What are shadow interest rates telling us?

We cannot forget that the zero bound on interest rates caused distortions in market price signals. Now in the US rates are above the zero bound so it seems like the concept of a shadow rate is not important; however, it is still relevant for many other central banks and it provides a good measure of where we have come over the last few years. Using the shadow rate as a historic measure of relative tightening, we can say that the Fed has actually been on a tightening policy since the end of quantitative easing. The size of this tightening is not much different than what we have seen in other Fed tightening cycles. While we cannot measure the true bite of rising rates, we can say that the Fed has been at tightening for much longer than most investors think.

The concept of the shadow interest rate was developed to determine what should be the short-term interest rate when constrained by the zero bound. The shadow rate can be an important tool to look at monetary policy even when rates go above the zero bound because it can give investors insight on where we have been versus where we are with rates. 

We use the Central Bank of New Zealand website as a place to check on the shadow short rates around the  world. 

For example, you cannot think about US rates rising from zero as the amount of tightening seen by the market. Rather investor should think about the rate rise from the minimum of the shadow rate. In this case, the Fed has been tightening for longer and the amount of tightening is significantly more than 200 plus bps. Similarly, there has been a significant rise in the shadow rate associated with the ECB. 

Looking at some of the research by the original author on shadow rates, Jing Wu from the University of Chicago, "A Shadow Rate New Keynesian Model", it is clear that tightening really began when QE ended. The connection with rates is a link that has been missing with many market watchers.

There is a fair amount of estimation error with these shadow rates. It is not  precise tool, but we can go back to the Taylor Rule and see that it does a good job of predicting the fed funds rate as well as the shadow rate. The shadow rate is similar to the Taylor Rule implied rate. Track the shadow rate and follow the Taylor Rule and you have a pretty good combination of indicators of what central banks may be up to without relying on reading central bank tea leaves through policy speak.

Hedge fund performance - Not great for those looking for absolute returns

The only hedge fund sectors that made significant returns in December were global macro and systematic CTAs.  These are the divergence strategies that are supposed to generate returns when there are market dislocations. Macro and systematic managers, through casting a wide net across asset classes and going both long and short, should find opportunities when there are significant dislocations. The remaining hedge fund strategies lost money, but significantly less than the exposure to market beta. It was not a successful month for most hedge funds, but it was not as bad as exposure to equity beta. However, long duration Treasuries proved to be a better hedge.

For the year, many hedge fund strategies actually underperformed equity and fixed income beta benchmarks. The only areas that performed well on a relative basis were fixed income relative value and CTA (global macro and systematic) strategies. Of course, these are index averages, but it provides some insight on hedge fund behavior during a difficult year.

Facts and Stats - Some facts are interesting but not useful

The end of the year is usually filled with reviews and facts about what happened and speculation on what may happen in the future, yet investors can be cluttered with too many facts. Some facts can be very interesting and great for conversations, but that does not mean they are useful for plotting a course for 2019.

One of the more interesting facts about 2018 is that just about all assets underperformed cash or were just outright negative. It was a bad year and the numbers prove it. It was an unusual in its badness because there was no protection, but these facts may not suggest what will happen to 2019.  These facts are interesting but not useful. 

Now, another interesting fact is the number of global stock indices that are in correction or a bear market. This is interesting, but actually useful in context.  We see that the numbers for 2018 are high and have exploded from a low base.  But, we have seen the same thing in 2016 as well as 2012. The number of markets in correction or worse is high but this state of the world is bad but not unusual. 

What makes this more useful is that a US perspective may have warped our view of what should be normal for equity markets. The high returns for the US and the long period without a bear market or a correction suggest that current conditions are not unusual, but that much of the behavior for US equity markets post the Financial Crisis was the extraordinary fact. If you are a US only investor, get used to what the rest of the world has been facing. 

Just as important as Powell Put - China monetary action; PBOC on the move

One of our major themes for 2019 is that investors should more closely track monetary policy developments in China. The reasons are simple: the economy is big, its trade impact is global, and the PBOC at times has followed a monetary policy at odds with the Fed and ECB.

Before the employment number and Fed Chairman Powell's comments at the AEA, the PBOC lowered the reserve requirement ratio (RRR) by a full 1 percent which could have a stimulus effect of $100 billion on the Chinese economy.  The RRR will move to 13.5 percent for large banks and 12.5 percent. This is the fourth change since the beginning of 2018. 

This RRR change was after an announcement earlier in the week that changed the definition of a small business to allow the RRR to impact smaller loans. The PBOC has also tightened the payment of reserve requirements to make policy more uniform.  The RRR will offset an announced of a cut in a lending facility in the first quarter. In December, the PBOC announced their policy stance has moved from "neutral to "an appropriate balance". Some of these actions will provide needed liquidity during the Chinese New Year period, but this is still part of a larger policy of gradual easing.

This announcement is part of an ongoing China policy process to provide needed monetary and fiscal stimulus without leading to or creating credit extremes. The gradualism wants to thread the needle between needed stimulus to keep the economy running well when the rest of the world may be slowing while not providing so much stimulus as to cause a dreaded bubble. This easing is concurrent with the enhanced trade tariff shock from the US.

Are these policies working? If you look at the contemporaneous data on growth, there is an argument that this gradualism is not having a strong impact. The economy may need a bigger boost, but there is the ongoing problem with an excessively credit fueled economy. The addicted economy needs continual fixes to just stay the course. Nevertheless, these internal issues do not change the need for investors to watch China monetary policy closely.