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February 5, 2015

Central Banks at Less Than Zero

By Joseph Y. Calhoun, Alhambra Investment Partners
“Where are we going?” I asked
“I don’t know,” he said. “Just driving.”
“But this road doesn’t go anywhere,” I told him.
“That doesn’t matter.”
“What does?” I asked, after a little while.
“Just that we’re on it, dude,” he said.”
― Bret Easton Ellis, Less Than Zero
The title of this post is, obviously, a reference to the state of the global bond market where yields in some countries have breached the zero level once thought to be inviolate. In Europe there are now 1.5 TRILLION Euros of outstanding bonds with yields less than zero. Japan auctioned some bonds late last year with a negative yield. Yes, this means what it sounds like – these bonds, if held to maturity, are guaranteed to lose money. Think about that for a minute and behold what the central bankers of the world have wrought.
Why has this happened? What could possibly induce someone to buy a security with a guaranteed loss? There are only two explanations that make any sense. Either the buyers of these bonds believe that Europe will experience extended deflation – which means their real return will be positive – or they believe someone will come along and offer them an even higher price before maturity – the greater fool theory. While Europe as a whole is seeing mild deflation, the second explanation is valid too. In this case, not only have investors – primarily banks – bought these bonds with the expectation that a greater fool would come along, they even knew his name – Mario Draghi. When the ECB announced the launch of QE last week, Draghi was very clear the program would not rule out buying bonds with negative yields. As long as front running the world’s central banks is the free lunch it appears to be, banks are not going to bother lending money to anyone who might not pay it back.
Central banks around the world are following the standard playbook of easing monetary policy in an effort to raise economic growth. In the last six months we’ve seen rate cuts from Russia (after hiking them to defend the Ruble), Norway, Sweden, India, Canada and Switzerland. Singapore, which targets its exchange rate, eased this week. Denmark has cut rates 3 times in the last 2 weeks. Australia and New Zealand appear to be on the verge of joining the global easing party and of course the ECB launched its version of QE recently. If you had any questions about the state of the global economy, that list should answer them. Central banks don’t generally ease monetary policy when things are good.
Meanwhile, for some reason, there remains an expectation that the Federal Reserve will raise rates sometime this year. The Fed’s statement after their meeting this week was, if anything, more bullish about the prospects for US growth although they did say that rate hikes could come earlier or later depending on the incoming economic data. I’d bet on later if I were a betting man. In fact, I’d bet on not at all. The most interesting market response to the Fed announcement was, by far, the reaction of bonds where an initial minor selloff turned into a buying stampede the rest of the week. The Fed may think it is going to hike rates but the bond market is saying pretty loudly that that would be a major mistake.
The Fed also said “…inflation is anticipated to decline further in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate.” They believe this because while “market-based measures of inflation compensation have declined substantially in recent months; survey-based measures of longer-term inflation expectations have remained stable.” In other words they don’t believe the market, they believe the surveys. I think that’s called confirmation bias.
What is most disconcerting about the Fed’s view of inflation is that they apparently have no idea what causes either inflation or deflation. The Phillips curve nonsense about labor markets is just plain wrong and based on a misreading of the original research done by A. W. Phillips. There is no tradeoff between unemployment and inflation; the correlation is essentially zero. All the Phillips study proved was that in an economy on a gold standard,wage inflation is higher when unemployment is low; in other words, real wages rise when the labor market is tight. Well, duh. That’s called supply and demand and we can thank Mr. Phillips for proving that those forces work in labor markets. I guess he ran out of research topics.
As I said last week, inflation and deflation are about the value of the currency, about purchasing power. In case the Fed hasn’t noticed the dollar is pretty much going straight up at this point and unless that changes, the drop in the Fed’s inflation measures will be far from “transitory”. Are they completely unaware that the rest of the world is easing as they contemplate tightening? Given a choice between a bond paying a negative rate denominated in a depreciating currency and one with a positive yield denominated in a rising currency, which one does the Fed think global investors will choose?
One would hope that after nearly 6 years of unprecedented monetary easing, unprecedented liquidity, the world’s central banks would start to wonder why economic growth remains so elusive. Does Mario Draghi really believe that with interest rates already negative in Europe that pushing them lower – more negative – will accomplish anything other than padding the income statements of the regions banks? Does he really think the banks are going to sell bonds to the ECB (actually the individual national central banks) and then use that money to lend more to a continent already choking on debt?
If the world’s central bankers want to find the culprit for the falling prices nipping at their heels they need look no further than the closest mirror. Every slow down in growth for the last three decades – at least – has been met by a lowering of interest rates. That allowed consumers to spend beyond their means and companies to borrow and invest in capacity to satisfy that artificial demand. Now that there is no more demand to pull forward from the future – central banks have been using that trick for decades – the world is left with excess capacity. With too much supply and too little demand, prices are bound to go lower and no amount of interest rate cutting is going to change that. In that environment why would companies invest in more capacity?
I don’t know where all this ends but I’d just point out that a European investor who doesn’t want to take US dollar risk can swap his negative yielding bond for gold and pick up yield. Gold doesn’t pay dividends or interest but zero is still greater than any number with a minus sign in front. Capital flowing into gold isn’t going to be a positive for European growth and the lower Draghi pushes interest rates the more attractive that swap looks. Of course, the other alternative is to ship that capital to the US where yields are falling fast but are at least still positive. If the essential problem in Europe is that investors aren’t willing to take risk – invest – how exactly is urging capital to hide in gold or flee the continent going to help alleviate that problem? The US should send Draghi a thank you card for sending all that capital our way.
And the higher the dollar goes the more likely it is to keep going higher. As I’ve said before the world is awash in dollar denominated debts and as the dollar climbs those companies and countries effectively short dollars are going to want to cover and hedge their risk. I think sometimes investors – and certainly central bankers – forget that there are actual people managing these debts. If you are the CFO of a company with falling dollar revenue – say an iron ore company – and a stack of dollar denominated debt, your blood pressure rises with every tick up in the dollar exchange rate. At some point you are going to relieve that pressure by buying dollars. And when you do that will amp up the pressure on the CFO who hasn’t done so yet.
The passage I quoted at the beginning of this piece is I think a perfect description of where the world’s central banks are right now. The road they are on – easing monetary policy – doesn’t go anywhere but they don’t really care. They just know that the textbooks say they need to be on that road and everyone expects them to be on that road and all their friends are on that road, so that’s the road they’re on. One can’t help but wonder what happens when they don’t get to where they think they are going. If you know the book, you know it doesn’t end well.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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