Government bonds are synonymous with safety. Volatility in the bond market has been picking up. The US Federal Reserve (FED) seems to be on hold for the rest of the year, but there could be more happening under the surface in one of the world’s most important asset classes.
In addition to increasing volatility, there also appears to be a policy rift emerging between the US and European central banks.
Mario Draghi, the head of the European Central Bank (ECB), recently earned Donald Trump’s ire after he gave a speech that hinted at greater stimulus in the Eurozone if inflation doesn’t pick up soon. The US seems to be on a very different monetary path and may face a strengthening currency as a result.
The Bond Market Bids Farewell to Higher Rates
There has been a rapid shift in interest rate expectations over the last year and a half. 2018 started with calls for much higher interest rates in the near future.
Bill Gross famously called for a bear market in bonds (higher interest rates) to begin in January of 2018; a bear market which never materialized.
Gross wasn’t alone in his views that interest rates would rise. JP Morgan CEO Jamie Dimon told the press that investors, “better be prepared to deal with rates 5% or higher…it’s a higher probability than most people think,” last August.
Fast forward to July of 2019, and the outlook for interest rates is moving in the opposite direction. While the FED seems to be on hold for now, the members project that rates will start to fall next year.
Things might change even sooner in Europe, where the ECB might start cutting as early as next month.
Et tu, Draghi?
Mario Draghi looks like he is ready to push more easy-money central bank policy into action. He told media that, “We have our remit, we have our mandate,” and that, “We are ready to use all instruments that are necessary to fulfill the mandate,” in a speech he gave earlier this week.
In plain English, Draghi said that the ECB needs to produce inflation, and the only way they can do that is by easing monetary conditions (further). The ECB’s interest rate is already under zero, so monetary easing will probably take the form of more bond buying.
The ECB has been bold in its use of unconventional monetary tools over the last decade. The FED has resisted buying US government bonds directly in great quantities ($600 billion USD isn’t much in an economy that is running $1 trillion USD deficits annually), but the ECB made it one of its go-to policy tools.
For the moment, the ECB caps the amount of debt that it will purchase from a single country at 33%, but this will probably have to change if the bond-buying program is going to expand.
It is very unlikely that Draghi would open to the door to more easing and then fail to follow through. Lower yields and more stimulus in the Eurozone are probably coming, it is just a matter of timing and magnitude.
Powell Fades Trump’s Tweets
The interest rate situation in the USA seems to be a bit more muddled. Yields have been under pressure all year, and there have been a number of inverted yield curves (depending on how one likes to measure) over the course of 2019.
In addition to the volatility that the bond market has been experiencing, President Trump has been very critical of FED Chairman Powell (who he appointed).
President Trump wants low rates from the FED. He tweeted that, “European Markets rose on comments (unfair to U.S.) made today by Mario D!,” and added, “They have been getting away with this for years, along with China and others.”
There is no doubt a trade imbalance between the US and Eurozone. A weaker European currency would help exporters in the region, but as the last year has shown us, that advantage could be met with tariffs from the Trump administration.
Despite the pressure from President Trump, it looks like FED Chief Powell isn’t going to push rates lower just yet. Interestingly, the US dollar has fallen in value against the euro in the wake of the FED decision.
A lower US dollar seems counterintuitive, given the fact that the EU is far more likely to cut sooner and lower than the FED.
The Party is Over
Draghi cited “lingering softness” in leading economic indicators as one of the reasons why the ECB may embark on more easing. The global economic environment is no doubt strained, and there could be a trapdoor waiting for global markets.
The impact on bond prices from a global economic slowdown is probably already underway. The likelihood of a recession in the US and Europe is only starting to be considered by investors, despite the fact that the nature of global trade has shifted radically over the last two years.
President Trump has pursued an aggressive program of tariffs that is endangering a global economy which took decades to create.
The US-China-EU trade zone is worth trillions of US dollars, and the US is at the heart of both the financial system and consumption. Trump is jacking up prices via trade barriers, and eventually, this will blow back on the economy in the form of a stalled global market.
Central banks only have a few tricks left to sustain economic stability, and easing monetary conditions via lower interest rates is the first one they are likely to use.
A Race to The Bottom, and Maybe Lower
It might be worth reiterating that the ECB is already using negative interest rates. The yield on German bunds (government bonds) routinely enters negative territory, meaning that investors pay to own them.
The FED’s discount rate is sitting at 2.25%-2.5% currently, which gives them a bit more room to maneuver before they enter the wonderful world of negative interest rates.
Unfortunately, dropping the cost of money into the negative side of zero brings with it a host of potential problems. One of the bigger ones is that it actually incentivizes the use of non-fiat alternatives, which is something along the lines of central banks shooting themselves in the foot.
Making investors pay to lend money to governments is an absurd concept, especially with deficits and national debts at extremely high levels. Negative interest rates would actually encourage governments to spend more, as borrowing costs would be further subsidized by lenders.
Inflation may end this monetary experiment, though as the last decade has demonstrated, the financial markets are willing to accept just about anything that keeps asset values moving higher.
Deutsche Bank’s Bad Omen
Deutsche Bank is on the brink of a major restructuring plan. Unlike the major US banks that were successfully bailed out by the FED, Deutsche never fully recovered from the crisis of 2008.
Now, it looks like Germany’s second largest bank is working on a major restructuring, which includes spinning off around $50 billion USD worth of bad assets into a so-called ‘bad bank’. The plan would also see Deutsche leave investment banking behind, as it shutters operation in many foreign markets.
Generally, a bad bank is set up after a crisis, this was the case in 2008, and also after the S&L scandals of the late 1980s. The fact that Deutsche is floating the idea of a bad bank during one of the longest global economic expansions on record is odd, to say the least.
It is highly unlikely that Deutsche is the only bank with a pile of nasty assets, and there could be more pain in store for a sector that isn’t going to respond well to falling interest rates.
Can Cheap Money Save the Day, Again?
In the wake of the FED’s rate decision, numerous investment banks have decided to come out with predictions of multiple rate cuts over the next year or so. That is a stark contrast to the story they were selling a few months ago, which raises some interesting questions.
How bad is it out there?
If both the FED and ECB are on the cusp of a fresh round of rate cutting and other easing measures, it is safe to assume that the economy isn’t doing so well.
We have to wonder if further monetary experimentation will lead the world into a fresh growth cycle, or if central banks are trying to get ahead of an economic downturn that is probably underway right now.
Adding trillions of US dollars, Yen, Yuan, Euros and Pounds was enough to create a decade-long economic expansion, but there is no guarantee that the same tactics will have a similar result going forward.
Asian manufacturers like China were willing to go along with ‘Monetary Madness 1.0’ a decade ago, but they may not be as happy to subsidize the West this time around.
The bond market is nearing the abyss once again, and it looks like rates are set to fall under 1% in the USA in the next 12 months. Where that leads is anyone’s guess, but if the cost of money falls below zero, there are sure to be some fresh surprises in store for central bankers.