Out of the Box: Lower Yields are Center Stage
San Francisco Fed President, Mary Daly, recently said that the U.S. central bankers are currently debating whether it should confine its controversial tool of bond buying to purely emergency situations or if it should turn to that tool more regularly. “In the financial crisis, in the aftermath of that when we were trying to help the economy, we engaged in these quantitative easing policies, and an important question is, should those always be in the tool kit, should you always have those at your ready, or should you think about those are only tools you use when you really hit the zero lower bound and you have no other things you can do,” she said. Then she stated the almost unthinkable, from a few months ago, “You could imagine executing policy with your interest rate as your primary tool and the balance sheet as a secondary tool, but one that you would use more readily. That’s not decided yet, but it’s part of what we are discussing now.”
Chicago Fed President Charles Evans has said, this week, that even two rate cuts might not be enough in the long run, given low inflation and global trade tensions. While traders are pricing in a 100% probability of an interest rate cut, opinion remains divided on how deep the easing will be as 28.7% of traders are currently expecting a more aggressive cut of half a percentage point.
It is clear, to me, that the notion of “global trade tensions” is just a ruse. I think the acute pressure, on the Fed, actually comes from what the other major central banks are doing. They have engaged in a new tactic where monetary creation replaces the traditional methodology of either raising taxes or cutting costs. By doing this they are driving their yields far underground and the Fed, as the central bank of the United States, must do what it can so that America can compete with other nations.
Any move by the Fed, to cut rates, will have a profound influence on both the bond and equity markets, if instituted. It first means that the Fed will always be “IN!” Meaning that the Fed is going to determine, on a constant and ongoing basis, whether Quantitative Easing should be used, for any of a number of reasons. It also means that they Fed will always be in control, because you can’t fight the people that make the currency. You have no chance, none, of going against them, because you do not have the same power that they do, which is to legally print money. They will not go to jail for counterfeiting.
If the Fed does decide to pursue this new strategy it will be a wholesale change in the way the financial system in the United States operates and I think that very few institutions or people appreciates what is taking place or what it will mean to the markets, all of the markets. This new concept dramatically enforces my opinion that interest rates will be “lower for longer and lingering,” for years, if not decades. We are not talking about some academic notion here but a fundamental change in what asset classes will become more valuable, and what asset classes will diminish in value.
The world now has $13.4 trillion in negative yielding bonds and I expect that number to accelerate, as Ms. Lagarde takes over the helm at the European Central Bank. With her installation, probably sometime in September, I believe she will institute another round of Quantitative Easing that will send European yields even further down, from their present, and almost unbelievable, levels. She may also widen the scope to include High Yield bonds, and maybe even equities, if she follows the lead of Switzerland and Japan.
Europe has a particular problem. The governments on the Continent can no longer afford their budgets, their social programs, or the aspiration of the EU without raising taxes, which would cause a major upheaval there, in my estimation. So, they have turned to their central bank to print and print and print to support their desires as an easier methodology than either cutting back their spending or adding to the tax burden of their citizens.
Between the Fed and the ECB, I think American yields will also be heading towards “Zero.” This will have a profound effect on both borrowers and savers as the borrowers benefit including corporate borrowers, the re-financing of both Investment Grade and High Yield bonds, and the American government, who will pay a much lower interest rate on Treasuries. Mortgages will get re-financed in droves, I believe, and it will be a positive for individuals with student loan debt, equity lines of credit and any debt that is pegged to LIBOR or any other of the floating rate Indexes. REITs, in my opinion, will also gain from the Fed’s new strategy and whether it is a single REIT, or a closed-end fund of REIT’s, as both classes of assets should benefit as they can re-finance their debt at lower and lower rates.
On the negative side will be the Pension Funds, that will adversely be affected by a prolonged period of low interest rates. It will also make it more difficult for retirees and senior citizens who depend upon their cash flows, to lead their lives. It may force both of these groups to make riskier bets to maintain their cash flows, their streams of income, and I expect just that to happen. Also, Zero, or close to Zero rates, will have negative effects on insurance companies and the banks, as their spreads will drop to a fraction of their normal returns.
Even in a slowing economy, with questions about tariffs headlining the Press, lower interest rates may neutralize, or even more than off-set, these other issues. It has been 10 years since the financial crisis of 2008/2009 and the central bankers may finally have learned some lessons. The primary lesson here is that lower interest rates can drive economic expansion and that the Fed, as well as other global central banks, can totally control the level of interest rates, and hence borrowing costs, by the way that rates are handled.
“Immense sums of interest” may be saved here, if the Fed adopts these new principles. The key issue for investors is going to be who is going to be the beneficiaries and who will be the losers. The assumed answers will no longer suffice, as we have never been in the position before where a handful of people, not elected by anyone, control the purse strings of the world.
Mark J. Grant
Chief Global Strategist, Fixed Income
B. Riley FBR Inc.
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