via Scotiabank's Guy Haselmann,
“It isn’t that they can’t see the solution. It is that they can’t see the problem.” – G.K. Chesteron
Down Side Up
It has been quite evident that central banks have been hyper-active in their attempts to mitigate the financial crisis and its aftermath. They have also taken a noticeable role in regulatory efforts to prevent a similar future crisis. For several years, their “whatever-it-takes” efforts have rewarded any investor (willing to get in front of and piggy-back off of their policies) with abnormal and outsized returns. However, the flaws in this unwritten and implicit contract are now being exposed.
Having few alternatives, once interest rates were pushed to zero, (we know) central banks had to resort to asset purchases (QE). It should be remembered that QE works by purposefully distorting market prices and altering investor behavior by flooding the system with money. Based on this evaluation measure alone, QE was wildly successful. However, the initial macro benefits are likely to reverse when central banks attempt to extract themselves from this policy stance - because there is ‘no free lunch’.
There is little doubt that investors were lured into playing along by the allure of easy profits through central bank-induced asset price appreciation. Moreover, there was great conventional pressure to outperform peers and benchmarks. Therefore, since being left behind risked job security, it was important to play along.
Central banks were successful at lowering market volatilities and correlations as investors herded into similar trades. As time passed, investors were lulled into ever-riskier assets at higher and higher prices which in turn pushed volatilities lower and lower. The result is a classic set-up for a ‘Minsky moment’ as the risk/reward of holding assets became ever-more skewed to the downside.
Since these QE policies are unproven, untested, and experimental, there are no good ways to measure their long-term success. There is also no way to determine when these policies have gone too far, or even when they have become counter-productive. Certainly, the negative consequences of debt-driven consumption and long-term financial repression have yet to be felt.
Unfortunately, investors have not adjusted adequately as the Fed’s stance has shifted, and as other warning signs have appeared. Complacent investors still remain fearful of ‘missing the upside’. At this point, investors in the US should be more fearful of participating in a downside correction. After all, the ‘Fed’s put’ that has ‘protected’ portfolios has been pushed further and further out-of-the-money, when: 1) the Fed’s balance sheet stopped growing last autumn; 2) the ‘forward guidance’ promises of low rates was removed; and, 3) the FOMC began threatening a near-term hike.
The clearest and most dramatic example of a major central bank policy mistake (so far) was in January when the Swiss National Bank removed its promise of pegging the Franc; which in turn led to a 40% currency re-pricing in 10 minutes.
The ECB announced an aggressive QE program the following week. Its intent was to lower the Euro and lift stock and bond prices. Markets originally moved aggressively as expected; that is, until the past two weeks when dramatic reversals materialized. The Financial Times stated today that, “In 12 days, owners of German benchmark bonds have seen the plummeting price wipe out more than 60 years’ worth of income, as the Bund sees the biggest rout in total return terms since 1994”.
Investors are beginning to question the efficacy of these extreme central bank policies. More are joining the chorus of critics that believe policies have become counter-productive in both the short and long run. If true, it could mean that a Fed hike might come sooner than markets believes; and may occur prior to the arrival of the desired and optimal economic conditions.
There must be a lesson to learn for those investors who blindly follow central bank actions. The lesson embedded in the dramatic re-pricing in European financial markets during the past 12 days may simply be that there are dangers when chasing assets irrespective of price levels. It seems to me that the ability of central banks to generate a Pavlovian or conditional investor response to their policy actions is now rightly being called into question.
The lesson for central banks is that zero or negative yields can cause highly-unstable capital flows. The ECB’s mistake may be that they tried to implement an aggressive and well-advertised QE policy after markets had already pushed yields to absurd and non-economic prices. This demonstrates that there is a practical limit to central bank policies (which may have already been reached). One consequence for markets going forward will be much greater market volatility.
Follow-up, Treasury Market Comment
There were four main causes of low Treasury yields over the past several months: 1) Fed hoarding of securities; 2) regulatory rules requiring bank hoarding; 3) no signs of inflation, and; 4) an attractive yield relative to European debt. A change in one of these factors was necessary for Treasury yields to rise. Factors #3 and #4 changed and Treasuries re-priced accordingly.
Last Thursday morning, I wrote in a “quick Treasury market comment” that Treasury risk/reward remained to the downside in the near term. I wrote the following:
“It wasn't so long ago that Yellen and crew were talking about needing to see wage growth. Well, the ECI wages and salaries increased from 2.3% to 2.6% in Q1 from year ago and 2.8% y/y in terms of private sector wages and compensation. Also, claims are at the lowest level since 4/14/2000 when Funds were 6%. This is happening when Bunds are under strong pressure. Most importantly, all this is occurring one week before a payroll report where the market will be afraid of a strong number....so Treasuries will have a difficult time gaining any traction”.
Tactically however, the risk/reward for re-establishing a long in Treasuries is now much improved.
If today's payrolls data is seen as a strong number...should be good support for 10’s in the mid 2.30’s (i.e., sub 2.40%). By several measures, back-end technicals are already quite over-sold; a move lower would increase that oversold condition. In addition, a strong number should make the curve flatten and cause some ‘risk off’ flight, as the odds of a ‘sooner’ rate hike rises. The dollar should also strengthen, benefiting Treasury bonds over stocks and foreign assets. Therefore, buying that dip may pay off.
If today's payrolls data is seen as a weak number... should also help Treasuries, while the May Treasury refunding (next week) and large corporate issue calendar might allow a reasonable entry level. A weak number may cause a drop in expectations for growth and inflation - supporting Treasuries. A weak number might lead to a further questioning of the effectiveness of central bank policy in general. It could also cause more European troubles, particularly if the Euro is pushed higher.
In addition, the 10-year Treasury bond still yields 160 bps over the comparable Bund. It remains the world’s only safe haven asset, despite the chatter that Treasuries are in bubble territory. The world, no doubt, is in the midst of some great challenges and geo-political tensions.
Greece
The most immediate obstacle (next week) is the negotiation in Brussels between Greece and its creditors. I am not in the camp that there will be limited contagion risk from a default or Grexit as policy makers’ state. I also believe it will be exceptionally difficult this time to find a way to ‘muddle along’.
This past Tuesday the Syriza-led government passed a law that allows them to re-hire 15,000 public sector workers. Those workers were let go as part of the reform enacted by the previous government as a condition of receiving the bailout money. In addition, the Greek government was supposed to have a primary surplus in 2015 of 3.0%, but instead has a deficit of 1.5%. Earlier this week, the European Commission downgraded its forecast for Greek economic growth.
Greece is headed in the wrong direction. I find it difficult to see how Brussels can reach a compromise this time with a government that seems rebellious towards its creditors and unwilling to implement the necessary reforms. After intense negotiations in Latvia two weeks ago, Greek Finance Minister Varoufakis was called “a gambler, a time-waster, and an amateur”. He responded by saying that he “welcomes their hatred of him”.
At a minimum, the ECB may demand (as soon as next week) increases on haircuts for the ELA-posted collateral, and refuse to increase Greek T-bill issuance limits that were requested by Athens. Such ECB actions would mark the beginning of the end of Greece’s membership in the Eurozone.
“The sooner you fall behind, the more time you have to catch-up.” - Steven Wright
