Draghi’s Bazooka Is Not Enough
On Wednesday, March 2nd, 2016 I published a piece in Business Insider arguing there is large segment of unpriced risk that only the Bank of International Settlements (BIS) in Geneva is able to see. My argument then was there is extraordinary stress in the currency swap lines extended by central banks to other central banks, both large and small, and those institutions hold a large segment of the world’s asset valuations in a state of artificial suspension (Learning Objective: Calculate a financial institution’s potential dollar gain or loss exposure to a particular currency [FMP-13].
On Sunday, March 6, the BIS publicly acknowledged just the same in details buried in their 300-page quarterly report. Specifically, Claudio Borio of the BIS said the “signs of a gathering storm [have] been building for a long time”. That is usually diplomat-speak for “you need to be worried”.
Just last night, the European Central Bank effectively went nuclear into uncharted monetary policy waters and announced an expanded quantitative easing program & a new corporate bond buying program – because there are few sovereign bonds left unpurchased – in a last gamble to use negative interest rates to punish holders of cash and push new and free cash into the risk-on trade. It is now clear that interest rates in the EU and the US will be near zero well into the next decade. Not only is the U.S. “one and done” but we are “one and done for a long time”. Meanwhile, Goldman Sachs continues to warn of sharply lower oil – typically a proxy for, and a driver of, growth – in the face of limited supply capacity (Learning Objective: Apply commodity concepts such as storage costs, carry markets, lease rate, and convenience yield [FMP-12].
Problems arise when we only focus on headlines: 4.9% unemployment in the United States, low or negative interest rates, and low gas prices normally are a concoction that drive above average growth. This would be true if the path to those goldilocks numbers wasn’t the product of massive and artificial intervention. Fully 82% of the new jobs created in Friday’s jobs report are in the low to minimum wage category (Learning Objective: Describe and contrast the process for rating corporate and sovereign debt and describe how the distribution of these ratings may differ [FMP-11].
That isn’t growth – that is people giving up. Oil will be low for years – literally years — and the income predicated on higher price point oil sales needed to make energy based debt payments is going to be nonexistent. This certainly means large-scale global debt default, but more importantly, it means an inability to defend the dollar peg by both China and Saudi Arabia leading, I believe, to a devaluation by both countries of their currency this year (Learning objective: Calculate a forward foreign exchange rate using the interest rate parity relationship [FMP-5].
Global central banks have officially begun a race to the bottom. On March 9th, the Reserve Bank of New Zealand (RBNZ), New Zealand’s central bank, “surprised” the markets by cutting interest rates 25 basis points. The RBNZ cited all things China as part of their reasoning. These decisions do not happen in a vacuum and, more often than not, are driven by what lies beneath.
So, what lies beneath? Looking back to 2007, long term projections of GDP growth at that time looking forward until now have fallen short of estimates by 15 trillion dollars, (2007 IMF GDP forecast vs actual growth x 2007 GDP baseline). The Eurozone has an equal shortfall even while excluding Spain and Greece. During that same period, global debt increased by 62 trillion dollars. In less than a decade, we have “missed” an anticipated growth of 30 trillion and printed 62 trillion more (Learning Objective: Compare instances of sovereign default in both foreign currency debt and local currency debt, and explain common causes of sovereign defaults [VRM-12].
Yet, 24 countries now stand at the zero rate threshold – unheard of in modern financial history. Additionally, the United States is likely to join them before we see higher rates. The potential for zero rates in the US for years to come is well above a fair coin flip. Investors need to be prepared for a tectonic shift in one of the bedrocks of the capital asset pricing model: that bonds with negative rates are a good investment as rates dig deeper into negative territory worldwide. I don’t believe negative 80 basis points on the Japanese 10YR government bond is out of the question (Learning Objective: Define the “flattening” and “steepening” of rate curves and describe a trade to reflect expectations that a curve will flatten or steepen [VRM-8]).
There is one silver lining. Growth, as defined by GDP, is not the only path to economic security, and the path to negative interest rates will do more to spur growth and innovation than any creative monetary policy, short of central banks offering deflation insurance. We may be in a period as significant as the United States moving away from the gold standard. If we can accept structurally lower growth, realize negative rates are the new norm at least for years, and understand global monetary policy is at its limits, it has radical implications for valuation and pricing. Everything we use based on probability density functions, extreme value theory, lognormal behavior of asset prices, all fundamentally change (Learning Objective: Understand the derivation and components of the CAPM [FRM-9].
Understanding how those pieces fit together now can only help in understanding how they could potentially change in the future. I wrote the Wiley FRM program in the spirit of connecting a world of dots to a world of headlines that often have a different meaning when you look beyond the headlines. What lies beneath, indeed.