Out of the Box: At their Mercy
I have long contended that there are no more Bond Vigilantes and that they have been forced to their knees, by the world’s central banks. The paradigm has changed with the control, and dominance, of the only people on the planet that can make money from nothing, but keystrokes, and not go to jail for counterfeiting. It used to be that the central banks were a part of the “Great Game” but now, after the lessons learned from the 2008/2009 financial crisis, these people own the playing field.
Wells Fargo now reports that there are $17 trillion in negatively yielding sovereign debt and $1 trillion in negatively yielding corporate debt. Once, this would have been unthinkable. Now, it is the reality that we face. This has all been caused, in my opinion, by Japan, and Switzerland and the nations of the European Union, who can no longer afford their budgets, or social programs, and so they turn to their central banks to print money, in extremis, buy bonds and drive yields down, so that their budgets could be afforded. No one will admit this, of course, but that is exactly what has happened.
Therefore, we now face two critical junctures. The first being on September 12, when the European Central Bank announces its new policies. I think that a further interest rate cut is inevitable, given the change to rate guidance in July. The size of the rate cut is difficult to predict, with confidence, given the politics of the EU presently. I think the odds are on for a reduction of 20 basis points in the deposit rate, to -0.60%, a slightly larger cut than is currently priced in to the market.
To mitigate the possible negative side-effects, on the banking sector, I also expect the ECB to announce a new tiering framework for reserve remuneration. How they might set this up will be extremely interesting, as the try to protect the European banks and their earnings. I am also expecting a new Quantitative Easing program which may consist of new net asset purchases, of about $33 billion per month, through the mid-point of next year. Here will be another interesting decision as I expect a significant adjustment, on how much sovereign debt and corporate debt can be purchased.
The ECB, you must understand, is not constructed with any kind of “Independence,” like the Fed has in the United States. The ECB operates at the beck and call of the nations of the European Union. There is no “Independence” at all, as in Zero and none. Berlin and Brussels run this show, with various other nations campaigning on the sidelines. Given the precarious situation in Italy, some of the peripheral countries in the EU may get some additional help, in the new QE program and, frankly, I am expecting this result.
The ECB’s forthcoming meeting is also Mr. Draghi’s last turn at bat and I expect that he will open the spigot wide, in his final act. Germany is sinking towards a recession, the Inflation rate in the EU is quite subdued, and far from the ECB’s target, and the keys of the Realm are about to be turned over to Christine Lagarde shortly. Therefore, “shock and awe” may be on the table and it is even possible that the ECB may add equities to its mix of assets.
If some, or all of it, or more than I am expecting, occurs, then watch out for the Dollar. We could have a major move in our currency that may then cause our government to respond. You may think that this is an outlier, but I do not. It all depends on how Mr. Draghi redefines, “Whatever it takes.”
Then, a few weeks later, the Fed will be on center stage as Mr. Powell takes his turn in the big tent. President Trump’s comments, or not, the Fed was set-up by an Act of Congress, the Federal Reserve Act of 1913, and the first words of the Act states that the Fed is the central bank of the United States. Consequently, the Fed is part of the American government and not some off-shore institution protecting the world’s financial system.
I expect, therefore, an interest rate cut of a minimum of 25 basis points, if not 50 basis points, as they must respond to the collateral damage caused by the ECB’s protection of the nations that they represent. The Fed, when all is said and done, in my view, is going to have to respond to protect American interests. They will not cite the EU or the ECB as the reasons, of course, but they will be there, unsaid, none the less.
Also, I continue to project lower yields for American Treasuries and other debt. We are virtually the last man standing with positive yields and the inflow of European and Asian money will continue, in my estimation. Sure, Treasuries will vacillate one way and other, with each new economic announcement, but the general trend is down though, hopefully, not into negative territory.
While so much talk has been centered on Treasuries it is interesting to consider the Corporate Bond market. According to the Bloomberg Indexes, Treasuries have gained 3.55%, in the last three months. During the same time period Corporates have gain 5.15% and it is indicative of where both domestic and foreign money is flowing. Corporates are in compression now, against Treasuries, and you may wish to consider this when you re-evaluate your asset allocation models.
In the meantime, Wonderland continues, and I see no reversal of course on the horizon. With $18 trillion in negative yielding debt today, I think $20 trillion and then $25 trillion is not too far behind. You can say it with certainty:
“It is Different this Time!”
Mark J. Grant
Chief Global Strategist, Fixed Income
B. Riley FBR Inc.
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