It is well-known that over the past two years, in an attempt to justify the “recovery narrative”, central bankers and policymakers have been doing everything in their power to push long-term interest rates higher in order to reprice all-important inflation expectations with one end goal: boost long-term rates while keeping the yield curve steep, and reflate away the record global debt load.
So far this strategy has failed to work – after all central banks only control the short-end – with yield curves flattening to levels not seen since the last recession, and prompting growing concerns about an inverted yield curve, and thus economic recession.
There is another, bigger, if less discussed concern: what happens if they actually succeed?
The reason for that, as Eric Peters explains today in his latest weekend note, is that we now live in a world in which “nearly all financial assets are ultimately priced off the US 10yr yield.” And, with treasuries priced at extraordinarily low yields because of negative term premia – the result of an extraordinary experiment in central bank policy “combined with complacency that inflation will remain permanently low – because it has” – the low rates are “distorting the valuation of all financial asset prices.”
Stated in practical terms, this means that “investors have made one gigantic inflation bet.” Specifically, that it’s not coming back.
As a result, the problem is that “we’ve become so complacent about central bank policies that we’ve quietly tolerated a rise in financial asset prices to the point where even a little inflation would devastate portfolio returns.“
Which is why central banks – whose only mandate in the past decade was to rebuild the “wealth effect” by raising asset prices, should be extremely concerned with what they are hoping to achieve: they just may get it.
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Key excerpts from Peters’ full note below.
What’s Old is New
“Last time we had negative term premia was the 1960s,” said the CIO. “Last time we had realized volatility in the bond market this low was also the 1960s,” she continued.
“These things correspond to periods of inflation complacency.” US core CPI has bounced between 1.3% and 2.0% since 1994. “Very quietly, we’ve crept to extreme levels of economic data.” UK unemployment is at levels last seen in 1975 despite Brexit (perhaps because of it). “US unemployment has been lower only twice, and once was in the 1960s.”
“When valuations move completely out of line with long-term norms, markets can really move” said the same CIO. “But this really requires a new narrative to justify such misalignments.” In the dotcom era, we convinced ourselves that earnings no longer mattered. And in 2007, we believed national housing prices could never decline.
“Today, we’ve become so complacent about central bank policies that we’ve quietly tolerated a rise in financial asset prices to the point where even a little inflation would devastate portfolio returns.”
“Nearly all financial assets are ultimately priced off the US 10yr yield,” said the investor. “And treasuries are being priced at extraordinarily low yields because of negative term premia,” he continued.
“So implicitly, negative term premia are distorting the valuation of all financial asset prices.” And what has driven term premia lower is a combination of an extraordinary experiment in central bank policy combined with complacency that inflation will remain permanently low – because it has.
“So, in fact, investors have made one gigantic inflation bet.”
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