Fed And ECB’s Convincingly Irrational Behavior by Axel Merk, Merk Investments
To make sense of the markets, it may be ever more important to dissect what we may call convincingly irrational behavior by policy makers. To make sense of stocks, bonds and currencies, you might need to discern some of the madness that’s unfolding in front of our eyes. We assume no responsibility if you turn mad yourself in reading this analysis.
As most of us love a bull market, not everyone will agree that the markets are embroiled in what former Fed Chair Greenspan referred to as “irrational exuberance.” The exuberance we are facing these days I call complacency: investors may be lured into seemingly docile assets, not realizing just how risky they are. This misallocation is fostered by our central banks whose ultra-low monetary policy encourages risk taking. In the stock market, it manifests itself through higher valuations on the backdrop of low volatility, a common measure of risk. But of course the markets are still a risky place; and anything might shake investors back into reality. When that happens, all those that thought the stock market is safe might be running for the exit (no pun intended) in a heartbeat. Hence, we’ve played party poopers and cautioned of a potential crash in the market. In fact, the party pooper might be the Fed in its attempt to engineer an exit. In our analysis, asset prices need to be re-priced (lower) should the Fed attempt an exit.
We find a great number of investors agreeing that bond prices might be irrational. As of this writing 10 year U.S. Treasuries yield 2.36%. How is this possible if the Fed is serious about an exit? Some argue that we are much closer to full employment than Fed Chair Yellen thinks (and thus leaving us vulnerable to inflation); notably, as loads of baby boomers turn 65 years old, they are eligible for Medicare, providing a major incentive to leave the labor force (and thus contributing to a low labor participation rate). But others argue against it, pointing out that the labor participation rate is low amongst young people; and that the labor force is far from maxed out, as the Affordable Care Act has created a large number of under-employed (businesses have an incentive to move full-time employees to part-time employees to avoid being required to offer healthcare).
So why are long-term rates so low? Is it one of the following:
• The market doesn’t believe there will be an exit anytime soon?
• “Easy money” by the Bank of Japan and European Central Bank depress US yields?
• The global economy is not doing well?
• Forget about the 10-year bond; look at the 2-year Treasury note that’s been inching up (a bit, at least)?
• The longer-term growth potential is lower than it used to be?
• The U.S. issuing much less debt in the short-term (although deficits are projected to rise again, both from increased spending on entitlements, as well as higher cost of servicing the federal debt)
We obviously don’t have a crystal ball either. However, our assessment is that a key driver to the low longer-term rates is that the market has lost faith in the longer-term growth potential. This could be due to excessive disincentives to generate growth, be that regulatory burden for industrial projects; ‘macro-prudential’ supervision to hold banks back from extending credit; be that Medicare and disability insurance (those receiving benefits have less of an incentive to work).
And while policies that hold back growth could be reverted, the high government and consumer debt levels may also make it difficult to raise rates. This is exacerbated by the fact that much of this so-called recovery has been based on asset price inflation. If indeed, as we believe, asset prices have to be re-priced lower as rates rise, the economic headwinds might be severe. In fact, we don’t think we can achieve positive real interest rates before the economy falters once again. We would go as far as questioning whether we will get positive real interest rates over an extended period over the next 10 years. It’s the key reason why we like gold, which pays no interest and, as such, may be more attractive than anything that has a negative real return.
When I discussed this view with a current FOMC member the other day, I was told that this cannot be the outcome, as it cannot provide a stable equilibrium; economic theory suggests we either get the Japanese experience or an inflationary one, but we cannot churn along with slightly negative real interest rates forever. My reaction was: I never said this would be stable.
Complacency may also be a way to describe the bond market. After all, central banks have caused anything from Portuguese bonds to US junk bonds to provide only meager yields. Should the Fed try to engineer an exit, these yields ought to rise should risk premia expand once again.
If all of this sounds academic, let’s just say that my own conclusion is I wouldn’t touch bonds with a 10-foot pole.
Last quarter, the greenback appeared to rise relentlessly. The reason? U.S. interest rates will be so much higher than those in the rest of the world. Indeed, it’s not just the pundits saying so, it’s what the market is pricing in. Never mind the analysis above that the Fed exit might be elusive; never mind the fact that real interest rates are more negative in the U.S. than in the Eurozone; never mind that even if the Fed Funds rate were to move up to 1.75% at the end of 2015 (the market prices in much lower rates), real interest rates in the U.S. would – in our assessment – still be below those in the Eurozone. Never mind that when “everyone” knows the dollar will rise that it just might not happen.
So what is happening? It turns out Mr. Draghi, the head of the European Central Bank (ECB) has become what I would deem “convincingly irrational.” In September, Draghi threw the kitchen sink at the market, announcing more refinancing operations (“TLTROs”), that he will proceed with an Asset-Backed Securities (ABS) purchase program, and that the ECB will buy covered bonds. There are just a few problems with these:
• Demand for TLTROs has been lackluster at best;
• In the Eurozone, there is no ABS market to speak of;
• There is a covered bond market in the Eurozone, but there’s nothing wrong with it.
Since then he has provided some vague guidance on how the plumbing on his kitchen sink is supposed to be working. The Bundesbank is not happy as it appears the ECB is willing to put junk into the sink, i.e., buy risky securities. As background, let’s keep in mind that yields in the Eurozone have plummeted. As an example, Spain, which paid almost seven percent on ten-year bonds not long ago, pays less than two percent now. If that’s not a stimulus, what is? The key reasons the Eurozone economy