Negative Rates Positive Feedback?

April 18, 2016 17:22

Off the map

The whole market is trying to get to grips with the ongoing implications of negative interest rates. After all this is unchartered territory for central bankers, investors, price makers and businesses alike.The general public in Japan and the Eurozone having been shielded thus far from this Alice through the looking glass world.

It was only last week that the FT and Bloomberg flagged that the average yield across the whole of the German government bond market was zero percent! That startling turn of events has been achieved at a time when risk assets are back in favour. And therefore a period in which,according to the market and economic orthodoxy, the price of risk averse assets, such as German government bonds, should fall and their yields rise. That indeed was the relationship up until the 12th of February 2016 when it changed dramatically as we can see below.

Prior to this point, as the chart shows,as volatility increased (green line) so the price of risk free assets in this case the price of German 5 year bond or BOBL futures, increased (blue line) and vice versa.

But since that fateful day,volatility (the level of fear in the market) has declined and yet the price of German bond futures has continued to rise.

chart shows VSTOXX volatility index versus German 5 year bond futures.

The most likely explanation is that as the return on cash becomes negative, there is a disincentive to hold cash and therefore money moves into instruments that are the next best thing to cash.Typically bills (short term IOUs) and bonds (longer-term Government and corporate debt). However corporate treasurers are an exceptionally risk adverse bunch, who don't want any exposure to market risk, if they can avoid it.

Short-term paper with negative yields / returns looks as unattractive to this group as cash (and perhaps even worse). So they must look to longer term Government bonds in which to park their money. If only for a relatively short space of time compared to the maturity of the bonds.

There are other groups such as pension funds and income investors who are very keen to see some kind of positive return over the longer term. As the returns on shorter term bonds diminish so they must look further out into the future, or along the curve as we say in the market, to find that return.

As Bloomberg succinctly put it on 12 April

"For the first time in history, the average yield across the entire German bond complex has collapsed to zero. With the yield curve (falling) below zero out to 9 years, and 1 month yields at -62bps (minus 62 basis points) it is no surprise that asset managers are extending duration"

Of course we also need to factor in the effects of the ECB QE program, which now stands at €80 billion per month.

For the avoidance of doubt this means that the ECB is now spending 80 billion Euros per month buying up Government and corporate debt,in an effort to stimulate growth in the Eurozone economy. To put that into context if this program ran for just over two years,it could effectively buy back the national debt of Germany. Which stands at around €2.08 trillion currently. These figures are mind boggling the implications are frightening.

Not that ECB could buy back the German national debt,because bonds that yield less than the ECB deposit rate (which is currently -0.40%) are excluded from its purchase plan.

Casting its net wider

This is one of the reasons that the ECB is now buying corporate bonds as well as, or instead of Government paper. However despite the sizeable nature of the European corporate bond market which is estimated to be around €2 trillion (there is that figure again) much of it is off limits to the ECB,based on quality of the bond issuer. And what is open to ECB purchasing is tightly held by similar groups of investors to those mentioned above, who are unlikely to be willing sellers.

There is also the small matter of liquidity or rather the lack of it. Prior to the financial crisis and subsequent crackdown on the banks Market Makers held inventory in and added liquidity to the bond markets. But in many cases,following the regulatory backlash,those functions no longer exist. That means that outsize buying by the ECB will drive bond process higher and send yields lower,much quicker than it may have done in previous times. In effect the ECB may be running out of things to buy.

In the past innovative investment bankers would have spotted an opportunity here and encouraged their clients to issue bonds,to satisfy this new demand and lock in cheap financing for themselves. But those clients are corporate treasurers. But wait a minute we are back where we started!

Confusing isn't it?

Bond prices are not the only thing that's going up

The central bankers at the ECB take a sanguine view of all this market noise. Preferring to focus instead on the end goal. Although Mr Draghi will no doubt have to address the market issues in his speech, post the ECB meeting on Thursday.

However he can do so in the knowledge that at least on the face of it, QE seems to be working. It would seem that inflation has started to rise in the Euro zone once more. The chart below plots Eurozone core inflation versus the month on month change in inflation in the Euro area,over a five year period. As we can see both metrics are pushing higher once more. Of course these are green shoots and they need to be sustained. But they can't be ignored, even by critics of the ECB such as myself.

Chart shows the performance of selected Eurozone inflation measures.

For my next trick

That's definitely a feather in the ECB cap and it will likely encourage them to continue down the path they are on. Particularly if they see a link between negative rates and rising prices.

However for their next trick the ECB need to show that this process can address the chart below. This graphic plots the Composite PMI,the measure of economic activity in the Eurozone, across both industry and services (blue line left hand scale) in which readings above 50 reflect econimic growth. It plots that metric against the Producer Price Index,or "Factory Gate" inflation.

What the chart shows is that Eurozone businesses are still growing. However the prices that they ship goods and services at are still falling. The inference here being that profit margins are under pressure. For real economic growth to happen and be sustained,that needs to change,particularly if input costs (raw material prices) start to pick up with inflation.

Chart plots the Eurozone Composite PMI vs PPI for the Eurozone.

Don't be surprised therefore if there is a further interest rate cut on Thursday or a heavy hint that that action could follow at future ECB meetings. After all they may think they are on to a good thing.

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