Out of the Box: The Tour de “Force”
Make no mistake in your thinking. The nations of Germany, France, the Netherlands, and the rest of the European Union, along with Switzerland, and Japan, are “forcing” the Fed into a corner without any real escape. To begin with, the Fed, by its charter, is an “Independent Entity” created by the Federal Reserve Act of 1913. The Fed, without doubt, is part of the government of the United States and its mandate can, and has, been changed several times, over the years, by Congress. Yet, from inception, and right up until this day, the Fed can make its own decisions, while the President, or any Senator or Congressman, can offer his opinion on what they are doing. This is the set up in America.
Having said all of this, this is “not” how the world’s other central banks operate. They are captive institutions, without the same kind of “Independence,” and they report directly to, and take orders from, their respective governments. So, when you see the ECB lowering rates, or buying both sovereign and corporate bonds, it is at the direction of the various nations in the European Union. The same can be said of Switzerland, and Japan, as the governments are telling their central banks what they want done. In essence, the central banks, in most of the world, are nothing more than a smoke screen for the nations they represent.
So, now in Europe, we have realized the Alchemist’s dream. Money from nothing but keystrokes. What has happened, in Europe, that no one wants to discuss, is that their government budgets, their social programs, their costs of belonging to the European Union, can no longer be afforded, and so they learned from the financial debacle of 2008/2009. What they learned is that they can get away with negative yielding bonds and so they keep the ECB pumped up and buying more and more sovereign and Investment Grade bonds.
Today, half of all European government bonds have a negative yield, with the total amount having almost doubled, since the end of January, according to data from Tradeweb. In fact, in the EU now, one third of all European Investment Grade bonds, and one third of 1-2 year European BB- rated bonds now yield less than Zero. Then, as shocking as that may be, it pales in comparison with the Swiss Corporate IG market, where 83% of those bonds yields less than Zero.
“What is coming next,” you may ask and I’ll tell you. Christine Lagarde is likely to be voted in by the EU Parliament as the next Chief of the European Central Bank. She is quite adept at bowing to her Masters’ wishes which, in this case, are Berlin and Brussels. Consequently, there will be more Sub-Zero debt in Europe in both sovereign and Investment Grade Corporates and even some chance that they will widen their net and head into High Yield Bonds or possibly even equities along with the Swiss Central Bank and the Bank of Japan. There is just no end in sight, as the ECB supports each and every nation in the European Union with money made from nothing but thin air. No new taxes required.
Globally, there are now $13.4 trillion of negatively-yielding bonds which is 24.5% of the total universe that consists of $54.6 trillion of government, corporate and securitized bonds. So, here is the rub, this puts tremendous pressure on the Fed, and on the currency markets, as the collateral damage is the EU, Switzerland and Japan are going head to head with the United States by utilizing this kind of disruptive central bank behavior. President Trumps comments or not, at some point the Fed is going to have to respond to global yields that are so much lower than yields in America. The Fed, in my opinion, is going to get “Forced!”
|U.S. High Yield||5.88%|
*All data from Bloomberg
These kinds of spreads, in my view, are just not sustainable. Treasuries are 78% higher than their European counterparts while even in High Yield, the U.S. has yields that are 35% higher than European ones. Then, factoring in that the ECB is highly likely to start cutting rates again soon, and lowering yields even further, the pressure mounts ever higher on the Fed.
The Heat is On!
I make the point, since is the Fed is a part of the American government, that the biggest beneficiary of lower yields is the U.S. government since the debt of the country is the amount of the debt multiplied by the interest rate it has to pay on it. The other beneficiaries are borrowers, of any sort, including corporations, individuals, mortgage holders, student loan debtors, stock buyback programs and private equity firms. The losers are savers, banks, insurance companies, pension funds, retirees and other corporations or individuals that relies upon income for their sustenance. Lower yields will also push everyone out of bonds and into equities and Real Estate as speculation will overcome “Cash Flows,” and bond yields, in a major fashion.
This will all go on until one of two things happens. First, you could see the currency markets getting hammered, as people and institutions respond to what is going on in Europe and Japan. Then, second, you could get to the point where lower interest rates no longer stimulate “risk assets” and you could see a blow-out in equities and Real Estate as a result. There is a point, a line, where lower interest rates no longer support “appreciation plays” and, if we get here, it will be one Hell of a bubble that gets popped.
For now, carry on. For the future, keep a wary eye wide open!
Mark J. Grant
Chief Global Strategist, Fixed Income
B. Riley FBR Inc.
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