Truman Show-esque
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
March 10, 2015
• All is not what it seems. Markets are upside down. Some ‘risk-free’ assets can be purchased for a guaranteed loss. EU asset markets (ex-Greece) are soaring at the same time that EU disunity is rising. An interest rate hike by the Fed is likely to cause a rally in Treasury bonds and a steep correction in US equities.
• Unlike in years past, neither central bankers nor market participants can extract any information from current bond valuations. Despite high debt and deficits, regulations and central bank QE programs have caused demand for sovereign bonds to surpass supply. The combination of forced purchasers of securities and the distorted price of money (interest rates) makes it a futile exercise to forecast bond yields base off the economic fundamentals.
• In a normal market environment, yields would typically rise if a major central bank was able to successfully increase growth and inflation. Today, an increase in yields would probably not be viewed as an indication of success for a central bank, since higher yields might accompany negative consequences: such as, lending issues in the EU, housing headwinds in US, and debt servicing troubles in Japan (see May 30, 2013 note, “The Abenomics Paradox”).
• In this light, the ECB QE program was designed to buy twice the amount of net issuance across the Eurozone. However, driving yields down and risk asset up has its own set of consequences. For this reason, I stand by my February statement that the program will end prior to the estimated end date of September 2016.
• The ECB and ESRB (European Systemic Risk Board), for instance, may already be worried about the impact of the QE program in the midst of the aggressive regulatory environment. Today’s report by the ESRB entitled “ESRB Report on the Regulatory Treatment of Sovereign Exposures”, recognizes the “significant amounts of risks to financial institutions stemming from their holdings of sovereign exposures”.
• Basically, the report admits that regulations may have led banks to counter-productively invest too much in their own sovereign bonds. The report is 222 pages long, but a clear outline of their worries can be gleaned by reading the Executive Summary and Introduction sections (pages 6-12).
• As Reuters reported today, Draghi fully recognizes the difficulty of reforming the existing regulatory framework without rocking sovereign debt markets. Nonetheless, a full review is likely. In the meantime, core EU bonds should continue to be pulled down to 0.0% as hoarding and demand stays high. Yet, the negative 0.20% cap may be a level too disruptive to achieve before something cracks.
• Currently, there are QE-eligible negative-yielding bonds in Germany, France, Finland, Belgium, Austria, Slovakia and the Netherlands. Over time, having too many bonds trading at negative yields could result in destabilizing capital flows and unstable markets.
• Some banks and insurance companies may not be willing sellers even at deeper negative yields due to accounting aspects and their reinvestment risk. As bonds decline into negative territory, the negative second order effects could get the ECB to end its QE program early. Softening of the regulatory rules is unlikely; but should such changes occur, an ugly bond market sell-off would result.
• Note: some believe that paying money to lend to governments is a sign of Japanese-like economic stagnation, but it is more likely due to the regulatory and QE effects mentioned above.
• It is interesting that yields are falling and spreads converging in the Eurozone concurrent with what appears to be budding EU disunity. There have been dissents or differences in regards to the handling of Greece, Ukraine, budgets, and ECB QE. Even more important, however, is the fact that the strict budget rules adopted under the ‘Growth and Stability Pact’ have unravelled with yet another reprieve to Italy and France’s deficit violations. The frequent changing of the rules and deadlines is not good for the credibility of the system
• Despite significant (non-Greek) periphery spread tightening, a Greek default is looking more likely with each passing day. An exit would set the precedence that a country can leave the Eurozone. The dramatic risk in Greek yields this week should be an indication that the powerful convergence trade of other sovereign is not a one-way bet.
• Nonetheless, the stampede into core European bonds may continue for a while longer. However, it’s wise to remember that as more bonds plunge into negative yields, their risks push farther away from ‘risk-free’ status.
• Markets will increase their probability of a June Fed hike when the FOMC removes the word “patience” from its statement on March 18th. This should add to the momentum behind USD strength which in turn is bad for US stocks, the EURO, and Emerging Markets. It is also disinflationary. I prefer exposures to US Treasuries over EU debt, and I stand by my comment from March 5th that the S&P will trade sub 2000 before the March 18th FOMC meeting. I still expect the US 10-year Treasury to trade sub 2.00% by the end of the month and to make a new low in 2015 (below 1.65%).
- “OK. Just a little pin prick. There’ll be no more – Aaaaaahhhhh! But you may feel a little sick.” – Pink Floyd
Regards,
Guy
Guy Haselmann | Director, Capital Markets Strategy
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