Asset Management
Fixed Income Training Seminar
Interest Rates – How to Position?
Karsten Linowsky
August 2014
Content
Interest Rates – How to Position for the End of a Secular Bull Market?
1
Long-term perspective and central bank behavior
2
What to expect from “normalization”
3
Inflation – the big risk to fixed income investors
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August 2014
2
1
Interest Rate History
30 Years of Secular Bull Market
%
%
14
12
10
8
6
4
2
0
Jan 84
Jan 88
Jan 92
US
Jan 96
EMU
Jan 00
Switzerland
Jan 04
UK
Jan 08
Jan 12
Japan
Bond yields have trended lower over the last 30 years in all major developed markets (DM)
Contributing (and correlated) factors: low inflation, low volatility, growing FX reserves, supportive monetary policies
Sources: Bloomberg, Credit Suisse
As of 07.07.2014
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1
Secular Factor Inflation
“The Great Moderation”
14
Inflation is not only lower on average than in previous periods, but volatility of inflation has decreased a lot as well
Inflation targeting by central banks is one reason for this, but globalization of goods and labor has also had some
influence
Sources: Bloomberg, Credit Suisse
As of 07.07.2014
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1
Secular Factor Savings
“The Global Savings Glut”
The savings to GDP ratio in emerging market economies increased markedly after 2000
According to the IMF, rising oil prices, structural changes in the Chinese economy, financial constraints, demographic
factors and official reserve accumulation have caused the savings increase
Sources: Bloomberg, Credit Suisse
As of 07.07.2014
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1
Where Are We in the Cycle? (Rates, Growth, Inflation)
On top of the long-term structural trends, markets are moving in cycles
Usually, these cycles are closely linked to economic activity
Extraordinary monetary policy measures have left interest rates lower than in previous cycles
Labor market has improved over the last few years
GDP cycle would suggest pickup as well
Sources: Bloomberg, Credit Suisse
As of 07.07.2014
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1
A Simple Alternative Perspective
Time to First Hike
A simple model relating the 10-year Treasury yield to the
time to first Fed hike has worked surprisingly well in the
past five years, but might not work so easily in the future,
when other factors get a stronger weight
Source: Credit Suisse
As of 30.05.2014
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1
Central Bank Targets
Inflation
Today, all major central banks have a price stability
target
Most central banks use the headline consumer price
index (CPI)
The definition of price stability can vary, but in
developed markets it is often seen at ~2% per year
Growth
Growth is often an implicit central bank target,
as slack in the economy leads to a lack of price
pressure – the Fed even has an explicit growth target
(full employment) and therefore a dual mandate
FX
Central banks can follow an exchange rate policy, sometimes only
temporarily
Even central banks with a price stability target can often justify measures
on the exchange rate by the currency effect on inflation
Some simple simulations to steer the world economies:
The Fed chairman game:
http://www.frbsf.org/education/activities/chairman/
Bank of England monetary policy balloon:
http://www.bankofengland.co.uk/education/Pages/resources/inflationtools/balloon/balloon.aspx
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1
Rule-based Approach
The Taylor Rule
In order to achieve their targets, central banks use several instruments (conventional and unconventional)
to impact the economic activity and the level of prices. One instrument is to adjust short-term interest rates
(e.g. Fed funds rate, ECB main refinancing rate).
The Taylor Rule (formula) was introduced by Stanford economist John Taylor, in a way to provide “recommendations”
on how a central bank should set short-term interest rates as economic conditions change, in order to achieve both its
short-run goal for stabilizing the economy and its long-run goal for inflation:
Where the target short-term interest rate is explained respectively by the inflation rate, the equilibrium real interest rate,
the differential between the inflation rate and the target inflation, and finally the output gap calculated from the
logarithmic differential between the real GDP and the potential output (determined by a linear trend).
It suggests that central banks should increase interest rates in times of high inflation, or when output is above its full
employment level, and decrease interest rates in the reverse situation
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1
Examples of Taylor Rule Projections
Taylor rule implied rates point to lingering headwinds
In percent
United States
United Kingdom
Mean Taylor rate1
Euro area
Range of Taylor rates2
Japan
Market-implied rate3
The Taylor Rule can be used to simulate projections of the future monetary policy path
According to the BIS, the simulation suggests that “the risk of central banks normalizing too late and too gradually
should not be underestimated”
Source: BIS Annual Report
As of June 2014
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Content
Interest Rates – How to Position for the End of a Secular Bull Market?
1
Long-term perspective and central bank behavior
2
What to expect from “normalization”
3
Inflation – the big risk to fixed income investors
The disclaimer at the end is also applicable to this page.
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August 2014 11
2
Forward Rates and FOMC “Dots”
What’s Priced In?
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Sep-14
Sep-15
FOMC "dots"
Sep-16
FF futures
Sep-17
2Y Swap path
Federal Open Market Committee (FOMC) projections (median) can be compared with market implied Fed funds rates.
In the above example, the market has been more cautious than the policy makers’ projections.
Two-year rates would rise significantly before the first Fed hike actually occurs
Sources: Bloomberg, Credit Suisse
As of 03.07.2014
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2
A Brief Reminder
How to Calculate Total Returns
At the moment, forward rates are high and curves are steep
Total returns can be calculated for several assumptions of yield changes
Overall, it is important how yields change relative to the forward curve
Total return scenarios relative to the forward curve
Using Bloomberg’s TRA function to do the calculation
12M horizon
Sources: Bloomberg, Credit Suisse
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2
Total Return Simulations Relative to the Forwards
1.20%
1.00%
0.80%
0.60%
0.40%
0.20%
0.00%
-0.20%
1
2
3
4
5
6
7
8
9
10
-0.40%
-0.60%
-0.80%
later shift
forwards
earlier shift
Total returns are equal to the “risk free” rate when forward rates are reached
Return simulations can be done, for example, by shifting the forward curve forward or backward by a quarter
Sources: Bloomberg, Credit Suisse
As of 03.07.2014
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2
Impact on the Yield Curve
3.0
0
2.5
1.0
2.0
2.0
3.0
1.5
4.0
1.0
5.0
0.5
6.0
0
7.0
-0.5
-1.0
Jan 89
8.0
9.0
Jan 93
Jan 97
Jan 01
10Yr-2Yr Yield Spread (US Treasuries)
Jan 05
Jan 09
Jan 13
Federal Funds Target Rate (rhs, inv)
The shape of the yield curve is linked to the rate cycle
In “normal”, the short end of the curve is more volatile than the long end
In the last five years, however, short rates were “fixed” at zero and short end volatility was low
Sources: Bloomberg, Credit Suisse
As of 03.07.2014
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August 2014 15
2
Term Structure Forecast Model
Nelson-Siegel Model
3.50
par-yield curve USD
3.00
2.50
2.00
1.50
1.00
0.50
0.00
1
2
3
4
5
6
7
8
9
10
3M Forward curve
Nelson-Siegel forecast
CS forecast
Spot curve
The Nelson-Siegel type models are widely used for three reasons:
1. They are relatively easy to estimate
2. The parameters have intuitive interpretation, namely level, slope, curvature
3. They exhibit good empirical performance
Sources: Bloomberg, Credit Suisse
As of 07.07.2014
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Content
Interest Rates – How to Position for the End of a Secular Bull Market?
1
Long-term perspective and central bank behavior
2
What to expect from “normalization”
3
Inflation – the big risk to fixed income investors
The disclaimer at the end is also applicable to this page.
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August 2014 17
3
Financial Repression
Low Long-Term Real Yields
in %
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0
-1.0
-2.0
Jan 07
Jan 08
10-year real yield USD
Jan 09
Jan 10
10-year real yield EUR (Italy)
Jan 11
Jan 12
10-year real yield GBP
Jan 13
Jan 14
10-year real yield EUR (France)
Not only have nominal yields fallen in the past, this is also the case for yields after adjusting for inflation
This can be achieved, for example, by keeping the central bank rate at lower levels than in “normal” cycles, tolerating
temporary overshootings in inflation and performing quantitative easing in long-term bonds
Sources: Bloomberg, Credit Suisse
As of 07.07.2014
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3
Inflation-linked Bonds (ILB)
Cash Flow Example
Five-year ILB with 1.50% coupon issued at par; initial notional = 10,000
Assumption: Inflation 2% p.a.
Year
Today
Inflation
Index ratio
Notional
Coupon
Notional payment
Cash flow
–
1.000
10,000.00
–
-10,000.00
-10,000.00
1
2%
1.020
10,200.00
153.00
–
153.00
2
2%
1.040
10,404.00
156.06
–
156.06
3
2%
1.061
10,612.08
159.18
–
159.18
4
2%
1.082
10,824.32
162.36
–
162.36
5
2%
1.104
11,040.81
165.61
11,040.81
11,206.42
Notional = 10,000 × index ratio
Index ratio
changes with
inflation
Coupon = 1.50% × notional
Cash flow = coupon + notional payment
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August 2014 19
3
Breakeven Inflation
in %
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0
-0.5
Jan 07
Jan 08
Jan 09
10-year BE inflation USD
10-year BE inflation EUR (France)
Jan 10
Jan 11
Jan 12
10-year BE inflation EUR (Italy)
10-year BE inflation EUR (Germany)
Jan 13
Jan 14
10-year BE inflation GBP
Breakeven inflation is the difference between nominal yields and real yields
It tells how high inflation has to be on average so that the performance of an inflation-linked bond is the same
as of a nominal bond with the same maturity
Sources: Bloomberg, Credit Suisse
As of 07.07.2014
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August 2014 20
3
Issuer Base Is Broadening
Developed markets
Emerging markets
Year of 1st issuance
1981
1985
1991
1994
1995
1997
1998
2003
2004
2006
2012
2014
UK
Australia
Canada
Sweden
New Zealand
US
France
Italy
Japan
Germany
Denmark
Spain
Sum DM
EMU
France
Italy
Outstanding ILBs (USD bn)
683
30
60
35
9
1,035
223
287
42
95
6
7
2,512
Spain
Outstanding ILBs (USD bn)
74
259
35
15
1
8
3
53
44
9
5
506
Sum EM
US
Germany
Year of 1st issuance
1996
2000
2000
2002
2002
2003
2003
2006
2007
2007
2011
Mexico
Brazil
South Africa
Chile
Colombia
Argentina
Poland
Israel
Turkey
South Korea
Thailand
90,000
80,000
80,000
70,000
Maturity
2043
2041
2039
2037
2035
2033
2031
2029
2027
2025
2023
>=2038
2036
2034
2032
2030
2028
2026
2024
-
2022
10,000
2020
10,000
2018
20,000
2016
20,000
2021
30,000
2019
30,000
40,000
2017
40,000
50,000
2015
50,000
60,000
2013
Amount (Mio USD)
60,000
2014
Amount (Mio EUR)
70,000
Maturity
Sources: Bloomberg, Barclays, Credit Suisse
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3
A Fair Value Model for Breakeven Inflation
Factors
Gradients of the Objective Function
Growth indicator: JPM Global PMI Manufacturing
Price and costs indicator: Consumer Price Index (YoY, %)
Commodity prices: Brent Oil
Economic activity indicator: 6-lag Unemployment Rate (%)
Financial variables: USD Libor-OIS spread (measure of risk and liquidity in the money market)
Source: Credit Suisse
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3
A Fair Value Model for Breakeven Inflation
Output
To a large degree, changes in breakeven inflation can be explained by fundamental variables
This can be used to assess if there is “value” in the market, as the market tends to trade around the fundamentally
derived value
Source: Credit Suisse
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4
Summary and Conclusions
Economic cycles and monetary policy
Several factors have caused interest rates to fall
to historically low levels
Structural factors can explain the 30-year bull market,
but cyclical indicators will be relevant in
the short-to-medium term
Central banks will react to the cyclical indicators
in the coming years, probably by entering a hiking cycle
Normalization
Central bank assumptions can be compared with market
implied rates
Rate hike cycles are usually linked to yield curve
flattening, led by the short end
The two-year yield will rise significantly this year if
the market continues to expect the first rate hike
in 2015
But the yield curve is steep and forward rates are high
Short positions have a highly negative carry
Inflation
Inflation is one of the biggest risks to fixed income investors
The ILB market is a growing market, in which the bonds are linked to an inflation index and offer a fixed real yield
Fundamental regression models can be used to determine if implied inflation rates of ILBs offer attractive value
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Disclaimer
This material has been prepared by the Private Banking & Wealth Management
division of Credit Suisse (“Credit Suisse”) and not by Credit Suisse's Research
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