RATES Revisiting The Inflation Versus Deflation Debate STRATEGY And Taking A Look At US Election Risk
US and SG money market rates have floored. Improved liquidity seen in SORA products.
Steeper yield curves driven by higher bond yields.
Discussion 1: US inflation has undershot the Fed’s 2% target since 2019, the new AIT regime means a Fed that will be less sensitive to inflation upside in order to make up for the prior periods of undershooting.
Discussion 2: A contested US election outcome is on our risk radar for 4Q. The ensuing “risk off” narrative will see yields pressured lower and a richer US dollar premium.
Money Markets Funding markets in the US and locally have 1Y Swaps Forward Curves Vs. Spot largely found a floor over the past quarter. (Difference - %) We believe that liquidity conditions will be Source: Bloomberg, UOB Global Economics & Markets Research maintained at accommodative levels since policy makers will want to avoid endangering 0.80 the nascent economic recovery by prematurely removing their support. At the same time, the 0.60 COVID-19 shock is also clearly less acute now which will argue against unleashing additional 0.40 floods of liquidity into markets at this point. 0.20 The likely scenario Forwards markets are priced for a more is for US and SG meaningful increase in yields beyond three 0.00 money market rates years. This also overlaps with the latest Fed to stay range bound dot-plots, and we do not have an argument -0.20 at prevailing levels against either. The likely scenario is for US and Spot 6M 1Y 18M 3Y 5Y until signs of economic SG money market rates to stay range bound US SI overheating emerges. at prevailing levels until signs of economic overheating emerges.
Table A: Short Term Money Market Rates Heatmap
18-Sep-20 -1 Week -1 Month -3 Month -6 Month -1 Year
SORA
US 3M Libor
SG 3M Sibor
SG 3M Sor
Source: UOB Global Economics & Markets Research
Quarterly Global Outlook 4Q 2020 39 RATES STRATEGY UOB Global Economics & Markets Research The global transition The global transition towards risk free benchmark rates continues to make progress and in towards risk free Singapore we have seen a number of industry-first SORA cash products launched as well as the benchmark rates inaugural 6-month SORA floating rate note auction by the MAS. continues to make progress. In the SORA derivatives space, liquidity has also shown signs of improvement. For example, the total notional amount outstanding of SORA interest rate swaps cleared by the London Clearing House (LCH) has almost doubled to USD 0.86 billion in August compared to USD 0.44 billion in May. Another example of better liquidity conditions can be seen in the bid-ask spreads of the 1-year SORA interest rate swap. Volatility in the bid-ask spread has stabilized significantly since its inception in May and the spread has narrowed further to around 7bps since late August.
LCH Cleared SORA Derivatives 1Y SORA OIS Bid-Ask Spread (%) (Notional USD Billions) Source: Bloomberg, UOB Global Economics & Markets arch Source: Bloomberg, UOB Global Economics & Markets Research
1.00 0.35 0.90 0.30 0.80 0.70 0.25 0.60 0.20 0.50 0.15 0.40
0.30 0.10 0.20 0.05 0.10 0.00 0.00 May 20 Jun 20 Jul 20 Aug 20 May 20 Jun 20 Jul 20 Aug 20 Sep 20 <1Y 1-2Y >2Y
Our views on SORA’s central tendency anchored at around 10bps for 4Q2020. US and SG 3M US Libor forecast at 0.25% by end 2020 and remains at 0.25% by end 2021. money markets 3M SG Sibor forecast at 0.35% by end 2020 and remains at 0.35% by end 2021. 3M SG Sor forecast at 0.25% by end 2020 and remains at 0.25% by end 2021.
Bond Markets Over the course of 3Q 2020, the US real rates yield curve continued to steepen further US 5s30s Real vs. Nominal Curve (%)
and this has narrowed the gap against the Source: Bloomberg, UOB Global Economics & Markets Research nominal yield curve back to levels prevailing before COVID-19 made its presence felt on 1.40 1.20 financial markets. In the case of the 5s30s UST 1.20 1.00 versus TIPS, the gap between the two curves 1.00 narrowed by 30bps in 2Q followed by a further 0.80 24bps in 3Q (as of 17 Sep). 0.80 0.60 0.60
0.40 0.40 0.20 0.20 0.00
-0.20 0.00 Sep 19 Dec 19 Mar 20 Jun 20 Gap - RHS UST TIPS
Quarterly Global Outlook 4Q 2020 40 UOB Global Economics & Markets Research RATES STRATEGY Table B: Longer Term Bond Yield Heatmap
18 Sep 20 -1 Week -1 Month -3 Month -6 Month -1 Year
10Y UST
10Y SGS
2s10s UST Curve
2s10s SGS Curve
Source: UOB Global Economics & Markets Research
Additional convergence between the nominal and real yield curves in 4Q seem to be an unlikely scenario in our view, given that virtually all of the COVID-19 safe haven premium has already been unwound. That said, there may still be scope for a steeper real yield curve when vaccines become widely available and if the recovery in economic activity can find another gear off the back of the massive fiscal and monetary support that is already in play.
We see room for bond Steeper yield curves will be driven by higher bond yields given that the front end of the curve has yields to reprice higher already hit the zero bound. Bond markets have also been a beneficiary of the COVID-19 liquidity when liquidity support injections which is a reason why we are seeing disconnects between bond yields and the typical measures are gradually indicators of economic recovery such as PMIs and prices of industrial metals. Therefore, we see pulled back alongside room for bond yields to reprice higher when liquidity support measures are gradually pulled back the resumption of alongside the resumption of economic activity. economic activity.
10Y UST And ISM Manufacturing 10Y UST and Industrial Metal Index
Source: Bloomberg, UOB Global Economics & Markets Research Source: Bloomberg, UOB Global Economics & Markets Research
3.50 65 2.50 125
120 3.00 60 2.00 115 2.50 55 1.50 110 2.00 50 105 1.50 1.00 100 45 1.00 95 0.50 0.50 40 90
0.00 35 0.00 85 Oct 15 Feb 17 Jun 18 Oct 19 Sep 19 Feb 20 Jul 20 10Y UST (%) 10Y UST (%) ISM Manufacturing (Index) - RHS Bloomberg Industrial Metals (Index) - RHS
Our views on 10Y UST forecast at 1.05% by end 2020 and 1.20% by end 2021. US and SG 10Y SGS forecast at 1.15% by end 2020 and 1.30% by end 2021. bond markets AIT regime is supportive of a steeper yield curve, but unlimited QE sits in the background ready to tamp down on excessive gains.
Quarterly Global Outlook 4Q 2020 41 RATES STRATEGY UOB Global Economics & Markets Research DISCUSSION 1: The US Fed unveiled its new strategy of US Core PCE Deviations From 2% Fed Target Average Average Inflation Targeting (AIT) on 27 Aug (%) and this marked an important shift in its policy Inflation Target Source: Bloomberg, UOB Global Economics & Markets Research conduct going forward. In essence, AIT allows policy makers at the Fed more flexibility in 0.8 managing their price stability mandate of a 0.6 long run 2% inflation rate. What AIT entails is 0.4 a shift in the Fed’s reaction function to being 0.2
more tolerant of inflation rate running over 0.0 its 2% target when it comes off the back of a -0.2 period where it has undershot. -0.4
-0.6
-0.8
-1.0
-1.2 1995 2001 2007 2013 2019
Going forward under Using the Fed’s favoured measure of inflation, the core personal consumption expenditures price the new AIT regime, index (core PCE), inflation outcomes have persistently undershot the 2% target since 2019 at an the Fed will be less average of -0.43%. Therefore, going forward under the new AIT regime, the Fed will be less eager eager to tamp down to tamp down on higher inflation outcomes (within a reasonable tolerance of up to perhaps 2.50%). on higher inflation So, even with signs of an economic rebound from the initial COVID-19 hit, the “lower for longer” outcomes. rates narrative remains validated by AIT.
Inflation vs. A Fed that is more tolerant of inflation does not mean that they will get inflation. This debate over Deflation Debate whether the future is an inflationary or deflationary world has been a perennial one but based on the deviation of core PCE from the Fed’s 2% target it would seem that fears of runaway inflation have largely been unfounded since 1995.
Proponents of the Nonetheless, it is useful to remind ourselves on the logic that underpins both camps. Proponents inflationary narrative tend of the inflationary narrative tend to rely on two general arguments, the first is the expansion of to rely on two general the Fed balance sheet and the second is fiscal deficits. Both arguments hinge on the assumption arguments, the first is that the economic engine will eventually respond to growth oriented policies and through the the expansion of the Fed multiplier effects, as well as policy reaction functions which have historically been slow to tighten, balance sheet and the we would eventually reach a situation of excessive credit creation that results in higher inflation. second is fiscal deficits. Recent political developments which have steered towards de-globalization has also added a third argument in the form of higher input costs from redesigned supply chains to the mix.
Combined Central Bank Balance Sheets Of US Fiscal Balance (% of GDP) US, UK, EU, and JP (% of GDP) Source: Bloomberg, UOB Global Economics & Markets Research Source: Bloomberg, UOB Global Economics & Markets Research
60 4
2 50 0 -2 40 -4 30 -6 -8 20 -10 -12 10 -14
0 -16 1992 1998 2004 2010 2016 1990 1997 2004 2011 2018
Quarterly Global Outlook 4Q 2020 42 UOB Global Economics & Markets Research RATES STRATEGY Deflationists on the other Deflationists on the other hand downplays the credit creation argument by pointing toexcess hand downplays the capacity, i.e. output gaps, which will prevent upside price pressures from building. In addition, they credit creation argument would also argue that the velocity of money has also been on a long term declining trend, therefore by pointing to excess the marginal creation of credit does not have the same impact that it used to. Another justification capacity, i.e. output gaps, that is aired regularly by the deflationary camp is that the amount of debt amassed will have to be which will prevent upside repaid and when private and public sectors deleverage, this would trigger a strong deflationary price pressures from impulse. building.
US Real Output Gap (% of GDP) US M2 Velocity (%) With CBO Projection Source: Bloomberg, UOB Global Economics & Markets Research Source: Bloomberg, UOB Global Economics & Markets Research
4 2.4
2 2.2
0 2.0 -2 1.8 -4 1.6 -6 1.4 -8
-10 1.2
-12 1.0 1990 1997 2004 2011 2018 2025 1990 1995 2000 2005 2010 2015 2020
We are fairly certain We are fairly certain that in the near term deflation risks outweighs that of inflation due to the that in the near term lingering impact of COVID-19 and the potential of a winter spike in cases which could further drag deflation risks outweighs out economic recovery. On a longer term perspective, we see the scales becoming more balanced that of inflation due to and could tilt in favour of inflation. For example, de-globalization trends if left unaddressed could the lingering impact result in supply side factors (resource hording and increased barriers to entry) lifting inflation in the of COVID-19 and the long run. In any event, the cost to hedge against higher long term inflation is not expensive seeing potential of a winter as the entire US breakeven curve lies under the Fed’s 2% target and the 30-year tenor resides spike in cases which below its 1 standard deviation level for the past 20 years. could further drag out economic recovery.
US Breakeven Curve 1- To 30-years (%) 30Y US Breakeven (%)
Source: Bloomberg, UOB Global Economics & Markets Research Source: Bloomberg, UOB Global Economics & Markets Research
2.1 3.5
1.9 3.0 2.5 1.7 2.0 1.5 1.5 1.3 1.0 1.1 0.5
0.9 0.0 1 2 3 4 5 6 7 8 9 10 20 30 2000 2003 2006 2009 2012 2015 2018 Maturity Breakeven Fed Target -1SD -2SD
Quarterly Global Outlook 4Q 2020 43 RATES STRATEGY UOB Global Economics & Markets Research DISCUSSION 2: As we draw closer to the US Presidential election in November, it is reasonable to assume that Risk Radar - financial markets could become more sensitized to swings in polling results. This will likely result US Election in an uptick in asset price volatility. Notably, the prospect for higher volatility could receive a further boost based on the trajectory of recent political discourse which has veered towards debates over the possibility of a contested election outcome.
There have only been four occasions when the results of a Presidential election were contested. The most recent being the 2000 election between George W. Bush and Al Gore. Prior to this, the elections of 1960, 1888, and 1876 were also mired in some controversy. Additional uncertainty has also emerged after the death of Ruth Bader Ginsburg on 18 Sep. Who, and when her seat will be filled takes on significance because the 2000 election was decided in a 5 to 4 Supreme Court decision in favour of Bush.
We looked at the price behaviour in rates markets during the 2000 episode, for a sense of possible reactions that could occur if the upcoming 2020 election turned out to be a contested one.
What we find is a pattern that fits with the “risk off” narrative. Over the period of uncertainty between election day (7 Nov) to the day that Al Gore conceded (13 Dec), the 3-month Treasury versus Eurodollar spread (TED) widened by as much as 26bps while the 10-year US Treasury yield fell by 60bps and the 5s30s US Treasury yield curve bull steepened by 27bps.
3M TED Spread 10Y UST 5s30s UST (Change, %) (Change, %) (Change, %) Source: Bloomberg, UOB Global Source: Bloomberg, UOB Global Source: Bloomberg, UOB Global Economics & Markets Research Economics & Markets Research Economics & Markets Research
0.90 0.00 0.60 0.80 -0.10 0.50 0.70 -0.20 0.60 -0.30 0.40 0.50 -0.40 0.30 0.40 -0.50 0.20 0.30 -0.60 0.20 -0.70 0.10 0.10 -0.80 0.00 0.00 -0.90 -0.10 -1.00 -0.10 -20 -12 -4 4 12 20 28 -20 -12 -4 4 12 20 28 -20 -12 -4 4 12 20 28 Business Days Around Business Days Around Business Days Around 2000 Election 2000 Election 2000 Election Gore Concedes Gore Concedes Gore Concedes 3M TED Spread 10Y UST 5s30s UST
Over in our SG rates markets, it was a similar story with the 10-year SGS yield dropping by 26bps, and dragged the 2s10s SGS curve flatter by 18bps. However, there was less spillover in terms of US dollar liquidity stress in the domestic market than what was suggested by the repricing in the 3-month TED spread. The 3-month Sor cheapened (vis-à-vis a richer US dollar premium) by 10bps against the 3-month Sibor but this magnitude of change wasn’t too dissimilar when compared with periods prior to the onset of election uncertainty.
Quarterly Global Outlook 4Q 2020 44 UOB Global Economics & Markets Research RATES STRATEGY 3M SOR-SIBOR Spread 10Y SGS 2s10s SGS (Change, %) (Change, %) (Change, %) Source: Bloomberg, UOB Global Source: Bloomberg, UOB Global Source: Bloomberg, UOB Global Economics & Markets Research Economics & Markets Research Economics & Markets Research
0.10 0.15 0.20 0.10 0.15 0.05 0.05 0.10 0.00 0.00 0.05 -0.05 0.00 -0.05 -0.10 -0.05 -0.10 -0.15 -0.10 -0.20 -0.15 -0.15 -0.25 -0.20 -0.20 -0.30 -0.25 -20 -12 -4 4 12 20 28 -20 -12 -4 4 12 20 28 -20 -12 -4 4 12 20 28 Business Days Around 2000 Business Days Around 2000 Business Days Around 2000 Election Election Election Gore Concedes Gore Concedes Gore Concedes 3M SOR-SIBOR Spread 10Y SGS 2s10s SGS
Taking a broader view, it is likely that the rates markets’ reaction to the 2000 contested election was exacerbated by a global economy that was starting to show signs of strain from restrictive financial conditions due to tighter monetary policies from the US Fed’s 50bps hike to 6.50% in May 2000 and the ECB raising its main refinancing rate by 25bps to 4.75% in October 2000. Indeed, the absence of a meaningful reversal in the price action after Al Gore conceded the election on 13 Dec also suggests that the market reaction had moved past election uncertainties and were being driven by other factors.
This is hardly the case in 2020, with global monetary policies locked in an accommodative setting for an extended period of time, the probability of encountering a policy induced tightening in financial conditions is de minimis. Therefore, while we can still expect to see a “risk off”auto response in a contested election outcome, the impact on rates markets may be more muted when compared to what had occurred in 2000 due to the absence of coincident aggravating factors.
Implications Guard against funding market dysfunction and richer US dollar premium. from event risk Structural yield curve steepening bias could run into temporary headwinds.
Quarterly Global Outlook 4Q 2020 45 RATES STRATEGY UOB Global Economics & Markets Research