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Out of the Box: The Verdict is In

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After all of the hoopla surrounding what the Fed was going to do, or not going to do, the pronouncement has now been made. The Fed did several things, in actuality. First, it cut interest rates by one-quarter point, as was widely anticipated. This was their first rate cut since 2008 and it marks a benchmark change in the Fed’s outlook and policies. Then, they dropped their range target to 2.00%-2.25%. The Fed also decided to preemptively end its process of shrinking its balance sheet, a process known as quantitative tightening, two months ahead of what they had previously announced so that as of today, 8/1/19, their balance sheet will not be cut further.

Chairman Powell stated, “It’s not the beginning of a long series of rate cuts. I didn’t say it’s just one…What we’re seeing is that it’s appropriate to adjust policy to a somewhat more accommodative stance over time, and that’s how we’re looking at it.”

The Fed also stated that they will now use all payments, from their Agency holdings, to reinvest in Treasuries. In doing so, the Fed hopes to reduce its holdings of debt and mortgage-backed securities in an effort to neutralize its balance sheet with more plain vanilla assets, they said. This is a very significant statement, in my opinion, because it means that Agency securities, of all types, will now widen to Treasuries as the Fed is no longer supporting this segment of the market. For those of you that are Agency buyers I would be taking a hard look at your portfolios as they are going to drop in price, in my view, as they widen to Treasuries. Your free lunch is over.

Personally, I believe that yesterday’s interest rate cut is just the beginning of the Fed’s reversal. My opinion here is not based upon anything that President Trump exclaims or anything that is American centric. One of the biggest errors in judgment, when assessing the Fed, is to assume that it is a stand-alone institution that is somehow above and beyond the other central banks of the world. This is just not the case. In fact, Chairman Powell intoned, several times, yesterday, about the notion of protecting American interests and our economic expansion.

It is my viewpoint that what is happening globally will force the Fed’s hand. The market value of the Bloomberg Barclays Global Negative Yielding Debt Index closed at $14.1 trillion on Wednesday, the biggest one-day jump in a month. In fact, there is now not one country in the European Union with yields as high as American yields including Italy and Greece. The Swiss 10 year now stands at -0.81% and Japan is now -0.14, according to Bloomberg data.

It is fair to say that the United States is now under assault, from many other governments in the world, and that our central bank, the Fed, is going to be forced to respond to protect American interests. As all of this plays out, I also note that the Dollar is gaining strength by the hour as it is now 1.1030 versus the Euro and 109.0035 versus the Japanese yen. This, without doubt, will affect American companies as our exports and imports are very sensitive to interest rate swings.

As the Fed cut rates yesterday, and will cut rates again in September, in my estimation, this sets up a very interesting dynamic. What the Fed, and other central banks are doing, is a boon for borrowers and a tragedy for investors. It will certainly help with America’s borrowings as the yields on Treasuries plummet ever lower as not only motivated by the Fed’s actions, but by the fact that America is about the only place left with positive yields.

The pool of Eurozone government bonds with negative yields has now surged to 4.8 trillion Euros or around 60% of the total, the highest proportion since August 2016. The share of Eurozone government bond yields trading below the European Central Bank’s -0.40% deposit rate has also increased to 42%, up from 36% a month earlier.

The volume of corporate Euro investment grade bonds, with a negative yield on the Tradeweb system, rose to 1.4 trillion euros on July 31, equating to 42% of the market. A year earlier that number was less than half a trillion euros, or 17.9% of the overall market.
We have entered “Wonderland,” I tell you.

UBS just reported that they plan to levy a negative interest rate on wealthy clients who deposit more than SFr2m with its Swiss bank. Several banks in Switzerland, and in the Eurozone, already pass on the cost of negative official rates to corporate depositors. Now with policymakers expected to adopt a “lower for longer and lingering” stance for the foreseeable future, UBS Switzerland will now charge 0.75% a year on individual cash balances above SFr2m. In other words, people will now pay the bank, for accepting their money.

For American borrowers, I say, take what advantage that you can because lower rates will mean more stock buy-backs, more refinancing of both Investment Grade and High Yield debt, lower mortgage rates, lower rates on student loans, and it will be a boon for the REIT’s, and other holders of commercial property, as you will be able to borrow for less and less and less.

The flip side of this coin is that there will be no yield, almost anywhere, for investors. This is a decided negative for insurance companies, the banks, pension funds, savers and retirees, who depend upon yield, and cash flow payments, for their profits and existence. It will be equities “up,” Real Estate prices “up,” other hard assets “up,” as both people and institutions alike are forced into riskier assets in an attempt to cover their expenses.

I do point to one of the last segments, in the markets, that still offer some double-digit yields and that is Closed-End Funds. These securities are complicated and a lot of homework has to be done to separate the wheat from the chaff but, in opinion, it is well worth the time or find someone that is experienced in this part of the markets. Double digit yields here, can be found in the MLP space, in the energy and pipeline space, in some high yield bond portfolios, in some REIT and Real Estate funds and in some hedged dividend plays. Yes, many Closed-End Funds have leverage but I also point out that the leverage is theirs, and not yours.

I also point out that our new negative yield, no yield, almost no yield, environment will eventually play out for “appreciation plays.” This will happen as the effect of lower and lower rates no longer moves the needle as the cost of borrowing no longer helps assets appreciate. We are not there yet, in America, but I can foresee this coming, at some point in time. Well, with all of these negative yields, who knows what is possible any longer.

“For you see, so many out-of-the-way things had happened lately, that Alice had begun to think that very few things indeed were really impossible.”
-Wonderland

Mark J. Grant
Chief Global Strategist, Fixed Income
Managing Director
B. Riley FBR Inc.
Mgrant69@Bloomberg.net
U.S. 954-468-2366

Information herein is for general use; is not unbiased/impartial; is current at publication date, subject to change; may be from third parties; and may not be accurate or complete. Opinions are the Author’s, not B. Riley FBR, Inc., or their respective affiliates or subsidiaries. This is not a research report or solicitation or recommendation to buy/sell the subject securities. Investment factors are not fully addressed herein. B. Riley FBR Inc. and their affiliates may have a proprietary position in the subject securities.
Redistribution/reproduction of this material is prohibited. See additional disclosures at: http://brileyfbr.com/legal/legal_disclosures

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