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August 25, 2016

Caveat Venditor

by Amareos.

More than a third of government debt trades with a negative yield. This is a truly remarkable statistic; one many financial market participants never thought they would ever see during their careers. Perpetuating the bull market in fixed income has been the lacklustre economic recovery from the Great Recession and the monetary policy response that this has necessitated. Most investors agree that based on long-run fundamentals government debt is overvalued leading them to conclude that a significant back-up in bond yields will occur. In this note we outline why – Japan aside – we judge the bond bears will once again be frustrated using insights generated from high frequency sentiment data.

The anticipation of rising nominal interest rates – both in the short and long-end of the yield curve – in the leading developed economies has been one of the more persistent forecast errors of the post Great Recession period. It is not only investors that have made such forecast errors even monetary policymakers have been caught out (see exhibit below for a good example of the latter)[1].

Exhibit 1. Riksbank Repo Rate Forecasts



Despite this repeated failure to correctly predict the trajectory of short-term interest rates and the numerous fallacious warnings about an imminent bear market in government bond markets[2] this forecast bias refuses to go the way of Monty Python’s parrot in their famous comedy sketch[3].

In the immediate post Great Recession period, the anticipation of higher nominal interest rates reflected the widespread assumption that the textbook Keynesian demand-side stimulus injected in 2008/9 (aggressive conventional and unconventional monetary easing combined with deficit-financed fiscal stimulus) would result in a swift economic recovery and accelerating nominal GDP growth rates.

However, as we now know, the return to pre-crisis economic growth rates has proved much more challenging than originally envisaged and inflation has persistently undershot central bank mandated levels. “New normal” was born[4] – a concept that has clearly seeped into the public psyche. Because nominal GDP growth is comprised of real economic growth and inflation, by summing sentiment indicators on these two macroeconomic topics it is possible to generate a real-time measure of public perceptions towards an economy’s nominal GDP growth rate to demonstrate this shift.

As the exhibit below illustrates, in the first few years of the decade public perceptions of US economic growth and future inflation rates rebounded smartly, rising to levels not dissimilar to those seen in the pre-crisis period – the crowd believed policymakers would be able to deliver the promised self-sustaining recovery. However, as the decade progressed and the US economy failed to live up to these prior expectations, a steady but consistent decline in sentiment towards economic growth and inflation took hold.

Exhibit 2. Nominal GDP Growth Sentiment – US



Taking a cursory look at the far right hand side of the chart it is clear that public sentiment towards US nominal GDP growth remains low, with recent readings having only been exceeded on the downside during the depths of the Great Recession; hardly the sort of environment that would seem to warrant, or justify, higher nominal interest rates. Nevertheless, this is what most economists and investors continue to predict.

In part, such rate forecasts mirror the Fed’s own thinking with the latest “dot-plot” projections showing the target Fed funds rate on a linear glide path to its long-run tendency just above the 3% mark; which, if it were to materialize, would exert upward pressure on the longer-end of the Treasury curve[5].

As last week’s FOMC minutes showed, the view of US central bankers is that while the recovery has been less dynamic than hoped disinflationary slack is being eroded (most visibly in the labour market) and hence it is appropriate to resume withdrawing monetary policy accommodation[6], particularly as fiscal policy is poised to be more stimulative with both US presidential candidates having promised greater infrastructure investment[7],[8].

This scenario seems perfectly plausible. Yet, if the past several years have taught us anything, it is that inflation is not simply a “monetary phenomenon” – it is also a psychological phenomenon[9].

Injecting additional monetary stimulus into the economic system may be a necessary condition for boosting inflation but it is by no means a sufficient condition. The reflationary process is much more complex.

Sustained domestic reflation[10] requires the public en masse to be convinced that the opportunity cost of holding cash, either in paper or electronic form, is sufficiently high that the perceived erosion in the future purchasing power of money due to higher expected prices incentivizes consumers to spend today rather than tomorrow, and/or that the future return from investing will exceed than the prevailing interest rate[11].

Naturally these effects should be associated with positive and rising public perceptions towards economic growth and future inflation something we are able to track in real-time using the aforementioned nominal GDP growth rate proxy. But, as the above chart confirmed, at present there is scant evidence we are anywhere near this juncture in the US. Such subdued public perceptions regards US nominal GDP growth therefore strongly suggests to us that there is very limited room for US interest rates – short or long – to rise without risking a renewed economic downturn.

To be clear, the sentiment-based nominal GDP growth rate proxy is not designed to predict how the economy will actually evolve, rather it is a proxy of how the crowd envisages the economy is evolving. The two can – as indeed has occurred in the past – be different. Our point is that for predictions for sustained interest rate increases to be correct one would, minimally, expect the crowd to be much more constructive regards nominal GDP growth than they are presently in the US. Given this, we judge that bond bears are likely to be frustrated yet again[12].

It is not just the US where we see this happening; sentiment dynamics in developed European economies are very similar. As the following two exhibits show, sentiment-based nominal GDP growth rate proxies in both the Eurozone and the UK have consistently trended lower over the past two years and presently are in negative territory. That said if one squints hard enough an uptick is apparent in the UK inflation perceptions over the past month or so consistent with the pass-through of the weaker exchange rate following the Brexit vote – a trend confirmed this week by the release of the July CPI data.

Exhibit 3. Nominal GDP Growth Sentiment – Eurozone



Exhibit 4. Nominal GDP Growth Sentiment – UK



Interestingly, in this regard Japan is a notable outlier relative to the aforementioned countries. Crowd sentiment towards economic growth and future inflation peaked later, in 2013 versus 2011, concomitant with the implementation[13] of Abenomics and the resultant, substantial, JPY devaluation. Even though strong positive sentiment readings also proved unsustainable, triggering widespread criticism of Abenomics, Japan’s sentiment-based nominal GDP proxy has drifted higher in recent months to a level notably higher than that observed in the US and Europe.

Exhibit 5. Nominal GDP Growth Sentiment – Japan



For investors still disappointed with the BoJ’s last monetary stimulus package this may come as a surprise. Japan’s sentiment-based nominal GDP growth proxy indicates the crowd is more constructive than in the US, Eurozone, or the UK, and could well indicate ongoing conviction that the BoJ will implement a more aggressive reflationary policy stance in the near future. This is clearly a scenario the FX market is not focussed on at present with USD/JPY having revisited the psychologically important 100 mark, but given the very recent move up[14] in nominal bond yields it may be something the JGB market is starting to discount[15].


 *Sentiment Analytics are based on MarketPsych indices. 


[1] Although we have used the Riksbank as the example in the exhibit, similar forecast errors have been seen in other central banks including the Fed.

[2] Japan has been especially unproductive – and painful – for bond vigilantes. Indeed, short JGB positions are often called “widow-makers” and with good reason given how nominal government bond yields have evolved over the past decade or so.

[3] See:

[4] A much more palatable phrase than low, or even stagnant, economic growth.

[5] For US investors to shun short-term deposits in favour of holding government debt with a nominal yield much lower than the target Fed Funds rate would require a fairly bearish macroeconomic prognosis as justification; something that would imply a highly unusual – in the sense that it would be correctly anticipated by investors – policy error from the Fed.

[6] Recent comments by regional Fed governors Dudley and Lockhart indicate that September remains a “live” policy meeting. The minutes, by contrast, suggested less uniformity of opinion on the timing of the next rate hike with some preferring a move in December (November being ruled out because of its proximity to the Presidential election).

[7] See:

[8] Some investors/economists continue to worry about the long-run consequences – both for inflation and financial stability – of central bank balance sheets (not just the Fed) having bloated to levels rarely observed in peace-time economies or as Lord Rothschild recently described it the “greatest experiment in monetary policy in the history of the world”.

[9] For the avoidance of doubt we do not subscribe to the Neo-Fisherian notion that interest rate hikes are stimulative for reasons we outlined in a prior research note: see –

[10] That is to say, not attributable to external shocks such as higher oil prices etc.

[11] Investment initially serves to boost aggregate demand (it is one of the components of the GDP when calculated via the expenditure method) but once it comes on-stream it adds to aggregate supply – lifting the economy’s potential growth rate.

[12] Obviously crowd pessimism towards nominal GDP growth could prove to be incorrect, just as earlier optimism was incorrect. But, the positive growth/inflation surprises this implies would still prompt an upward revision in crowd sentiment as perceptions change.

[13] Or rather partial implementation given the lack of progress on the so-called third arrow: structural reform.

[14] Less negative that is to say.

[15] To be clear we are not contemplating a “death-spiral” sell-off in JGBs for reasons we outlined in a recent post see:

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