EPSTEIN
page 6 / 469 . OCR, unverified
Currently the market is pricing that the neutral real rate (estimated as 4YIY 0IS
minus 2%) will remain close to zero. One side of the argument for low neutral
real rates is a structurally lower level of productivity (the secular stagnation
argument). Productivity has indeed been close to historical lows during this
recovery. However, the uptick in real wages since the trough of the recession
would suggest that there could be some upside to productivity from these
levels. This would be particularly the case if wages do follow the leading
indicators, which suggest some improvement towards 2.5% yoy on a nominal
basis (around 1% in real terms based on current core PCE forecasts).
Figure 6: Productivity at historical low levels, but the
improvement in real wages suggests some upside risks
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Figure 7: There is scope for a limited normalization of
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Others (including the Fed) argue that real rates have been low because of
headwinds, namely tight fiscal policy, tighter regulation and credit supply,
weaker demand for credit due to balance sheet repair and general macro
uncertainty (fiscal cliff, Europe, China etc...). For Chair Yellen, we expect the
normalization of policy will be driven not by an increase in GDP growth, but
rather by the fact that the neutral real rate will drift up. The improvement in
lending conditions and the marginally more supportive fiscal policy would also
argue for some upside risks for the neutral rate. Irrespective of which side
proves to be correct (within our own research team, the views are mixed),
given that the market is de-facto pricing secular stagnation, the risks are to the
upside in yields.
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Deutsche Bank AG/London
CONFIDENTIAL — PURSUANT TO FED. R. CRIM. P. 6(e)
DB-SDNY-0119151
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December 2015
World Outlook 2016: Managing with less liquidity
Back-end and swap spreads convergence
The rationale outlined above would be consistent with a possible
underperformance of the European back-end relative to the US. This macro
assessment is supported by valuation arguments. Long-term valuation
arguments which ignore flow effects such as OE suggest a significant richness
of 5Y5Y rates in Europe relative to the US. Accounting for flows, the relative
richness is less clear. The corollary however is that any pricing out of flow
effect should lead to an underpeformance of European fixed income in the
long end of the curve. At the same time, the structural drivers of the cheapness
of swap spreads in the US are likely to become more prominent in Europe. This
should also lead to a relative cheapening of the long end of the German curve
vs. USTs.
Figure 12: 5Y5Y adjusted risk premium (which ignores
flow effects) indicate some scope for underperformance
of European fixed income
!Figure 13: Swap spreads have diverged significantly in
Ithe US vs. Germany (cheapening of long UST bonds)
3° 1
%
• -30
Spread between VS730Y ASW
Gennen 30Y ASW
—
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Key risks to the outlook:
As always, there are important risks to this outlook. These include external
risks such es China and the dynamics of oil prices, but also domestic risks
such as a change in the fiscal policy outlook, political risks in Europe or a turn
in the US credit cycle. We summarise the key risks below.
Cii;n:i• We argued earlier this year that China rather than Europe was the main
disinflationary source at the global level. In contrast to Europe, credit growth
remains relatively high, long-term real rates are above 4%, the GDP deflator is
in negative territory and the currency has appreciated close to 30% and is now
overvalued on some metrics. Our economists are positive on the short-term
outlook for growth and China's ability/desire to maintain a relatively stable
currency. However, they also recognize the secular decline in growth. Putting
it all together, China could continue to exert background disinflationary
pressures, but without creating a significant financial shock. Relative to this