A Tale of Two Markets
The stock market and the bond market are presently telling us two very different stories. One of them has to be wrong.
Remember the good old days when stocks and bonds used to move inversely with respect to each other? For years, that inverse relationship between stocks and bonds was considered to be almost sacrosanct. That relationship appears to have broken down over the past decade, however.
Anecdotally, it would seem that the stock market now likes bad news; when we have a negative jobs report, the S&P 500 rises because it believes a rate hike will be postponed. Many commentators seem to believe that the present valuation of the stock market is fundamentally justified, because they believe we will have low interest rates forever. If one truly believes this, then maybe the S&P 500 is, indeed, severely undervalued. This dynamic implies that equity markets have confidence that the worlds' central banks will always be able to bail them out in the future and will always be able to provide adequate policy accommodation whenever needed.
The Bond Market Disagrees
Bill Gross, Portfolio Manager of the Janus Global Unconstrained Bond Fund (MUTF:JUCAX), recently described the $11 trillion of outstanding sovereign debt with negative yield as "nothing but liabilities". Normally, he would be correct; only a fool would buy a bond with a negative yield and hold it to maturity. Such a fool would be guaranteed to make a loss, unless he could subsequently sell it to a greater fool at a higher price. So who, pray tell, would ever want to hold such an instrument?
The Yellen Put?
At last month's symposium in Jackson Hole, Janet Yellen spoke at length about the Fed's monetary policy toolkit, and the message was clear:
Don't worry, the Fed will always be able to provide policy accommodation when necessary in future recessions, if necessary by innovating new policy mechanisms.
Former Treasury Secretary Lawrence Summers recently opined in the Washington Post that Yellen may not, in fact, be able to accommodate as much as needed in a future recession.
We must hope that Mr. Summers is wrong, but his point is clear; in a future recession, the FOMC may not have enough room to cut rates as much as needed.
The Fed is Behind the Curve
So, why is Yellen so far behind the curve? Isn't the FOMC risking its credibility by dithering and beating about the bush? This writer believes it is highly likely that the Fed simply cannot hike rates while BOJ is desperately fighting to prevent its economy from falling back into deflation and the ECB is desperately trying to inflate away the high debt burden that is weighing on its banking sector.
To be unambiguously clear, when your central bank has resorted to purchasing equities and corporate bonds in an effort to provide additional policy accommodation - because they have already bought (and now hold) all the available market supply of sovereign debt - those measures can only be characterized as desperate.
As the equity markets have grinded higher over the past summer in a gradual "melt-up" driven by investor confidence that the world's central banks will be collectively dovish for the foreseeable future, events in Europe and Japan are unfolding in slow motion that presage a likely hard landing for monetary policy. This would have severe consequences for the global economy.
Out of Ammo
It is very likely that both BOJ and ECB now have their backs against the wall and are merely putting on a brave face for the world. They are probably very worried that their policies have, thus far, failed to cause the desired impact on inflationary pressures, and they are now going back to the drawing board to try to figure out a way to avoid a hard landing.
The Liquidity Trap
When policy rates are at zero and below, the classical physics of the financial world begin to break down and what results is much more akin to quantum mechanics; you enter the twilight zone where spooky interactions take place. Normally, when a recession unfolds, following the Taylor Rule, interest rates must be lowered in relation to output and inflation to bring everything back into harmonious equilibrium. At the zero bound, however, central banks are constrained and have a more limited set of options with which to provide policy accomodation. Those options are, as follows:
- Set a negative rate on bank reserves, thereby penalizing banks for keeping excess reserves on hand (instead of lending them out);
- Buy up various assets and flood the market with cash, thereby encouraging price to rise so that consumers can buy new sports cars;
- Talk dirty to the markets and thereby get them hot and bothered;
- Print money and throw it out of helicopters (i.e. pay down sovereign debt with monopoly money).
None of these options constitute a free lunch.
Option #1 slowly bleeds your banking system and encourages banks to make riskier loans than they would otherwise make. This slowly destroys your banking system. The ECB definitely cannot keep doing this; many of its bank counterparties are already threatened by a rising tide of NPL's.
Option #2 is also known as Quantitative Easing. For this policy to work, the central bank needs assets to buy with the money it prints; if it already owns the entire market, it can't very well sustain this policy. Japan cannot keep doing this, as it already nearly owns the entire market for Japanese sovereign debt (!). Europe cannot keep doing this much longer. This policy also requires that people go and buy new sports cars with their newfound wealth; if they instead decide to sock their money into a savings account or underneath their mattresses, it is ineffective. It is worth noting here that this policy has been tried for the past 10 years and has not been as effective as hoped. This policy is also akin to "pushing on a string"; just as you can lead a horse to water, but you can't make it drink, you can lead the market to money, but you can't force the market to spend it.
Option #3 is almost consequence free, but for it to work the central bank needs to be seen as credible in the eyes of market participants (cue peals of laughter from the SA community).
Option #4 is the nuclear option. It has only been tried in failed states such as Zimbabwe and the Weimar Republic. It has never been tried in developed economies with sane and sober monetary policies, because it is truly neither sane nor sober.
It is also worth noting here that Option #4 is a very dangerous game to play with your bond market, because it runs a very huge risk that inflationary expectations will lose their moorings entirely and shoot into outer space on a quantum mechanical rocket ship of doom. Once the market thinks that your government has turned into the next Weimar Republic, bad things happen. Policymakers who go down this road run a huge risk of falling off the tiger they are riding and getting eaten alive by it.
The Final Act
The central banks are running out of options and running out of time to implement them. If they are unable to collectively ease policy in a future recession through some combination of the above four mechanisms, real interest rates will go UP in relation to falling output, because they are essentially stuck at zero and can't go any further negative. To put it lightly, this is bad for equity valuations, especially when the equity market suddenly thinks it is a bond.
It is worth noting that more of Option #2 (Quantitative Easing) is a virtual certainty, but that future rounds of QE will likely be increasingly ineffective, because the central banks will need to buy increasing quantities of assets in order to increase the monetary base as much as the Taylor rule dictates. The BOJ could very well nationalize the entirety of the equity and bond markets, but it can't buy the law of gravity. Simply put, the inflation plane is running out of runway.
Who needs a bathing suit?
So, essentially the stock market appears to be signaling either that:
- The Yellen Put is real; central banks can and always will be able to use some combinations of the above four options to ease rates; or
- We will not have a recession at any time in the foreseeable future.
The Bond Market Still Disagrees
So, back to those trillions of dollars of negative yielding sovereign bonds.
Q: Who on Earth would want to own an asset that is guaranteed to make a loss in the future if held to maturity?
A: Somebody who thinks there is deflation on the horizon.
So, it would seem that Bill Gross is wrong; a negative yielding bond isn't a liability when the laws of classical financial physics have broken down, and you find yourself within the twilight zone of quantum mechanical monetary policy. When you have a period of deflation, a bond with a negative yield may not be a liability at all, but an asset! When prices are falling for an extended period of time, money itself becomes more valuable in the future! Most fixed income guys, being trained in the dark art of mathematics, should know this. The stock market clearly hasn't figured it out yet. And who could blame them? Almost nobody alive today can remember the last time the USA had a sustained period of deflation, which was back in 1930-1933.
They cannot both be right
Either the stock market is right, and rates will be low forever, we will return to organic 6% YoY GDP growth, or we will not otherwise have another recession in this lifetime. In this case, holders of negative yielding debt are just a bunch of dummies who are assured of realizing a future loss. Or, the bond market is right, and we will have a recession in the future, and a whole lot of people who are holding on to their negative yielding long bonds will come out whole in the end, making a slight gain relative to falling prices... and a whole lot of people who are presently in risk-assets will get their faces incinerated.
The market can stay irrational longer than you can stay solvent. That said, any bad news coming over the next 6 months will likely be magnified by the slowly emerging reality that the central banks cannot continue to provide a backstop to this bull market. It is time to start moving your portfolio into market-neutral territory by slowly building a short position in the entire market. Because my longs are domestic, I prefer to do this with a short position in the SPDR S&P 500 Trust ETF (SPY), and I have additional been buying long-dated bear put debit spreads on the S&P 500 index. Savvier traders than this author are probably eyeing Japanese indices and European financial stocks. Hedge funds will likely do very well when volatility eventually spikes, and going long volatility as an additional hedge may be advisable for advanced traders.
Which argument is your money betting on?
Source: The Federal Reserve Bank of St. Louis
Disclosure: I am/we are short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article provides the opinions of the author alone, has been written for informational purposes only, and does not constitute investment advice. References to specific securities are for illustrative purposes only and are not intended and should not be interpreted as recommendations to buy or sell such securities. Forward looking statements contained herein are highly speculative in nature and do not constitute actionable trading advice. Please consult a professional advisor and perform your own research before making any investment decisions.