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? 2300 North Ridgetop Road | Santa Fe, New Mexico 87506 | 505.984.0200 tel | 800.533.9337 toll-free | 505.992.8681 fax | thornburg.com 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? 2300 North Ridgetop Road | Santa Fe, New Mexico 87506 | 505.984.0200 tel | 800.533.9337 toll-free | 505.992.8681 fax | thornburg.com 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.