The Interest Rate Conundrum

hot potatoHere are some headlines from this week’s reading.

World Braces for Taper Tantrum II Even as Yellen Soothes Nerves

Swiss, Mexican Bond Deals Represent Milestones for Debt

Bill Gross: German bunds are ‘the short of a lifetime’

The general gist of these headlines is twofold. Janet Yellen and the U.S. Federal Reserve Board of Governors is doing everything they can to talk the market into behaving in an orderly fashion as the Fed prepares to enact the shift in interest rate policy that they’ve been telegraphing since the end of the taper announcement last summer. Secondly, the reason the Fed is trying to talk some sense into the markets is because the markets don’t seem to believe the in the Fed’s intentions.

The second two headlines help illustrate just how idiotic today’s  manipulated debt market has become. Bill Gross discussing German Bunds as the, “Short of a lifetime,” carries substantial weight. Of course, he’s referring to the fact that newly auctioned 10-year German Bunds were issued at a negative interest rate. To be clear, this is not an inflation adjusted negative rate. This is simply buying Euro currency denominated German debt that guarantees an interest rate loss.160x600

The purpose behind this and the reason the public is still willing to buy them is based on two thoughts. First, purchasers are assuming that Euro currency appreciation will offset the interest rate loss. After all, most total return bond funds have made the bulk of their returns based on bond price appreciation over the last eight years as long bond prices here in the US have more than doubled during this time. The second reason these notes are still finding willing buyers has to do with the capital controls being put in place in multiple by multiple members of Europe and the European Union, primarily through a direct savings haircut.

This leaves anyone with Euros to hold facing the unenviable position of losing up to .5% of their savings on deposit or, buying government notes that at least offer a chance, through currency appreciation to hold their original value. Most importantly, the savings haircut forces purchasers into government issued debt so that the next round of European Quantitative Easing can be funded. This is a governmentally manipulated pricing structure with coordinated efforts of the G20 designed to engineer a specific outcome – transferring debt from the governments’ balance sheets to individual investors.

Now, moving to the last headline regarding the Swiss. From the Wall Street Journal.

“But in the latest stark sign of how easy the era of easy money has become, Switzerland on Wednesday sold 10-year bonds that investors are actually paying to hold, while Mexico lined up a rare transaction to borrow euros it promised to repay a century from now—at a yield of 4.2%.”

“Switzerland sold a total of 377.9 million Swiss francs (about $391 million) of bonds maturing in 2025 and 2049. On the 10-year slice, the yield was minus 0.055%, compared with 0.011% on its most recent similar bond two months ago. In the secondary market, the prices of Swiss bonds maturing up to 11 years in the future have risen so much that their yields have tipped into negative territory. ”

Moving to the Mexican issuance of a 100-year bond denominated in Euros at a yield of 4.2% just blows me away. From a simple historical context, what are the odds of the Euro still being a currency 100 years from now? Can we really extrapolate 15 years of shaky history into something that can be bet on that far into the future?

Finally, I want to take a look at Bill Gross’ take on, “The short of a lifetime.” This has been written up a couple of different ways. The premise is simply front running the European Central Bank’s debt purchases as it resorts to a U.S. style Quantitative Easing. Simply, “Don’t fight the Fed,” Euro style. As Mario Draghi and the ECB purchase the member nations’ debt to the tune of 60 billion Euros per month, there’s extra safety in purchasing the debt of the Union’s strongest nations like the German Bund. The rush has pushed the yield on the Bund down to .07% at its current low.

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Here is where I see the issue, and it’s going to come sooner rather than later. It simply comes down to the diminishing effects of repeated application of the same protocol. Each similarly sized dose has a smaller effect than the one previously administered. A tolerance is built up. So it is with the Quantitative Easing measures applied here in the US and being adopted now in Europe. Each round of QE provided a smaller effect with a shorter duration. There are several reasons for this pattern. It’s human nature and it will continue. Therefore, the ECB will have an even tougher time the Fed did here in the US.

Snapshot of QE over time provided by RJ O'Brien's Market Research Team.
Snapshot of QE over time provided by RJ O’Brien’s Market Research Team.

Notice that the Fed’s balance sheet more than doubled in the last four years while GDP and10-year Treasury Note yields have remained fairly neutral once the initial buying rush ended.

GDP has experienced little in the way of a lasting increase due to the Quantitative Easing Programs.
GDP has experienced little in the way of a lasting increase due to the Quantitative Easing Programs.
Ten year Treasury yields had already begun to reverse prior to the Fed's taper talk of last summer.
Ten year Treasury yields had already begun to reverse prior to the Fed’s taper talk of last summer.

It’s impossible to predict psychological cyclicality. There’s no telling when the first marker will be called and trigger the event’s unwinding. What can be predicted is that with each announcement geared towards talking down interest rates as Europe works through its own QE program, is that yields won’t fall as much as predicted and eventually, we’ll see yields backup on ECB actions that should have compressed them even further. At that point things will get interesting and they’ll have my undivided attention. Zero Interest Rate Policies (ZIRP) can only last so long in the real world. Market’s will always find the weakest point.


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