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‚Äôs 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.

The Dollar and Deflation

Written by Bruce J. Clark

April 29, 2019

Friday’s better than expected number for first quarter GDP may be dominating the headlines but it’s the report on Personal Consumption Expenditures that is driving the market reaction. Prices paid by consumers for goods and services, excluding volatile food and energy components, fell sharply in the first three months of the year, extending a decline that began at this time last year (see chart below.) The big drop in US bond yields on the week despite otherwise good news for new home sales, durable goods orders and growth, in general, is a sign that global deflationary forces are gaining an upper hand.

It wasn’t supposed to be this way. In theory, robust growth, rising wages, and full employment create greater aggregate demand that leads to higher prices and higher inflation. Ever since the Fed began raising rates in 2015, tighter monetary policy has been predicated on this basic economic assumption.

The disconnect isn’t limited to the US. Some foreign central banks are beginning to panic as inflation fails to respond to years of stimulative policy. This past week Japan and Sweden joined a growing list of countries putting off any chance of rate hikes in 2019. See here: https://reut.rs/2GI0gjI and https://reut.rs/2IUj6pv . The problem is that like Europe and Switzerland, they too have already imposed negative interest rates and are running out of options to kickstart growth.

Credit to the Fed for pursuing a course of policy normalization over the past few years. They planned ahead. Part of the rationale for raising rates was to make room for rate cuts in the event of a slowdown. While this gives the US a distinct economic advantage on the world stage it doesn’t necessarily mean it will produce a happy ending.

As I mentioned in (See “Good news, bad news) the downside in this scenario of divergent global growth is that it will drive the dollar higher against the world’s other currencies. In fact, it has already begun. While the equity markets are still celebrating a good Q1 earnings season, the risk going forward now shifts to the negative impact a stronger dollar will have on the bottom line as it makes American exports less competitive. It also starts to turn the screws on entities that leveraged cheap dollars at low rates during a decade of Fed largess. In my opinion, the aggregate short exposure to the USD is grossly underestimated.

The most efficient way to express the view of intensifying deflationary pressure is to own both the dollar and treasuries. The 2-year sector is especially attractive as a play on possible rate cuts and as the flattening trend in the yield curve of the last couple of years begins to reverse (see chart below).