Zero Interest Rate Policy) for the past ten years, tagging it as irresponsible and the proximate cause of “an equity bubble.” We are told that such low rates are unsustainable, they distort markets, and will, of course, need to move quickly higher to a more natural point of equilibrium because today’s low rate are simply abnormal, according to these experts. Our Twitter feed is peppered with commentary from some very smart people apoplectic every time the Fed declines to raise the discount rate. If you read what we read daily, you would come away thinking there are no more irresponsible people on earth than the current lineup of Fed governors. But are they really?
Here is the 2-year yield since 2014. It reflects the Fed’s recent impulse to raise rates, but also the market’s anticipation of a more “normalized” curve and perhaps higher inflation.
But what happens when you heed John Roque’s advice and step back and take a longer look at history? The chart below is the very same 2-year yield back to 1976, which has actually been in a persistent downtrend. You look at this and the Fed doesn’t seem so crazy (nor do real rates).
It is entirely possible steadily lower rates are the new normal and should be embraced by investors. But why is that? Because when one considers the productivity improvements realized by the developed and developing economies over the past few decades, low rates don’t seem misplaced. Again, skeptics will claim productivity improvements have resulted in excess capacity, which is perhaps a negative. Indeed, the inflation curve would suggest we should expect more persistent deflation than inflation. Regardless, when considering the historical context of this two-year curve, lower rates for longer is not an insane notion and deflation is probably as much of a reality as inflation. Low rates might actually be reflective of true economic conditions and therefore appropriate. So, considering the downward sloping two-year curve since 1976, how does it follow that multi-year trends of lower interest rates are causing an “equity bubble” today?
And speaking of historical measures, one of my favorite Roque observations is the 10- year treasury yield since its inception date in 1790. What this suggests is the late 1970’s and early 1980’s was the anomaly, not today. If we were truly dispassionate observers, and checked our biases at the door, this chart would tell us yields are continuing a course they’ve charted since 1790. Low rates might actually be the norm.
Source: Bank of America
The 10-year’s historical trendline, and what it means for us going forward, is actually easy to accept when one considers what happened from the early 70’s to the mid-80’s. Nixon’s price controls, dropping the gold standard, the first oil shock and its resulting impact on inflation, Gerry Ford’s WHIP Inflation Now campaign, late 70’s Soviet aggression, the Iranian Hostage Crisis and so on. So many unknowns (then), so many shocks to the system not really seen before, and all occurring as we moved to a fiat currency regime. Is it any wonder rates went wild?
We’ve now arguably come through the longest lasting period of stability the civilized world has ever known. Real threats to world peace are dramatically lower. OPEC is not the threat it once was. The Asian economies are now massive sources of cost efficiencies and are more likely to add to deflationary rather than inflationary pressure for years to come. The Emerging Markets are 50% of the world’s GDP (but only 25% of global equity market cap). None of that is bad. All of it is reflected in rates. If everyone would take John Roque’s advice, our current rate environment would seem almost normal.