Going Negative

Photo by Ussama Azam on Unsplash

Debt deflation starts the U.S. on a path to negative interest rates

Written May 10, 2020

Last week, for the first time in the country’s history, the financial markets began discounting the possibility of negative interest rate policy.  

On Thursday, the December Fed Funds futures contract settled above par (100.00), implying that traders have moved beyond talking in the abstract about negative interest rates and started betting with real money that the Federal Reserve will be forced by events into crossing a line they’ve long insisted they would not step over. 

Japan, Europe, Switzerland, Sweden, and Denmark currently have negative interest rates, policy legacies left over from fighting the last recession in 2008. The theory was that people would be so repulsed by having to pay a bank to hold their money that they would gladly spend it instead, stimulating the economy in the process. It hasn’t exactly worked out that way.

Rather than driving consumer demand, negative interest rates have resulted in a minefield of unintended consequences. Besides the lack of confidence it conveys to the public on behalf of impotent policymakers, it has clogged the banking system and perverted the lending process.

Count us among those who previously thought there was little chance that the Fed would follow the rate policies of its Japanese and European counterparts. But as we recently wrote in “The L-Shaped Recovery“, the pandemic has exposed and accelerated the threat of debt deflation that could end up triggering waves of bankruptcies.

The deflationary scenario was brought into stark relief after we recently came across a chart overlaying the Economic Cycle Research Institute’s Weekly Leading Index (WLI) with the US consumer price index (see below). As the name suggests, the WLI anticipates economic activity 2 to 3 quarters in the future. If the correlation with the CPI holds, it means prices could begin dropping later this summer.

Just as the value of debt falls in real terms in an inflationary environment, it rises in deflationary times. The problem is compounded by declining cash flows as a result of weak economic activity, making it harder to service that debt and potentially creating a serious problem for highly leveraged economies like ours.

The other moving part in the relationship between debt and deflation is the U.S. dollar. If the Fed’s policy rate is anchored at zero and market yields can’t keep pace with falling prices for goods and services, real yields (the nominal yield minus the rate of inflation) will rise, driving the dollar higher and depressing the price of imports domestically and commodities globally. As we said in “The Biggest Trade in the World“, “the risk to the broader economy is that a stronger dollar triggers a doom loop of debt deflation, where slower global growth causes the dollar to rise and a stronger dollar, in turn, depresses prices and causes growth to slow.”

As has been the case with every rate cut in this cycle, the market will lead the way for the Fed’s next move. And given the risk that rising real yields could pose to the prospects for a recovery, investors are concluding that the Fed may have no choice but to take rates negative.

Besides being long-time proponents of the U.S. dollar and front-end treasuries as core investment themes, we recently recommended adding a position in physical gold. Gold may be subject to bouts of selling if the dollar continues to rise, as many traders still reflexively see the two as inversely correlated. But because there doesn’t seem to be any limit on central bank money printing, gold will shine as the ultimate store of value in a world of increasingly negative interest rates.

Economic Cycle Research Institute Weekly Leading Index vs US Consumer Price Index. Chart courtesy of Real Vision.
December 2020 Fed funds Futures, trading above 100 for the first time ever and implying negative policy rates in the U.S.

Stall Speed

The Fed’s foot is on the gas but the economy is losing altitude

Photo by Richard R Schünemann on Unsplash

Investors have gone all-in on the bet that the Fed and its central banking colleagues abroad will be successful in turning around a slowing global economy. The melt-up in the S&P since early last month is like Wall Street’s version of pushing your chips to the middle of the table. It’s not really surprising seeing that in October the Fed, the Bank of Japan, the European Central Bank and the People’s Bank of China all expanded their balance sheets for the first time in more than two years, giving the markets a massive shot of adrenaline.

As far as actual economic results, there aren’t many green shoots to be found around the world. Last week the U.S. reported unimpressive Industrial Production and Retail Sales numbers, dragging the Atlanta Fed’s widely watched U.S. GDP tracking model down to just a 0.4% pace for the current quarter. See https://bit.ly/2r3ifvH. China also had poor production and sales results. Japan’s economy is growing at only 0.2% and Germany just barely avoided recession with a 0.1% growth rate. Not an encouraging picture.

Given all the monetary firepower that the central banks have deployed over the past decade, they don’t have much to show for it. But the thing that sticks out to us, and the real threat to the global economy is pictured in the chart below. Despite the appearance of policy success as reflected by rising equity prices, corporate bond defaults are actually increasing. If the policy was working, that wouldn’t be happening.

The Fed can’t stop the deterioration in credit. Chart courtesy S&P.

We have written extensively on the danger that a deteriorating credit sector poses for policymakers. (See Time to BBBe Careful). Recently the IMF raised a red flag on the state of U.S. corporate risk-taking and declining leveraged loan quality. See https://bit.ly/35m9DPL. They ominously predict that in the event of an economic downturn “corporate debt at risk of default would rise to $19 trillion, or nearly 40 percent of the total debt in eight major economies.” Yes, that’s trillion with a ‘T’. The IMF also noted that “surges in financial risk-taking usually precede economic downturns.

To say that this is potentially a massive problem is the understatement of the year. The market, in this case the corporate bond market, has officially become the economy. An explosion in global debt pushed by extreme central bank policies since the 2008 recession is a burden that steals from future growth, meaning that a simple economic slowdown carries not just cyclical but systemic risks of default. It is the Fed’s greatest nightmare. And they can’t allow it to happen.

Rather than seeing the Fed’s actions for what they are, an act of disaster prevention for the credit markets, many investors are taking the dynamic of falling rates as a cue to pile into riskier trades. There’s an unshakable faith that the Fed will allow no harm to come to them. It seems like a misreading of macro conditions to us, and an unwise strategy after a 10 year-long bull run, but for now the market obviously disagrees.

It’s gotten so crazy that even one of the world’s largest mutual fund companies is urging baby-boomers to lay off the stocks. According to Fidelity Investments, more than one-third of boomers (born 1944-1964, and entering retirement) have a greater than 70% allocation to equities, and one-in-ten were invested entirely in stocks. See https://bloom.bg/2pxjvXu. This has disaster written all over it when the market eventually turns.

We’ve long said that some enormous trading opportunities will present themselves at that point when the markets lose faith in the Fed and realize that current policies will fail to stop the rot. We’re not there yet, but it’s getting close. In the meantime take the market rally as a gift to raise cash, and stay long the front end rate complex.

Jaws 2

Diverging paths of the economy and the market continues to be a study in contradictions

Photo by Viktor Talashuk on Unsplash

In the weeks since our last comment the major central banks, led by the Fed, have ridden in hard to try and extend the life of what is already the oldest economic expansion in history. A confluence of declining corporate earnings forecasts, weakening industrial and retail activity, and persistent funding shortfalls in dollar-based securities markets has forced the Fed to administer CPR on the financial system. Despite the outwardly calm appearance, the Fed is very nervous, literally throwing money at both the economy and the markets in an effort to prevent a downturn in global growth from metastasizing into another financial crisis. Massive levels of debt and leverage encouraged by profligate central bank policies over the past decade now mean that the normal cycles of the economy…and the inevitable periods of weakness…cannot be allowed to play out naturally without risking a complete meltdown in the financial markets. (See BBBe Careful).

In October alone the Fed restarted their balance sheet expansion, ramped the daily overnight repo financing allocation and cut rates for the third time in four months. It’s a veritable fire hose of liquidity that pumps between $60 and $100 billion per month into the marketplace. It’s also a dead giveaway that everything is not fine. Former Dallas Fed advisor Danielle DiMartino-Booth aptly described the state of play as the Fed trying to “suppress the unknown, that at its best is credit volatility and at its worst systemic risk.”

So far the deluge of liquidity, at least initially, seems to be having the desired effect. Like every other time in the last eleven years that the Fed has fired up another round of quantitative easing, regardless of prevailing economic trends, record highs in the S&P were all but certain to follow. This time is no different. And almost as if the third consecutive quarterly decline in year-on-year corporate earnings don’t matter. The title of our recent piece ‘Liquidity Trumps Fundamentals‘ speaks for itself.

Don’t be fooled by Jay Powell’s attempt at downplaying the need for future rate cuts and reassuring investors that the expansion still has legs. See https://on.wsj.com/2pTHtfE Having to hit the panic button after nearly a decade of policy stimulus is definitely not a position in which anyone on the board of governors thought they would find themselves. It’s becoming abundantly clear that without a major reset in asset prices and a restructuring of the role of the central banks in the markets, rates will never be normalized. The Fed is headed into a policy cul-de-sac from which there is no exit. Like an addict, they’ve hooked the markets on easy money. Make no mistake, the minute stocks stumble, rate cuts will be back on the table. As much as they’d like everyone to believe it, this is no simple mid-cycle policy adjustment. It’s a one way street toward zero interest rates. If there’s a lesson from the past year, it’s that the economy remains vulnerable and that the bull market in equities and credit is not self-sustaining without the Fed’s foot firmly on the gas.

Presumably, corporate CEOs get this. These are the guys making decisions on hiring and capital investment. The latest survey of CEO confidence is shockingly bad and contrasts starkly with optimism among consumers (see charts below). Visually, the surveys are very similar to the chart that became popular several months ago comparing opposing trends in equities and bond yields. Coined with the name “Jaws” it illustrated two major financial benchmarks projecting distinctly different economic outcomes. (See “Jaws” Could Take a Bite Out of Markets). Which indicator is ultimately proven right (bonds or stocks) remains an open question. The two charts below from The Conference Board on confidence reveals a similar contradiction. History shows two things: 1) CEO confidence leads consumer confidence and 2) a sharp deterioration in CEO confidence has immediately preceded each of the last five recessions (the gray shaded areas). But as with the original Jaws chart, which side is ultimately right and how these normally correlated, but currently divergent, trends snap back into line is yet unknown.

Our preference is to bet on the side of history. The heavy dose of hopium from coordinated central bank intervention driving stocks and bond yields higher in the past few weeks will fade in time. It’s another sugar high. We have been long the front end U.S. rate complex for all of 2019 and still see this sector as the most effective play on slowing global growth. The Fed has a trigger finger with respect to cutting rates. Be patient, but the widespread position flush underway in the bond market this week is an excellent opportunity to reload those long positions between now and year-end.

Jaws 2. CEO and Consumer Confidence telling different stories. Shaded areas are recessions. Courtesy Quill Intelligence

Or, expressed another way:

Record discrepancy between corporate and consumer confidence. Shaded areas are recessions. Courtesy Deutsche Bank Global Research
Dec 2021 Eurodollar future. Approaching support.

Tipping Point

Declining economic growth may become too much for equity markets to ignore

Photo by Michał Parzuchowski on Unsplash

Written October 2, 2019

Yesterday’s sharp deterioration in risk sentiment is a sign that the equity market and its patrons at the Fed may have a couple of serious problems: 1) The latest numbers from the Institute for Supply Management (ISM) suggests the US economy may be close to, or already in recession and 2) the Fed has been too slow to recognize it. Neither of these issues is exactly new news but the stock market’s seemingly oblivious reaction to the growing danger has been nothing short of remarkable. Until now.

The continued erosion of benchmark ISM survey data on U.S. manufacturing, its worst reading since 2009, was punctuated by a complete collapse in the forward-looking new export orders component. See https://bloom.bg/2oWfXgK. The disruption in commerce and global supply chains from trade wars is real and intensifying. Similarly, contractionary readings on factory production from China and Europe this week only added to the recessionary drumbeat.

It is undeniable that the Fed underestimated the deceleration in the economy. Their hesitancy to ease when signs of economic weakness first appeared earlier this year probably means that a recession is now inevitable. They missed the boat. Even if the Fed cut rates aggressively now it may not matter. And that possibility is starting to occur to investors who had come to rely on the Fed as a consistent backstop for asset prices.

It feels like the markets are at a tipping point. The major central banks have spent a decade throwing trillions at the economy and have little to show for it except for unprecedented levels of income inequality. But it hasn’t stopped them from pressing forward with more of the same policies. The renewed race to the bottom on interest rates is becoming less effective while at the same time increasingly desperate.

The failed WeWork IPO might have rung the proverbial bell in this era of easy money and stretched valuations. Fundamentals matter. Earnings, which they clearly don’t have, matter. Like Pets.com, the poster child of absurdity from an earlier bubble, WeWork will go down as an example of “what were they thinking?” for years to come. See https://bit.ly/2nE1y8N.

As I noted in my two previous pieces (see VIX Cheap as Impeachment Threat Grows and Liquidity Trumps Fundamentals), the most obvious trades in this shifting paradigm are to be long volatility and long the front-end rate market. Historically, October is more volatile than most other months. And the lurch lower in key economic data points could be the catalyst that makes volatility in equities, bonds, and FX all suddenly appear to be ridiculously underpriced.

Furthermore, anyone who doubts that the Fed could take rates back to zero, and quickly, has not looked at the U.S. dollar. The growing global dollar shortage, which we’ve written about extensively, is pushing the buck up through multi-decade resistance (see Fed Rate Cut: Too Little, Too Late). The long term dollar index (DXY) chart is very bullish, and if the USD gets legs it will make the 2018 emerging market selloff look tame by comparison. The Fed can’t afford for that to happen and will be forced to keep cutting rates to try to prevent it.

US dollar index (DXY). Breaking out higher.
Emerging market ETF (EEM). Look out below. A stronger USD leaves this sector very vulnerable.
CBOE volatility index (VIX). Cheap and bullish.

Liquidity Trumps Fundamentals

Inadequate funding a potential problem for markets

Photo by Robin Spielmann on Unsplash

Written September 26, 2019

Just like the equity market’s general complacency over the uncertainty created by a potential presidential impeachment, it is exhibiting a similar lack of interest in the ongoing liquidity squeeze in short-term funding markets.

A sharp spike in overnight financing rates last week due to a scarcity of bank reserves was initially dismissed as an unexpected confluence of technical factors.  Everything from quarterly tax bills, treasury auction settlements, and principal and interest payments were blamed for draining an unusual amount of money from the system and causing an acute shortage of free reserves.  Overnight rates were said to have traded as high as 10% before the Fed was forced to step in with emergency funds.  The panic passed but the underlying problem hasn’t gone away.  Lots of confusion still hangs over the money markets.  Financing remains tight, enough so that the Fed has had to supplement the system with cash every day since.  This is not normal and the longer it goes on the explanation that it is merely a temporary quirk becomes less credible.

As of now, the consensus opinion is that this problem will fix itself simply by a turn of the calendar past quarter-end (September 30).  That seems to be a big leap of faith.  In a Bloomberg piece today former Minneapolis Fed President Narayana Kocherlakota says that regulatory changes after the 2008 crisis, like more stringent capital and leverage requirements, have restricted the amount of free reserves in the financial system and banks’ willingness to lend those reserves among themselves. See https://bloom.bg/2mGcO3B. None of this was a problem while the Fed was expanding its balance sheet and providing almost limitless liquidity.  Only when the Fed began to shrink its balance sheet a year ago did this unintended consequence emerge. 

The explosion in the issuance of US dollar-based debt, both domestic and foreign, during the previous decade of easy money policies created a massive need to finance that debt.  What has now become obvious is that without additional liquidity provided by the Fed, there just aren’t enough dollars in the system to go around. Kocherlakota notes that “the financial system is acting like it has $1.3 billion in excess reserves rather than the actual $1.3 trillion.”

This means the Fed can forget about any plans they might have had for normalizing interest rates and reducing their balance sheet.  Quite the opposite, it slants the probabilities in the direction of even lower rates. The problem in the money markets is structural and has disrupted one of the financial markets’ most essential functions.  Until they figure out how to fix it, simple liquidity will become an ever-important consideration for investors.  Fundamental investment strategies don’t matter much if they can’t be financed.

The fourth quarter of 2019 will see two issues elevated that were not big considerations in the current quarter: domestic political uncertainty and liquidity uncertainty.  These factors should lead to a general increase in market volatility as well as heightened concern over funding availability. This will almost certainly force banks and asset managers to begin paring back positions for year-end earlier than ever. Additionally, rate cuts at Fed meetings in October (Oct 29-30) and December (Dec 10-11) will be in play as the Fed seeks to offset the slowing economy and keep funding pressures contained. 

The two simplest trade opportunities are 1) long equity volatility such as the VIX (see VIX Cheap as Impeachment Threat Grows) and 2) long Eurodollar interest rate futures, such as the Dec 2021 contract.  Policy rates in the U.S. are on their way to zero and there’s a lot left in this trade.

December 2021 Eurodollar Future

Fed Rate Cut: Too Little, Too Late

Strong dollar poses risks for reluctant policymakers

Photo by Colin Watts on Unsplash

August 4th, 2019

The Fed cut rates by 25 basis points (one-quarter of a point) last week, as expected, amid signs of slowing global growth. Chairman Jerome Powell tried to reassure investors that the economy was still on solid ground and that the move was merely a “mid-cycle adjustment”, not the beginning of a prolonged easing cycle. Don’t bet on it. Persistent strength in the US dollar is both a sign and a reason why a recession is closer than they think.   

As we’ve noted repeatedly here before, the US dollar is the Achilles heel of the international financial system. Through their easy-money policies in the wake of the 2008 recession, the Fed encouraged a massive buildup in leverage by both sovereign and corporate entities. Unfortunately, to service that debt borrowers are negatively exposed to any decrease in the supply or increase in the price of those dollars.

In the past year, slower global growth, declining international trade volumes, tighter US monetary policy and a reduction in the Fed’s balance sheet have all contributed to a reduction of dollar liquidity in funding markets. This fundamental shortage of dollars has driven its price higher on FX exchanges. In 2018 a strong dollar roiled the markets (especially emerging markets) before the Fed was forced to pull the plug on its monetary policy normalization plans in the hopes of capping the currency’s rise. It worked, barely. After pausing for a couple of quarters the dollar is on the move again as the global shortage intensifies. See https://bloom.bg/2YnU5fh. The path of least resistance is clearly higher, perhaps significantly, and it’s going to take a lot more than one rate cut to turn it around.

Compounding the dollar squeeze is the current budget bill crafted by congress, which eliminates the debt ceiling for the next two years and allows US government spending to increase virtually unchecked. To meet these new financing needs it is expected that over the next several months the treasury will need to raise $250 billion in fresh cash, further draining the supply of dollars in the system. See https://on.wsj.com/2SXVJOE.

Despite the shift toward easier monetary policy, the broad dollar index (DXY) climbed to its best level in two years. The FX market’s message to the Fed is unmistakable: the cut in rates was too little, too late. The risk for policymakers from here is that a stronger dollar will create deflationary headwinds, possibly tipping weak economies into recession, and force the Fed to cut rates deeper than they’re willing to admit.

The US dollar, breaking out.

Powell Plays for Time

The Fed’s unspoken hope is that lower rates will keep the credit market from crumbling.

Photo by Adi Goldstein on Unsplash

July 15, 2019

Something doesn’t add up. Last week the Fed chairman Jerome Powell went before Congress to say that while the economy remains on “solid footing” it might need some assistance in the form of lower interest rates. It was barely six months ago when he was using similar language to advocate for higher rates. It makes no sense to pitch for easier monetary policy amid a hot labor market and record highs stock prices, but that’s exactly what Powell did.

The Fed chairman referred to economic headwinds blowing toward the US from abroad due to weakening global growth and disruptions in international trade. These pressures are real but hardly justifies the abrupt U-turn in Fed policy this year. It has to be something more than that.

Although Powell didn’t address it directly, the simplest explanation is growing concern over the state of the credit markets. As we wrote in “BBBe careful” one of the unintended consequences of easy money policies has been the explosion in debt, especially among weaker credits (lower-rated companies.) Despite a decade of massive monetary stimulus, the aggregate corporate credit profile has fallen well short of growth trends in the economy. In fact, half of the $5 trillion investment-grade bond universe is now rated just BBB, one notch above junk status.

It’s an understatement to say that this is an accident waiting to happen. It is quite literally a cliff edge, where even a handful of ratings downgrades could quickly create a feedback loop of forced liquidation by funds that are prohibited from owning junk, spreading outward and turning a simple economic slowdown to into a financial crisis.

The only option the Fed has is to play for time, massaging investor sentiment with the prospect of lower rates, maintaining ample liquidity and hoping (!) that growth will recover enough to feed through to corporate balance sheets. But considering that the current expansionary cycle is now already the oldest on record the odds are against it. Second-quarter corporate reporting season begins this week and will give us a look at whether the Fed-inspired exuberance in equities is matched by actual earnings.

Don’t underestimate the downside potential for interest rates. The Fed knows the credit market is the monster in the closet and is preemptively setting the stage for rate cuts despite the lack of any significant stress on the system. They are teed up to ease quickly and aggressively at the first outward sign of trouble. Whether the Fed has enough ammunition to alter the outcome under that scenario remains to be seen but given that the starting point on this next rate-cutting cycle begins with a policy rate at just 2.4%, we have our doubts. There is not much room between here and zero.

In April, we recommended owning short (2-3 year) treasuries. See “The dollar and deflation“. It’s still the best trade on the board and has much more to go.

HYG, the high-yield bond ETF. Despite a lot of heavy lifting from the Fed the bounces are getting smaller.

Pushing on a String

Lower rates may not bail out the economy this time around

Photo by Tara Evans on Unsplash

June 29, 2019

Looking back on the best performance for the S&P in the month of June since 1938 reveals a familiar pattern: economy shows signs of slowing, earnings outlooks decline, equity market stumbles, Fed rushes in with the promise of easier policy, market rallies to new record (again)…problem solved. Completely predictable, and almost comical at this point. There aren’t many people left that think that the Fed’s real mandate of fostering maximum employment and price stability hasn’t taken a back seat to maintain the appearance that everything’s fine through higher stock prices.

How many times can they keep running the same play? Right now investors still seem willing to believe that the Fed can extend the business cycle forever, but it does beg the question of whether the economy and the markets are even viable without support from the central bank.

The big issue in front of us is whether another round of rate cuts can rescue the economy? It might. But the next big trade is going to be recognizing that tipping point if and when the markets and economy fail to respond.

Next month the current expansion will become the oldest on record. Investors need to start worrying about the marginal effectiveness of any potential rate cuts this late in the cycle, especially now that yields globally are already at rock bottom. Lower rates almost certainly aren’t the answer to a system choking on debt from the past decade of easy money, but apparently, that won’t keep policymakers from offering it up again. The minute the markets realize that the Fed and other central banks are shooting blanks the entire game changes.

Which is why housing data is worth paying attention to. Over the past week, a series of reports on pending, existing and new home sales showed a continuation of weaker year-over-year trends despite the stimulus normally associated with declining mortgage rates. It might be an early and important sign that aside from the raging bull market in equities, demand in the economy is slipping and becoming inelastic to the level of rates. See https://cnb.cx/2IHmcfT . So even if the Fed embarks on another round of rate cuts they may find themselves pushing on a string.

New Home Sales (blue) and 30 year mortgage rate (green and inverted). Chart courtesy Zerohedge.

‘Jaws’ Could Take a Bite Out of Markets

Stocks and bonds both can’t be right on the economy

Photo by Clint Patterson on Unsplash

June 24, 2019

Wall Street has coined a term for the opposing economic messages being sent by the bond and stock markets: Jaws. Look at a simple chart (below) with the S&P overlayed on the benchmark 10 year Treasury note and you’ll see what I mean.

It refers to the yawning gap that began to widen early this year as a function of sharply higher equity prices and collapsing bond yields. One side suggests a boom and the other signals recession. Describing it is the easy part, guessing how it turns out is not. Both can’t be right.

The image of “jaws” also infers a danger to investors from a trap created by conflicting narratives that will inevitably snap shut, in this case as the macroeconomic state of play becomes clearer. But from which direction will the jaws close and who is most at risk? Will the economy take off or hit a wall? Will bond yields rise or will stocks succumb? We don’t know yet. Presently, both markets trade well and with the confidence that they represent the winning side.

Jaws is a reaction to 1) slower growth and 2) the Fed’s anticipated response. There’s no doubt that the global economy has been knocked off it’s footing by disruptions in international trade. In the US, it also suffers from old age. Next month the current expansion, that began in June 2009, will officially become the longest on record. Bond yields have fallen sharply as the possibility of a recession appears on the horizon, accelerated by these and other headwinds created by sub-par economic activity worldwide.

On the other hand, equity markets have enjoyed an impressive recovery since the Fed called off plans for tighter monetary policy back in January. The S&P spiked to fresh record highs last week after Fed chairman Powell went a step further and all but promised to begin cutting rates again. See https://bloom.bg/2WLgykO .

As I see it, the risk inherent in the jaws trade is that the prosperity projected by the equity markets is becoming more illusory, when in reality the economy and the markets are only viable when the Fed is backstopping them. All-time highs in stocks seem strangely disconnected from the expectation that more than half of the sectors in the S&P 500 are set to report negative growth in this current quarter.

In the last 50 years, only a quarter of all recessions were averted by easier monetary policy. Investors feeling confident that Chairman Powell has their backs may be overestimating the capabilities of the Fed to sustain a business cycle that is already past its sell-by-date.

JAWS. Competing outlooks from stocks and bonds.

Fed Set to Join Race to The Bottom on Rates

Increasingly negative yields in Europe and Japan weigh heavily on Fed policy

June 19, 2019

Photo by Braden Collum on Unsplash

Five years ago this month the European Central Bank made the desperate move of imposing negative interest rates in an attempt to spur growth and generate price inflation. It didn’t work. Economic activity on the continent now is barely noticeable, the banks are teetering and market-based inflation expectations are the weakest on record.

European bond yields are literally collapsing in a panic after European Central Bank president Mario Draghi revealed his latest prescription for growth: do more of the same. Because current policy obviously isn’t extreme enough the ECB thinks even deeper negative rates will certainly do the trick. Genius. Yesterday the benchmark 10yr German bund traded at -0.32 bps and similar yields in Poland, Sweden and France hit zero for the first time in history. Negative yielding bonds worldwide, mostly in Europe, now total about $12 trillion. What’s the goal here? How are banks ever supposed to profitably lend money with such a distorted yield structure? It has long been suspected, but today’s events confirmed that Draghi and the ECB are officially out of ideas. Europe is toast.

A similar experiment in Japan also failed miserably. The widely touted “shock and awe” scheme by the Bank of Japan in January 2016 also included a move to negative rates, which in theory was supposed to boost the economy by discouraging saving and encouraging spending. It didn’t turn out that way and the country remains trapped in a decades-long deflationary decline. A recent Reuters report claims that BOJ insiders knew immediately that the move to negative rates was a mistake. Despite the fact that they have nothing to show for it after three and a half years, the policy is still in place. See https://reut.rs/2Il0Sww .

This should be a lesson to all investors as the Fed stands poised to begin another rate cutting program of its own, possibly as soon as next month. While it’s becoming apparent that what ails the economy is moving beyond the reach of traditional policy remedies, central bankers like Mr. Draghi and Mr. Kuroda (of the Bank of Japan) are still fighting the last war. We assume that the Fed would never follow their lead and take US rates negative but who knows? The Japanese and the Europeans probably never thought they’d end up in their current predicaments either.

The last Fed easing cycle started in 2006 with an overnight rate of 5.25% before falling to 0% by 2008. This time around, if rates are eased again, the starting point will be less than half that, at only 2.4%. If the Fed feels compelled to ease policy every time the equity market gets in trouble, we’ll be at that zero threshold soon enough. In fact, some astute Fed observers think that chairman Powell’s recent reference to the downside limit on policy as being defined by the “effective lower bound” rather than a “zero lower bound” cracks the door for rates below zero. We’ll see.

Predictably, stocks are loving the possibility of lower rates but are we somehow supposed to feel good about all of this? It ignores the reason why an easier policy is back on the table in the first place. How long can we play the “bad news is good news” game before bad news actually becomes bad news?

As I wrote last week in Aussie-Yen: Currency Canary Keels Over, either growth needs to accelerate or there has to be a reset lower in the financial markets. The contrasting messages coming from the bond and equity sectors are as stretched as at any time in recent memory (see chart below.) One side will ultimately win out, but the waning influence of the central banks definitely poses a risk for growth.

Massive divergence: The S&P and the benchmark US 10yr Yield