Negative Yielding Sovereign Debt – You’re Not Sorry by Jeffrey Miller, Miller’s Market Musing

All this time I was wasting,

Hoping you would come around

I’ve been giving out chances every time

And all you do is let me down

And it’s taken me this long

Baby but I figured you out

And you’re thinking we’ll be fine again,

But not this time around

Taylor Swift, You’re Not Sorry

This letter is going to be full of weird mismatched analogies. I’m sure you’ll be ok. It goes with this weird, mismatched market we are forced to navigate. Some weirdness we’ve discussed at length: trillions of dollars of negative yielding sovereign debt, a Swiss yield curve negative out to 30 years, corporates issuing debt at 0% interest, and a Federal Reserve Board that is clearly lost and afraid of its own shadow. While central banks around the world are doing really inane things, the Fed is caught in a vicious feedback loop that it doesn’t even seem to understand it created. It gets spooked by every little downturn in the market, every reaction to a speech or meeting minutes release. In short, it’s a Hawthorne effect experiment gone bad.  The Hawthorne effect (also known as the observer effect), is when individuals modify their behavior once they become aware they are being observed.

Sovereign Debt, Federal Reserve, NIRP
Photo by Freeimages9 (Pixabay)

When the Fed was (or at least, said they were) focused on data points from the real economy in making their rate decisions, then the market could watch those same data points and make its own determination about whether or not the macro environment favored one type of investment or another. However, ever since Greenspan started playing God with the markets and focused on asset prices in securities markets as a means to create a wealth effect and increase economic activity, the Fed has been sliding down a slippery slope of reflexivity and feedback loops. By trying to cajole markets to do its bidding without actually moving rates or following through on its statements, the Fed has become a Frankenstein’s monster of the boy who cried wolf and Schrodinger’s cat.  No one believes anything a Fed official says anymore, and the Fed is both alive and dead at the same time.

The annual Jackson hole retreat for Federal Reserve officials is this week, and Janet Yellen is giving a much anticipated speech.  Market pundits keep writing that the speech will be eagerly parsed for signs that the Fed will raise rates sometime later this year. My view is that no matter what Chairwoman Yellen says, no one will believe her. She could stand at the podium and say “I fully believe that rate hikes are going to happen this year” and the market likely will do nothing. Why? Because Fed officials like Yellen and Dudley have lost all credibility. They’re like the little boy that cries wolf. Six months ago, the situation was different. But after so many contradictory speeches since then, the market now knows that if Yellen says she’s raising rates, and the market sells off, then they won’t raise rates, so the market will rise again. But not this time around. After wasting all this time, markets are done hoping the Fed will come around. That’s what happens when all you do is let someone down.  Eventually, they figure you out.

Looking so innocent,

I might believe you if I didn’t know

Could’ve loved you all my life

If you hadn’t left me waiting in the cold

And you got your share of secrets

And I’m tired of being last to know

And now you’re asking me to listen

Cause it’s worked each time before

Taylor Swift, You’re Not Sorry

I think markets are getting tired of being left out in the cold by central banks around the world manipulating securities prices to engineer economic growth. It appears to me that this acceleration into negative rates in the past few months has been driven by a capitulation on the part of income investors who never believed that rates could get this low, so they held back, afraid of locking in (at the time) historically low rates. Then they watched with shock and horror as NIRP replaced ZIRP – and FMO (fear of missing out) kicked in. But at some point, you reach that last marginal buyer. When will that happen? Nobody knows. Central banks keep reloading and doing dumber and dumber things, and since their stupidity seems to know no bounds, I’m willing to say that I don’t know how dumb things will get before they stop.  What I do know is that locking in a guaranteed loss on bonds that are held to maturity is not a good way for investors to meet their long-term liabilities. Think pension plans and insurance companies for example.  Central banks are eviscerating them. How insolvent pension systems and life insurance companies can be good for the global economy is beyond my pay grade, but then again, I don’t have a Ph.D. in economics.  (As an aside, I did take quite a lot of economics, including in graduate school, but quickly figured out that logic and reason had no place in the discipline. When I pointed out an obvious flaw in a professor’s work (outside of class, privately) he admitted that I was correct but that the flaw was needed to make the math work. That’s when I decided to be a history major instead.)

The Fed wants markets to believe that every meeting is “live” for a rate hike, but markets know that that is simply not true. But the Fed doesn’t know that yet. Like Schrodinger’s cat, the Fed exists in a state of quantum uncertainty in which it is both alive and dead at the same time. It thinks it can move, but it can’t. And now that it knows it’s being observed, it’s stuck.  Ironically, Einstein’s letter to Schrodinger in 1950 could easily be describing the state of monetary policy today. Simply replace “physicist” with “Federal Reserve Board Member”:

“You are the only contemporary physicist, besides Laue, who sees that one cannot get around the assumption of reality, if only one is honest. Most of them simply do not see what sort of risky game they are playing with reality—reality as something independent of what is experimentally established. Their interpretation is, however, refuted most elegantly by your system of radioactive atom + amplifier + charge of gunpowder + cat in a box, in which the psi-function of the system contains both the cat alive and blown to bits. Nobody really doubts that the presence or absence of the cat is something independent of the act of observation.”

So what’s an investor to do? I suggest building a robust portfolio. What’s a robust portfolio?  A portfolio that can survive exogenous shocks to the market systems and survive. Think Jason Bourne. All sorts of bad things happen to him, and he survives. He can get shot, thrown off a bridge, chased across continents, and

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