Falling Yields Signal They Were All Wrong About the Economy

Falling Yields Signal They Were All Wrong About the Economy
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With the Federal Reserve already partway there, markets are now expecting Jay Powell to go much further. The FOMC at its last meeting surrendered on further rate hikes. This Fed “pause” was obviously intended to reassure these same markets. Instead, they saw it for what it really was: chickens, not doves.

Over the last several weeks, curves have utterly collapsed. You have probably by now heard about inversion. Yes, the yield on the 10-year US Treasury bond is about 4 bps below the equivalent yield for the 3-month T-bill. It is but the latest indication that things are going wrong. There have been serious warnings stretching back nearly a year already.

The April contract (current front month) in eurodollar futures is right now priced at about 97.43. That means one of the deepest, most sophisticated markets in the world currently expects 3-month LIBOR to be somewhere around 2.57% next month when it comes off the board. The last update for the LIBOR fix puts it at 2.601%; meaning, eurodollar futures are betting that there is a very good chance it falls a little between now and then.

Or, more precisely, a little more. It has already dropped about 23 bps from its peak last December. Yes, the eurodollar futures market knew the Fed was going to pause before Jay Powell did.

If that was the sum total of the curve distortion, we would have what many call a policy error. The Fed, as President Trump and his new nominee to the FOMC board, Stephen Moore, allege, went too far. That’s not the end of the curve, though.

The December 2019 eurodollar futures contract is currently priced around 97.62. This suggests a future LIBOR rate of around 2.40%, or considerably less than where it is now. The market price doesn’t necessarily compute to an exact future expectation, rather it is indicating that balance of probabilities this one money market rate will be substantially below its current measure.

And it only gets worse into 2020. The December 2020 contract and all the way to the September 2021 are sighted around 97.95. The longer you go out in time the greater the expected variation, but still what the curve is saying, again balance of probabilities, there is a very high chance that money market interest rates are going to be lower this year and lower still over the next year maybe two following.

Therefore, as eurodollar futures continue to be bid higher in price, that tells us the market is anticipating both a greater probability for money rates to trend this way as well as a greater depth for them whenever they might finally finish.

The US Treasury yield curve readily concurs. It is no longer just the long end of that curve which is being bid. Short-term yields have been falling, too, rounding up to the same scenario pricing out in eurodollar futures.

Back in January, the 1-year (or 52-week) T-bill had been yielding more than 2.60%. Entering March, it was down to around 2.56%. As of recent trading, 2.42% with a low Wednesday at 2.40%.

Already money and equivalent rates are acting in concert. Again, 3-month LIBOR has dropped as have US$ equivalents in the longer bills. Even the 3-month and 4-week bills have lost some altitude.

With equivalent rates, UST yields, and even LIBOR all pointing downward, the big question is what all this means.

The short answer is that they were all wrong about the state of the economy. All wrong.

Central bankers globally are now in a near state of panic. Janet Yellen, Powell’s immediate predecessor as Fed Chairman, was over in Hong Kong recently lamenting how central banks don’t have enough tools to fight the next downturn – clearly referencing how that next one might be uncomfortably closer than mainstream convention is imagining it.

One of the only true claims any central bank might make is how the last ten years or so has been a golden age of central bank experimenting. Each one has fashioned or borrowed new tools that before August 2007 would’ve been thought lunatic. The toolkit, as they like to call it, has been expanded and then expanded some more. Only to be added to all over again.

If you keep asking for more tools, perhaps you don’t know how to use any of them.

The primary complaint is, actually, altitude; as in, interest rates are low all over the world, therefore how can the central bank offer stimulus with rates this way? Yellen, as her fellow travelers, fails to appreciate the irony. They’ve spent the last ten years claiming low rates were stimulus.

As she put it:

“The euro area and Japan have inflation that’s still well below their 2 percent targets and no room at all to cut short rates and large balance sheets because they’ve done a lot of asset purchases.”

I’ll paraphrase: We did all this really powerful stimulus and now because we did all that powerful stimulus we have no room to do more powerful stimulus now that it appears we really, really need it.

She focused in on Japan and Europe because unlike the Federal Reserve the central banks in those places haven’t even been able to reach “liftoff.” So much for globally synchronized growth. The Fed is in the same class, only slightly better (in conventional thinking) having only gotten nine hikes (spread out over three years) into this regime.

Because their prior stimulus left them little or no room for new stimulus, central banks are back to the drawing board. New policy tools are on order.

In Europe, there were unconfirmed rumors that the ECB is considering adjusting its deposit rate as one such. It has already announced the outlines for a third T-LTRO program coming later this year. So, instead of rate hikes as everyone was saying not that long ago, 2019 will be yet another year for expanding, or at least altering, the toolkit.

This whispered adjustment to its already ridiculous NIRP program is, if it ever materializes, another level of absurd. The theory behind a negative interest rate is quite simple and grows out of one old adage: you can lead a horse to water, but you can’t make him drink. In Europe (America, Japan, etc.), a central bank can create trillions in reserves, but it can’t make banks use them.

Or can it?

A negative interbank rate was intended punishment. We made all these reserves for you, so either use them or pay a penalty for hoarding. Unsurprisingly, if you aren’t a central banker or Economist, banks in Europe have been paying the fee. Even as the deposit rate was lowered, lowered some more, and then lowered twice again, registering -40 bps by March 2016, the aggregate balances being stored in it ballooned, ballooned some more, and has remained at greater than €600 billion.

As 2019 dawns with economic uncertainty everywhere, banks are shockingly complaining about the deposit account levy. They’ve probably been complaining this whole time; only now might the ECB start to listen. To perhaps help them out European officials are considering a two-tiered system very much like what the Japanese have developed. Yet another example of Japan’s primary export: Japanification.

The idea is, again, completely absurd. I summarized it a few days ago in another context:

“We [ECB] have to make sure banks lend from our reserves, so we will penalize them harshly for not doing what we want them to. They didn’t lend, so now we won’t penalize them as much because maybe our harm is too harmful, and by reducing the penalty that will get lending going again!”

The less crazy among you might wonder instead about this persistent reluctance to lend. By hoarding liquidity in the deposit account (and elsewhere, take a look at Eonia and the screwed up Euribor rates) and readily paying the freight for doing that, banks are telling the ECB they prefer paying the penalty over lending. What might that say about the success of these policies and therefore the real state of Europe’s so-called boom long before 2019?

In April 2015, Mario Draghi was holding a press conference as he so often does.  This one was the first following the ECB’s implementation of its latest experiment, or tool. The LSAP (large scale asset purchase) known as the Public Sector Purchase Program, called QE, was added to a corporate bond purchase LSAP stacked already on top of a third covered bond LSAP.

Draghi said:

“To sum up, a cross-check of the outcome of the economic analysis with the signals coming from the monetary analysis confirms the need to implement firmly the Governing Council’s recent decisions. The full implementation of all our monetary policy measures will provide the necessary support to the euro area recovery and bring inflation rates towards levels below, but close to, 2% in the medium term.”

Blah, blah. About the only thing anyone remembers from this media gathering was the young protestor who jumped on the desk in front of the ECB President showering him and VP Vítor Constâncio in paper and confetti. That was a far more powerful demonstration of what monetary policy in its modern incarnation is supposed to be about – shock.

Ultimately, that’s what Yellen’s complaint – and the market’s – comes down to. The ECB can’t shock everyone into happy thoughts because money market rates are already stuck below zero and LSAP’s are still ongoing (even if the PSPP was terminated) – even though it was these very programs which were supposed to lead to happy thoughts the last time around.

The Fed has little additional room to please anyone even if it reinstitutes ZIRP because it will be starting from 2.25% (RRP).

They really believe that’s how this works. Even if the world behaved according to this expectations doctrine as it is written in the Economics textbook, there’s no stimulus shock going from abnormal to abnormal; from absurd to a little more absurd. No wonder curves have bent as they did the last five years, every claimed basis for success distills down to the despicably irrational.

The lessons of 2008 were never learned; starting with interest rates. Ben Bernanke kicked off his “stimulus” from a height of 5.25% and even though he got down to zero he was forced to stand by and watch as the system burned nearly down to the ground around him. Altitude is meaningless because policy rates are; which shock actually mattered? The one in actual money.

The eurodollar futures market as well as bond yields all over the world are falling again not because they are welcoming a flood of dovishly experimental tools. Quite the opposite; as I’ve written many times over the years, if a central bank feels the need to get creative that’s a very bad sign. It was this which underpinned Montagu Norman’s prior central bank doctrine of “never explain, never apologize.”

Little needs to be explained when there is at least money in monetary policy.

Some people like to focus on the cuts themselves when the real question is why any central banker, let alone all those who have been predicting and guaranteeing much better outcomes, what is that would make them have to turn all the way around and head back in the opposite direction? Monetary policy doesn’t deliver a solution, it can only tell us that something has already gone wrong.

That’s ultimately what the curves around the world are all saying. Something has already gone wrong and soon enough even the central bankers will publicly confirm this view. They’ve started to, what with these pauses, complaints, and whispers.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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