Central Banks Throw Yield Curve Balls at Equity, Bond Markets

Charles Roth: Hi. Welcome to another episode of Away from the Noise, Thornburg Investment Management's podcast on key investment topics, economics and market developments of the day. I'm Charles Roth, Global Markets Editor at Thornburg. We're joined today by Jeff Klingelhofer, Co-Ed of Investments and who also wears another hat as Portfolio Manager on multiple strategies within Thornburg's global fixed income team. Prior to joining Thornburg in 2010, Jeff spent 4 years at Pimco, including stints in Tokyo and London. When not in the office or nowadays working from home, he may be piloting his plane or on the tennis court. But given the impact of the pandemic on economies globally and the response from monetary and fiscal authorities, there's no doubt plenty of work to do and, and things to discuss. Thanks for coming on Jeff.

Jeff Klingelhofer: Thank you for having me. It's great to be here.

Charles Roth: Among the things that monetary authorities are, are doing, uh, and frankly have been doing since the global financial crisis, Japan even longer, is quantitative easing, asset purchases, mainly treasury bonds and, and asset backed securities, agency aspects, varies in the case of, of the fed, but Japan has been engaging in quantitative easing for close to 2 decades and, and explicit yield curve control since 2016, and of course their 0 interest rate policy in Europe and, and negative interest rate policy in parts of Europe, and Japan is also en, engaged in, in that, but really it's the yield curve control that is somewhat fascinating. Could you first just tell us what yield curve control is and, and why the bank of Japan is engaging in it?

Jeff Klingelhofer: Absolutely. So yield curve control just very simply put is an additional tool in the central bank's tool kit to control rates not only in the front end of the curve but along the curve as well. So in Japan's example, yield curve control is targeting their 10-year government bond yield close to 0 percent. Let's keep in mind the central bank technically un, under the official lending scheme only controls the very front end of the curve, and it's up to the market to decide where they would place risk premia and ultimately what yield the 10-year treasury, for instance, should be. Under a yield curve control regime, the central bank pledges to keep rates at or around its, its benchmark rate or at or around whatever rate it determines is appropriate by either purchasing or selling along the yield curve in order to achieve that outcome.

Charles Roth: So, I'm just wonderin', the idea of QE and yield curve control in Japan's case is to generate inflation that is targeted at 2 percent and, of course, to, to support economic growth. So, the question is ha, has Japan after 4 years of yield curve control and really massive amounts of QE since 2013 achieved those goals?

Jeff Klingelhofer: By and large, if you, if you just think about it on the high level, no, they haven't. The flipside of it, of course, is that the counterfactual. Where would Japan sit or where would any large developed economy sit without the extraordinary measures of quantitative easing and, and yield curve control or, or perhaps negative rates. And it is generally my belief that ultimately, controlling rates or keeping rates low is meant to do one thing. It's meant to pull forward consumption from the future to today. That ultimately supports income. It ultimately supports consumer confidence, and what it's designed to do is cre, create a virtuous whereby if you spend today, that find, that money spent finds its way into the real economy, supports jobs, supports income which spurs further consumption. Right? It's meant to be a virtual positive cycle. So while ultimately, the answer to your question is we aren't creating inflation in many parts of the world, certainly not the large developed economies, would we be worse off without low rates? Ultimately, from the pure objective of creating inflation, I do, but that isn't to dismiss many of the distortionary effects that, that we've seen.

Charles Roth: Let's talk about some of the side effects. The, the counterfactual is certainly there, you have, you have to wonder if there's a, uh, case to be made that once you engage in it, you can't stop. And so then while the economy's not falling off a cliff, it seems to be limping along. While there's not deflation outright or, or deep, perhaps there's sort of a, a very low growth and very low inflationary environment. One of the things that Japan has tried to do with QE and yield curve control is end a deflationary mindset. Can you first kinda talk about, having lived in Japan, what that deflationary mindset is like and the progress that they've made in terms of ending it?

Jeff Klingelhofer: Absolutely, you know, and I'll start with broadly speaking, most central bankers grew up in an environment where I would classify their job was to avoid significant amounts of inflation. Right? A, a significant price uncertainty to the high side. The trap we've fallen into has been the exact opposite where today, a central banker's job is to avoid the disinflationary or outright deflationary mindset which we've had in Japan now for decades. You know, having lived there and, and moved directly from southern California from a very consumption-oriented economy, um, to arguably a very different place. Right? Tokyo and, and, and Japan broadly are eastern civilization versus western civilization and, and a beautiful society and very different than the U.S. And part of that is that, that deflationary mindset. The idea that if you delay consumption from today, you'll be able to actually consume more tomorrow. Right? Because prices are falling. That, that's an incredibly difficult trap for central bankers to get out of. And that's ultimately where they are readably worried that we're heading not only in Japan but, but globally today. A lot of it does have to do with demographics, but many, many other things go into, uh, ultimately deciding whether we get deflation, disinflation or inflation, um, and having seen it firsthand through my time in Japan was, was pretty interesting and, and, and definitely has negative consequences for the broad economic outlook.

Charles Roth: Have they been successful in ending the deflationary mindset? There, there has been some inflation, certainly not 2 percent, but are companies able to raise prices marginally and, and people willing to pay a little more for goods and services?

Jeff Klingelhofer: You know, before, before I directly answer, the, the interesting part is if you travel to Tokyo or, or most other countries with low inflation or perhaps even in times outright deflation, it doesn't necessarily feel that bad. And so it is interesting to, to take an individual versus more of a macro economy- wide viewpoint. To outright answer your question, though, maybe is probably the best way I could frame it. It does seem like the mindset is beginning to shift a little bit and particularly within the younger generation. But again, demographics is an incredibly powerful force, and while Japan is, is perhaps more advanced than, than most other countries with China following closely behind, uh, then Europe, uh, with an older population, the U.S. is actually in a pretty good spot. And so ultimately, I think central bankers here will stand a slightly better chance of, of overcoming the potential to have a, a deflationary mindset, but some countries are beginning to emerge from the other side but only after, as you point out, decades of expansion and, and significant efforts.

Charles Roth: So, uh, let's talk about a few of the side effects of zero rates and yield curve control, companies taking on more debt, companies that perhaps otherwise rate environment that wasn't so accommodative wouldn't be able to make it; zombies in other words. Can you talk about them and then the impact on the banking system as well and, and particularly the, the impact on net interest margins and net interest income among banks?

Jeff Klingelhofer: Absolutely, and so you're right. There's been a number of, of what I'll call distortionary effects of very low rates and even negative rates in, in some parts of the world. And you mentioned one of them. The rise of zombie companies. And, and so first, what is a zombie company? You know, I would define a, a zombie company as a company that doesn't even have free cash flow to meet its debt service payments. So a company that can only continue to exist by borrowing. So the only way you can do that is to pay off debt with more debt. And that's a direct consequence of, of central banks' actions. They've actually deliberately engineered this partly for political reasons, partly also to, to spur that virtuous growth cycle. And so in an environment where you face one of two outcomes, either companies going under and having short-term layoffs, the alternative in the short-term sounds good to, to prop up these companies, keep them alive, keep people employed. But the flipside of why I called it a, a distortionary effect is because ultimately, capital should find its ways to the most productive uses. And in many ways, companies seeking to borrow to invest in the future, to invest in, in raising GDP for their country is far more productive than a company just simply staying alive and, and kinda floating along with 0 percent or even negative growth. And that is, that has really long-tailed consequences. And then also, the second part that you touched on is the implication for banks. Coming from the fixed income side, it's, it's interesting to me. A lot of people focus on net interest margins, and that is, don't get me wrong, it's incredibly important, but that's important for the income statement side of a balance sheet. Many people argue that within the U.S. and, and many places, it's, it's had a negative outcome for banks because it does compress that interest margin, but that affects, again, the income statement. The flipside is, on the balance sheet side, what we've seen through COVID is many banks taking provisions for future losses. And ultimately, for a central bank, they need to support the sanctity of the banking system, not necessarily the future earnings power of banks. And they're able to do this via low rates by pushing the can out, right? By avoiding defaults. Simply put,

ensuring that current provisions for future losses aren't having to be used simply because they are propping up these zombie companies. You're not having to actually recognize the losses. And so there's a, there's a dual-sided effect on the, the banking system; one which keeps the banking system going and healthy, and in the U.S., we have a, a significantly well-capitalized banking system, but the flipside as you point out of course in the distortionary effects is compressing net interest margins ultimately making the income statement side of, of their balance sheet look much less attractive and depressing equity values.

Charles Roth: For the stock market, for the bond market, there are also side effects, probably adverse side effects of yield curve control. What does it mean for the equity risk premium if the benchmark yield is artificially suppressed or, or managed not by the market but by the central bank? Is it as meaningful as it used to be?

Jeff Klingelhofer: It's not. I mean, I would argue that at least academically, the basis for any valuation starts with the risk-free rate, and then you have to make assumptions, of course, on what you wanna add to the risk-free rate, uh, in order to get to an appropriate discount rate. And since as you point out, that starting place, that risk-free rate isn't determined by broad economic forces. Even in the U.S. where people argue we haven't necessarily seen yield curve control, but of course central banks have, have committed, and not just within the U.S. but certainly within the U.S. as well, to keep rates low for an incredibly long period of time, then it's no coincidence that all the way out to the 4-year U.S. Treasury that we sit kind of at the halfway point between 0 and, and, and 25 basis points, the official policy lending rate. So in many ways, we already have yield curve control, and it just feeds through to that distortionary effect. To directly answer your question, from the standpoint of the usefulness of the equity risk premium, it, it is absolutely less useful, but it's the environment that we live in, and so ultimately, we don't get to control front-end rates. We don't get to control central bank actions. We just have to react. And I think that that is the million- dollar question. Everyone is looking at, at tech companies with extremely high PEs and extremely great equity valuations or high equity valuations, and, and many of these are great companies. Right? And increasingly a, a winner take all type of economy, um, arguably, Amazon and Apple and Google are, are incredibly powerful. The question becomes is are they appropriately priced despite, you know, and, and, and in terms of, of even their, their, their significant forward earnings power. And, and that's, that's difficult, but I, I do worry that ultimately, the market is overly complacent in the belief that rates will forever stay low, and perhaps even more importantly that central banks have the ability to always step in and provide that put to market and always to keep rates low.

Charles Roth: So you, you, you mentioned that we may be witnessing some degree of yield curve control already in the U.S. at the front end, but what's kinda interesting to me is that, uh, of the yield, the front end of the yield curve, what's interesting to me is that if you look at the 5-year and the 10-year Treasury yields, they have traded in a very tight range for more than 3 months now, and, and so, you know, I don't know if that's by design or by accident, but whatever the case, it's, it's been a very volatile time, and those yields are, are awfully low and awfully stable, and so you discussed what it, it sort of means for the equity risk premium. What does it mean for on the bond side of the equation, for those strategies that engage in the

use of a ladder. First, maybe describe a ladder, what a ladder bond strategy is and, and then how this sort of environment, um, impacts that strategy.

Jeff Klingelhofer: Sure, so first, uh, to, to tackle your question, what is a ladder bond portfolio? Simply put, right, it's investing across the yield curve. All right? So if you wanna target a 5-year duration, you can buy nothing but 5-year bonds or you can buy equal quantities of, of 1-year bonds and 2-year bonds and 3 and 4 all the way out to 10 years and, and mathematically, you'll come out in roughly the same place. The purpose of a ladder is two-fold. First and foremost, a, a ladder provides natural liquidity. Right? So in a 10-year bond ladder for instance, if it's run on a straight-line basis, you have 10 percent of the portfolio maturing every single year. And given earlier comments of my belief that markets will remain volatile because, simply put, the central bank can try to provide a put, but that doesn't mean they'll provide the put before you see volatility, only after. And so I do believe markets will be volatile, and a laddered portfolio provides that liquidity to step into that volatility, to be numble, nimble, to be opportunistic. The second argument for a laddered bond portfolio is it keeps you diversified. So as you point out, whether or not the U.S. is officially engaging in yield curve control, regardless, rates are A, low, and B, quite stable. But that doesn't mean they always will be. If you view that you have a crystal ball and a clear crystal ball, you can step into that and make a bet ultimately if rates will move higher or lower over time along the yield curve, but if you're doing a laddered portfolio, just simply put, provides diversification for not having to make that bet. To instead focus on the fundamentals of individual cash flows within a portfolio and, and ultimately win and lose by your ability to assess those fundamentals.

Charles Roth: So the, the individual credits themselves, their relative value versus, you know, other opportunities and then they're fit within the broader portfolio. Let me ask you this. So if people are assuming that rates will stay low for long or forever given, uh, you know, a very accommodative fad in the Fed put, there is something that's a little bit different now than versus the global financial crisis, and both in the United States as well as Europe and, and we're of course seeing it in Japan, and that's the fiscal stimulus in addition to the monetary stimulus. Is, is there a danger that when you have so much liquidity sloshing around the globe that what we haven't see in a long time, that is inflation, could come back with force, particularly say when there's a vaccine for coronavirus and, and, or effective therapeutics or both?

Jeff Klingelhofer: There's absolutely the risk. And let me take it a little bit higher level. Ultimately, there's a lot of factors that feed into whether we get inflation or deflation, and, and I would argue even most people, certainly myself included, perhaps even no one fully understands the, the forces that control inflation versus de, deflation. But most would agree the demographics has a, a large part to play in this. So demographics isn't changing, right? Demographics is perhaps one of the most clear and clean sciences that we have. We know how many people are on, on the planet, we know that they're gonna get older, one year older every single year. We have pretty good models of, of mortality, and you can model these things out very cleanly for, for decades to come. So demographics isn't going to shift. But all of the other pieces are absolutely in flux. And the biggest risk as you point out is history may rhyme, but it doesn't necessarily repeat. And while we've seen central bank action, we haven't see the fiscal action that we've seen in many countries or, or certainly not in the size that we've seen it for quite some time. And the challenge is it's

incredibly difficult to walk this back, so in my view, it's likely to continue not just through COVID but beyond COVID as well. On top of that, you have geopolitical forces. I, I like to say if, if you were to assign, right, that the cr, the inflation creating all being of, of the globe, what would they be doing? They'd be closing down borders and, and looking inward, right? So why ****.

Charles Roth: De-globalization, yeah.

Jeff Klingelhofer: They, they'd be talking to central bankers and having them commit to keep policy rates at, at very low levels for quite some time. Importantly, they'd be changing the central bank mandates to not even target low inflation or 2 percent inflation, but within the U.S. right now, we're talking about perhaps price targeting to, a make-up strategy if you will. So there's lot of forces that potentially this time around are quite different, and we'll be watching those closely, but to simply answer your question, it's absolutely a risk, and I would argue that the turn from potential deflation to inflation over maybe the coming decade and a half which are, again, is a long-tailed event, but the ability to get that right and in front of market forces will perhaps be the defining moment of, of success or, or failure.

Charles Roth: So how do you manage a fixed-income portfolio in this kind of en, environment where you have these incredible risks that could move strongly in one direction or the other?

Jeff Klingelhofer: You do, but it's also important to remind ourselves what, what purpose does fixed- income serve? And absolutely income generation and total return are, are front and center of, of those solutions that fixed-income investors seek, but I would argue for, for core fixed-income investors that the, the ultimate solution is preservation of capital which gets directly to your inflation question, and it's also low and negative correlation with other risk assets. And so a couple things will help investors. First and foremost, preservation of capital within the construct of inflation will be difficult. But it's one of the two primary objectives. I think investors can stay short, then going back to that, that, uh, that bond ladder example. Having liquidity to step into and, and take advantage of potentially some of the volatility that inflationary environment would create would be hugely, hugely important. On top of that, being very, very nimble. Right? So I would argue in today's environment with spreads not super compressed but relatively compressed, especially in the areas where the Fed is distorting the market on top of very low risk-free rates as a starting place. So all-in yields very low. We are, again, we're turning to this environment where you're not well compensated to step into long-tailed risk assets. And so staying short on the yield curve will, will ultimately be fixed-income investors' best friend if we were to see an inflationary environment. Now, to be fair, I don't see inflation. I, I, I do agree that this is fundamentally a disinflationary shock, but the way that we are answering the current challenge perhaps sets up an inflationary environment in the future. You know, what will we be watching? Ultimately, we'll be watching for consumer confidence to shift and, and note endurably higher. And, and we'll be looking for, for, uh, people to, to have good long-term gainful employment. But at this point, I worry we're a number of quarters off from that.

Charles Roth: Well, thank you, Jeff.

Jeff Klingelhofer: Absolutely. Thank you.

Charles Roth: Today's episode was produced and edited by Michael Nelson. You can find us on Apple, Spotify, Google Podcast or your favorite audio provider or by visiting Thornburg.com podcasts. Subscribe, rate us and leave a review. Please join us next time on Away From the Noise.

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