Gundlach Reveals His Favorite Trade For 2018

One day after Stanley Druckenmiller confessional to CNBC that as a result of central planning and markets that make no sense, the legendary hedge fund manager had a "terrible" year, and his "first down year in currencies ever" (he also said many not very nice things about bitcoin), it was Jeffrey Gundlach"s turn to confess some of his more controversial views. And so, the man who two years ago correctly predicted the Trump presidency, first discussed his best investment idea for the new year. To those who listened to his latest DoubleLine investor presentation last week, the answer will hardly be a surprise: namely commodities, because they"re "historically, exactly where you want it to be a buy."

"I think investors should add commodities to their portfolios," Gundlach says on CNBC"s Halftime Report.

Gundlach said commodities are just as cheap relative to stocks as they were at historical turning points, while the macroeconomic backdrop also supports the case for commodities; he was referring to the following chart which he highlighted last week.

Echoing his presentation from last week, Gundlach said that once "you go into these massive cycles... the repetition is almost eerie. And so if you look at that chart the value in commodities is, historically, exactly where you want it to be a buy."

Investors should add commodities to their portfolios. There is a really remarkable relationship between a market cap or the total return of the s&p 500 and the total return something like the Goldman Sachs commodities index. The cyclicality is really repettiive.

Gundlach also noted that commodities are just as cheap relative to stocks as they were at turning points in previous cycles that began in the 1970s and 1990s. The S&P Goldman Sachs Commodity Index is up 5% this year, versus the S&P 500"s 19% gain.

There is also a fundamental case for investing in commodities, Gundlach said. He pointed out that global economic activity is increasing, a tax cut could boost growth and the European Central Bank is implementing "absurd" stimulus policies in the euro zone.

Jeffrey Gundlach: Investors should add commodities to their portfolios from CNBC.

In addition to his favorite trade, Gundlach touched upon several other topics including:

What drives the dollar:

"Short-term fed moves are not what drives the dollar. It correlates much more to what the bond market thinks vis-à-vis the fed say 18 months forward. So if you actually rook at the bond market pricing for 2019 now, there’s a pretty big discrepancy between the bond market and the fed, so that’s going to be really interesting in driving the dollar, and this time i think the bond market is going to be right."

Why the markets are so calm:

"I think it’s because of central bank pegging of rates and quantitative easing going on full bore in  europe and in japan. One of the charts that i love to reference is the nearly linear rise in central bank balance sheet holdings ever since 2011, where the Fed stopped quantitative easing back three years ago, and japan and the ecb just took over the slack, and it’s just a linear rise."

 

Jeffrey Gundlach: This has been a great year for investors from CNBC.

On ECB president Mario Draghi:

"That’s going to slow things down a little bit, but the real worry from the central bank activity would be forward about a year. Because Mr. Draghi has said astonishingly that they’re going to continue 30 billion euros per month of quantitative easing at least until September and then he threw  in, just to put a cherry on top of the cake of stimulus, he said, and negative rates well past the end of quantitative easing. Which means – sounds to me you’ll have negative rates as long has Mr. Draghi is around which is a little under two years."

On tax cuts and bonds:

"If there is a net tax cut, it has to be bond unfriendly. we already have growing bond supply. we’ve been liiving in a world for the last three years thanks to quantitative easing of negative net bond supply, really, from sovereign bonds in the developing world. and that’s gonna flip because the fed is now letting bonds roll off, the budget deficit is increasing, a tax cut would increase the deficit further, and to the extent that a tax cut might be stimulative to the economy, that’s bond unfriendly, because bonds don’t like economic growth and also it’s more bonds, expanding the deficit, so even more supply."

On tax hikes and risk:

"If i"m correct and i’m going to receive a seven-point bump in my tax rate, which is actually about a 15% tax increase, i have a feeling that i’m probably going to be less able and willing to buy risky assets or buy all the other things that are bubbling up these days, and maybe that side of the narrative will start showing up."

Jeffrey Gundlach: Tax plan could have unintended consequences from CNBC.

On stimulating the economy:

"While we’re not probably going to get 3% real for the year, we’ve had it for two quarters in a row. and gdp now at the atlanta fed has been bouncing around but it’s around 3% for the third quarter. when is the last time we had something like 3% growth for three quarters in a row? it’s a long time. why would you be stimulating the economy?"

Finally on bitcoin:

 

We Give Up! Government Spending And Deficits Soar Pretty Much Everywhere

Posted with permission and written by John Rubino, Dollar Collapse

 

 

A recurring pattern of the past few decades involves governments promising to limit their borrowing, only to discover that hardly anyone cares. So target dates slip, bonds are issued, and the debts keep

rising.

 

This time around the timing is especially notable, since eight years of global growth ought to be producing tax revenues sufficient to at least moderate the tide of red ink. But apparently not.

 

In Japan, for instance, government debt is now 250% of GDP, a figure which economists from, say, the 1990s, would have thought impossible.

 

 

Over the past decade the country’s leaders have proposed a series of plans for balancing the budget, and actually did manage to shrink debt/GDP slightly in 2016. But now they seem to have given up, and are looking for excuses to keep spending:

 

Japan plans extra budget of $24-26 billion for fiscal 2017

(Hellenic Shipping News) – Japan’s government is set to compile an extra budget worth around 2.7-2.9 trillion yen ($24-26 billion) for the fiscal year to March 2018, with additional bond issuance of around 1 trillion yen to help fund the spending, government sources told Reuters.

Following October’s big election win, Prime Minister Shinzo Abe’s cabinet has made plans to beef up childcare support, boost productivity at small and medium-sized companies, and strengthen competitiveness of the farm, fishery and forestry industries.

In the UK, a balanced budget has been pushed back from 2025 to 2031:

 

Britain in the red until 2031: Bid to balance the books pushed back yet again

(Daily Mail) – Philip Hammond’s ambition to get Britain’s finances back into the black receded further last night – as the Treasury watchdog said he would struggle to eliminate the deficit before 2031.

The Chancellor had promised to balance the books by 2025. The target has been pushed back twice already, after George Osborne’s pledge in his 2010 Budget to balance the books ‘within five years’, before he revised the figure to 2020.

In its assessment to accompany the Budget, the Office for Budget Responsibility said it was now ‘unlikely’ that the Chancellor would balance the books by 2025 as he had hoped.

It said the Government was on course to wipe out the deficit in 2030-31, 30 years after the country was last in surplus.

That would be the longest period of consecutive deficits on record – eclipsing the 25-year borrowing binge between 1793 and 1817 that included the Napoleonic Wars.

 

In the US, “tax reform” – the alteration of the tax code to make it simpler and more fair – has morphed into tax cutting, which is of course a lot easier:

 

Donald Trump is going to build a big, beautiful deficit and rely on China to help pay for it

(Washinton Post) – Assuming they pass, Republican tax plans are forecast to increase the federal debt by about $1.3 trillion to $1.6 trillion over the coming decade, though scoring and specifics vary. This is the same debt that, campaigning in Ohio, Trump called “a weight around the future of every young person in this country.”

But now that it’s time to pass a tax plan that nonpartisan observers agree will require deficit spending, Republicans are on board with growing the federal debt. Large-scale borrowing will help make up the gap in lower tax revenue while avoiding some painful cuts to government programs.

To cover that shortfall, Trump’s government and its successors will be issuing additional Treasury bonds for decades to come, with Eric Toder, co-director of the Tax Policy Center, posting that one version of the bill would grow the debt as a share of the economy by 10.1 percentage points by 2037. About half of those bonds will end up being

held abroad, according to Joseph Gagnon, senior fellow at the Peterson Institute for International Economics.

Treasury data compiled by the St. Louis Fed shows that foreign central banks, investors and corporations already own $6.17 trillion in Treasury bonds in the second quarter, compared with $5.73 trillion for private domestic investors. More than a third of those international investors are based in two countries: China and Japan.

China, meanwhile, is taking a different path. Instead of financing big government deficits by issuing bonds, Beijing borrows relatively little but encourages its businesses, local governments and “state-owned companies” to borrow like crazy. So its total debt is soaring:

 

China’s debt grew in September at fastest pace in four years

(Asia Times) – A Reuters analysis of more than 2,000 China-listed firms showed total debt at the end of September jumping by 23% from a year ago, according to a report Sunday.

The increase, which comes amid an ongoing deleveraging campaign, represented the fastest pace of growth since 2013.

The analysis shows the degree to which de-risking and deleveraging efforts have been concentrated within financial sector so far, with real estate and industrial sectors leading the way in debt growth.

According to the report, debt servicing costs have accounted for close to a quarter of state-owned companies’ revenue. That ratio rose to 27% in the second quarter before falling to just below 25% in the third quarter on increased revenue.

To put the above in visual terms, here’s an infographic from Howmuch.com that shows per-capita government debt for the world’s major countries. Note that a Japanese family of five’s share of its government’s debt is close to $450,000 while in the US a similar family owes $300,000. That’s in addition to their mortgages, car loans, credit cards, etc.

 

 

Obviously debts of this magnitude can’t and therefore won’t be repaid. Which means the coming decade will be defined by how — and how quickly — we end up defaulting.

 

 

 

 

Questions or comments about this article? Leave your thoughts HERE.

 

 

 

 

We Give Up! Government Spending And Deficits Soar Pretty Much Everywhere

Posted with permission and written by John Rubino, Dollar Collapse

 

 

 

Check out these other articles by our contributors:

Stewart Dougherty -  The War on Gold Intensifies: It Betrays the Elitists’ Panic and Augurs Their Coming Defeat (Part 1)

Stewart Dougherty - The War on Gold Intensifies: It Betrays the Elitists’ Panic and Augurs Their Coming Defeat (Part 2)

Steve St. Angelo - THE BLIND CONSPIRACY: The Gold Market Is Heading Towards A Big Fundamental Change

Eric Sprott and Craig Hemke - Eric Sprott Talks Global Demand for Metals, Impact in 2018 (Weekly Wrap-Up, December 1, 2017)

BoJ Briefs Reuters: We"ll Let 10-Year Yield Rise Above Zero Percent Target Around 1Q 2018

It looks like BoJ Governor, Haruhiko Kuroda’s, minions are getting out and about to brief the financial news services that the biggest stimulator of all the central banks might reduce stimulus earlier than expected. The recipient of the unofficial briefings by BoJ officials is Reuters, which has this to say.

The Bank of Japan is dropping subtle, yet intentional, hints that it could edge away from crisis-mode stimulus earlier than expected, through a future hike in its yield target, according to people familiar with the central bank’s thinking.

With inflation still way below its 2 percent target, the BOJ sees no immediate need to withdraw stimulus, and regards weak price growth as its most pressing policy challenge. But bank officials are now more vocal on the rising cost of prolonged easing, such as the hit to bank margins - a sign that their next move would be to roll back stimulus rather than expand it, the people said.

It seems that BoJ has been sending signals – in particular by referring to the “reversal rate” - but some people weren’t paying attention.

The first sign of change came in Nagoya on Nov. 6, when BOJ Governor Haruhiko Kuroda - whose current term ends in April - said he was “mindful” of the risk prolonged easing could hurt banks’ appetite to lend. Days later, board member Yukitoshi Funo said the BOJ must be vigilant to the cost of easing. The most striking warning came from Kuroda last week, when he referred to a “reversal rate” - the level where rate cuts by a central bank hurt, not help, the economy by damaging banks and discouraging lending.

Kuroda gave a speech with the catchy title “Quantitative and Qualitative Monetary Easing and Economic Theory” at the University of Zurich on 13 November 2017. During the speech, in a section “Determining the Optimal Yield Curve”, he specifically referred to the reversal rate.

Another issue that has recently gained attention with regard to the impact on the functioning of financial intermediation is the "reversal rate." This refers to the possibility that if the central bank lowers interest rates too far, the banking sector"s capital constraint tightens through the decline in net interest margins, impairing financial institutions" intermediation function, so that the effects of monetary easing on the economy reverses and becomes contractionary. In Japan"s case, financial institutions have a solid capital base and credit costs have fallen sharply, so that at present their financial intermediation function is not impaired. However, because the impact of the low interest rate environment on financial institutions" soundness is cumulative, the Bank will continue to pay attention to this risk as well…Taking also various kinds of qualitative information into account, the Bank of Japan will continue to pursue the shape of the yield curve that is deemed most appropriate in order to maintain the momentum toward the 2 percent price stability target.

Okay, so we know Kuroda is focusing on the impact of the so-called reversal rate in the context of the yield curve. The unnamed BoJ officials spell it out to Reuters.

The most likely first step - albeit some time away - would be to allow long-term rates to rise more, reflecting improvements in the economy, they said. “The change in tone doesn’t have immediate policy implications, but it’s probably intentional,” one of the people said. “The BOJ wants to make its policy framework more sustainable,” said another. “Allowing longer-term rates to rise more would give banks some breathing space.”

We really should have paid more attention because Reuters implies (kind of) that referencing the reversal rate is central bank code for "we are preparing to reduce stimulus"…and the BoJ does like to drop hints.

European Central Bank (ECB) executive board member Benoit Coeure referred to the reversal rate in July last year in discussing when further rate cuts could become counter-productive. Five months later, the ECB decided to cut monthly asset purchases from 2017. The BOJ also has a history of dropping early hints of a future policy shift. Roughly a year before adopting its yield curve control (YCC) policy, the BOJ published a research paper analysing the feasibility of the idea.

In his speech “Assessing the implications of negative interest rates” at the Yale Financial Crisis Forum, Coeure noted.

it has been suggested that at some point the level of rates can become low to the extent that the detrimental effects on the banking sector outweigh the benefits of lower rates. In a recent paper, Brunnermeier and Koby refer to this rate as the “reversal rate”. At the reversal rate, bank profitability will fall, reducing capital generation via retained earnings, which is an important source of capital accumulation, and thereby eventually restricting lending.

Surpassing itself, Reuters “found” a BoJ board member, a former one anyway, who will speak on the record.

“Reversal rate is a pretty shocking word to come out of the mouth of a BOJ governor. It’s unthinkable the BOJ would insert it in Kuroda’s speech without any policy intention,” said Takahide Kiuchi, who was a BOJ board member until July.

 

The BOJ may allow long-term rates to rise more by shifting its long-term rate target to five-year yields from 10-year yields around the first quarter of next year, Kiuchi said. “The BOJ could put a positive spin on the move by saying it can more effectively reflate growth by keeping short-term borrowing costs low while allowing longer yields to rise.”

So there we have it…the BoJ is preparing to pull back on its obscene level of stimulus. Some time in the first quarter of 2018, or just after, the bank will adjust its Yield Curve Control (YCCC) policy, allowing the 10-year JGB yield to rise above the current zero percent target. Reuters explains.

The shift in communication comes as the U.S. Federal Reserve and ECB head for an exit from ultra-loose policy, and suggests the BOJ could follow suit sooner than expected. A majority of economists polled by Reuters before Kuroda’s latest comments expect the BOJ’s next move to be a withdrawal of stimulus - but not until later next year or beyond.

Just to make it really clear what’s happening, this was Reuters’ parting shot.

“It’s important the BOJ prepares markets in advance with careful communication,” said a third person familiar with the bank’s thinking.

Is this why the Yen is strengthening?

Visualizing $63 Trillion Of World Debt

If you add up all the money that national governments have borrowed, it tallies to a hefty $63 trillion.

 

Courtesy of: Visual Capitalist

In an ideal situation, governments are just borrowing this money to cover short-term budget deficits or to finance mission critical projects. However, as Visual Capitalist"s Jeff Desjardins notes, around the globe, countries have taken to the idea of running constant deficits as the normal course of business, and too much accumulation of debt is not healthy for countries or the global economy as a whole.

The U.S. is a prime example of “debt creep” – the country hasn’t posted an annual budget surplus since 2001, when the federal debt was only $6.9 trillion (54% of GDP). Fast forward to today, and the debt has ballooned to roughly $20 trillion (107% of GDP), which is equal to 31.8% of the world’s sovereign debt nominally.

THE WORLD DEBT LEADERBOARD

In today’s infographic, we look at two major measures: (1) Share of global debt as a percentage, and (2) Debt-to-GDP.

Let’s look at the top five “leaders” in each category, starting with share of global debt on a nominal basis:

Together, just these five countries together hold 66% of the world’s debt in nominal terms – good for a total of $41.6 trillion.

Next, here’s the top five for Debt-to-GDP:

While only Italy and Japan here are considered major economies on a global scale, the high debt levels of countries like Greece or Portugal are also important to monitor.

In the IMF’s baseline scenario, Greece’s government debt will reach 275% of its GDP by 2060, when its financing needs will represent 62% of GDP.

 

- A recent IMF report, obtained by Bloomberg

Greece, for example, is continuing along a particularly unsustainable path – and external creditors are getting stingier. Most recently, both the IMF and Greece’s euro-area creditors have demanded for the country to implement a law that automatically introduces austerity measures if a budget surplus of 3.5% of GDP isn’t hit.

While Greece has dismissed such demands as “unacceptable”, the country – along with many others around the globe – will have to accept that constant debt accumulation has eventual consequences.

*  *  *

To get “$63 Trillion of World Debt” in printed form, go to the Kickstarter page now. Deadline: Oct. 31, 2017

The $2 Trillion Hole: "In 2019, Central Bank Liquidity Finally Turns Negative"

In all the euphoria over yesterday"s "dovish taper" by the ECB, markets appear to have forgotten one thing: the great Central Bank liquidity tide, which generated over $2 trillion in central bank purchasing power in 2017 alone - and which as Bank of America said last month is the only reason why stocks are at record highs, is now on its way out.

This was a point first made by Deutsche Bank"s Alan Ruskin two weeks ago, who looked at the collapse in global vol, and concluded that "as we look at what could shake the panoply of low vol forces, it is the thaw in Central Bank policy as they retreat from emergency measures that is potentially most intriguing/worrying. We are likely to be nearing a low point for major market bond and equity vol, and if the catalyst is policy it will likely come from positive volatility QE ‘flow effect’ being more powerful than the vol depressant ‘stock effect’. To twist a phrase from another well know Chicago economist: Vol may not always and everywhere be a monetary phenomena – but this is the first place to look for economic catalysts over the coming year."

He showed this great receding tide of liquidity in the following chart projecting central bank "flows" over the next two years, and which showed that "by the end of next year, the combined expansion of all the major Central Bank balance sheets will have collapsed from a 12 month growth rate of $2 trillion per annum to zero."

Shortly after, Fasanara Capital"s Francesco Filia used this core observation in his own bearish forecast, when he wrote that "the undoing of loose monetary policies (NIRP, ZIRP), and the transitioning from "Peak Quantitative Easing" to Quantitative Tightening, will create a liquidity withdrawal of over $1 trillion in 2018 alone. The reaction of the passive community will determine the speed of the adjustment in the pricing for both safe and risk assets."

Fast forward to today, when Bank of America"s Barnaby Martin is the latest analyst to pick up on this theme of great liquidity withdrawal.

Looking at (and past) the ECB"s announcement, Martin writes that "as expected, Mario Draghi took a knife to the ECB"s quantitative easing programme yesterday. From January 2018, monthly asset purchases will decline from €60bn to €30bn, and continue for another 9m (and remain open ended). The ECB now joins an array of central banks across the globe that are either shrinking their balance sheets or heavily scaling back bond buying."

So far so good, and in itself, this structural tightening when coupled with the open-ended nature of the ECB"s taper was ultimately perceived as very dovish for markets, sending not only the EUR plunging over 200 pips in the past 2 days, but sending Eurozone yields jumping, as the ECB telegraphed it was very much uncertain when, and if, it would truly be able to untangle itself from QE, especially since the ECB still can increase the 33% limit on bond purchases if needed be after 2018 to return back to a quantitative easing paradigm, one which may well include the direct purchase of equities and ETFs, as in the case of the SNB and BOJ.

Furthermore, as Martin adds, heading into the ECB decision "the market had a warm reception for yesterday"s big QE cut: 5yr bund yields declined 5bp, European equities finished the day up 1.3% and iTraxx credit spreads ended 2bp tighter. In fact, we think markets were very relaxed heading into yesterday"s landmark decision. Chart 2 shows that European rates volatility reached an all-time low of 33.2 towards the end of last week. Such was the market"s comfort with the notion that Draghi would offset the drop in QE with heavy doses of forward guidance…and he indeed delivered lots on this front yesterday"

However, as Ruskin and Filia warn, Martin underscores that it is the bigger point that is ignored by markets, namely that it is all about the "flow" of central bank purchases. And in this context, the BofA strategist warns that it will take just over a year before the global liquidity tide not only reaches zero, but turns negative... some time in early 2019.

Chart 1 shows year-over-year changes in global asset purchases by central banks (we also include China FX reserves here). Given this year"s slowdown in ECB and BoJ QE (the latter, in particular, is striking in USD terms), we are well past the peak in global asset buying by central banks. But with the Fed now embarking on balance sheet shrinkage, the start of 2019 should mark the point where year-over-year asset purchases finally turn negative - a trend change that will come after four straight years of expansion.

Still, despite virtually every strategist on Wall Street being familiar with this chart, few if any want to believe it. In fact, the favorable reception to what is fundamental a tightening shift by the ECB poses what Martin notes, is a the big risk to corporate bond markets, "for as long as the ECB"s message on rates is dovish, the incessant inflow story into European credit is unlikely to die. And big inflows mean "overwhelming" credit technicals would persist for the foreseeable future (see chart 3 below). Thus, credit bubbles become a legitimate risk down the line."

To be sure, there is just one event that could end this hypnotized paralysis: inflation, which however stubbornly refuses to emerge, which is why "the market seems to have dismissed the idea that inflation could surprise to the upside" However, "should it rise quicker than expected, we sense the dovish rhetoric from central banks would quickly change. And we believe that this may be all that"s needed to snuff out the great "reach for yield" trade that is currently gripping European corporate bonds."

And therein lies the rub: will inflation finally appear and prevent the world"s biggest asset bubble from becoming even bigger, or - as Eric Peters warned two weeks ago - will the "Nightmare Scenario" for the Fed emerge, and even as asset prices rise ever higher, inflation remains dormant:

If we don’t see a sustained cyclical jump in wages, then yields won’t go up. And if yields don’t go up, then the asset price ascent will accelerate... Which will lead us into a 2018 that looks like what we had expected out of 2017; a war against inequality, a battle for Main Street at the expense of Wall Street, an Occupy Silicon Valley movement. Then you’ll have this nightmare for the next Federal Reserve chief, because they’ll have to pop a bubble.

In conclusion, we go back to the person who first observed the dramatic shift in central bank flow, Citi"s Matt King, who had this to say:

To us, QE flows (i.e. marginal net purchases) rather than the stock of central bank holdings are the more important driver of asset prices. As we noted recently, if all major European investor types are already net selling or at least not buying € FI securities at prevailing market prices, then why should they stop or even start buying when the safety is withdrawn? Unless you have an emphatic answer, then with ECB QE falling by at least €500bn next year, according to our economists, and the Fed reducing its holdings of securities by almost $500bn at the same time, it would perhaps be best to tread cautiously.

The Fed Balance Sheet Unwind Myth

Authored by Lance Roberts via RealInvestmentAdvice.com,

Since the beginning of the year, the Federal Reserve has been heavily discussing, warning rather, they were going to begin to “unwind” their gargantuan balance sheet. As Michael Lebowitz recently penned in his subscription-only article “Draining The Punchbowl:”

“Since QE was first introduced, the S&P 500 has gained 1,546 points. All but 355 points were achieved during periods of QE. Of those remaining 355 points, over 80% occurred after Trump’s victory.”

That is a pretty amazing set of stats. I have previously noted the high correlation of the financial markets relative to the ongoing liquidity operations of the Federal Reserve. I have updated that analysis to show the reduction in the balance according to the Fed’s proposed schedule.

While the market stumbled following the end of QE in the United States, global QE, as shown in the charts of the major global Central Banks picked up the slack.

But now, the ECB has already begun discussing their plans to begin cutting the amount of their QE program by half in the coming year.

“European Central Bank officials are considering cutting their monthly bond buying by at least half starting in January and keeping their program active for at least nine months, according to officials familiar with the debate.

 

Reducing quantitative easing to 30 billion euros ($36 billion) a month from the current pace of 60 billion euros is a feasible option, said the officials, who asked not to be identified because the deliberations are private. That reduced flow would match existing predictions from economists at institutions including ABN Amro Bank NV and Bank of America Merrill Lynch.”

The hope, of course, by Central Bank officials is that global economies are now humming along at a pace strong enough to withstand the reduction of “emergency measures.” Of course, the real question is whether the Central Bank’s “measures” of economic strength are accurate. While there are certainly indicators such as GDP growth, production, and employment measures which suggests that global economies are indeed on a cyclical upswing, there are also numerous measures which suggest the opposite.

As I stated previously,

“The Fed understands that economic cycles do not last forever, and we are closer to the next recession than not. While raising rates will accelerate a potential recession and a significant market correction, from the Fed’s perspective it might be the ‘lesser of two evils.’ Being caught near the ‘zero bound’ at the onset of a recession leaves few options for the Federal Reserve to stabilize an economic decline.”

With the Fed trying to raise interest rates, and reduce the balance sheet simultaneously, the “tightening of monetary policy” is a drag on economic growth and ultimately the stock market. But as I stated above, while the Fed is currently “discussing” the reduction of their balance sheet beginning in October, they actually haven’t. In fact, just last week the Fed increased their balance sheet by over $13.5 billion dollars. No wonder the stock market shot higher. 

Since these balance sheet expansions generally have occurred at points where asset prices were at risk due to some “event,” the latest expansion occurred during the “tax cut hope” driven rise. The raises the potential question of:

“What does the Fed know that we don’t.” 

Wolf Richter recently proposed 5-possible conclusions to extract from the Fed’s actions:

1. The whole QE-unwind announcement was a hoax to test how stupid everyone is. But I doubt this.


2. The people running the OMO are on vacation and have been replaced by algos or interns, and they just keep doing what the folks now on vacation have been doing for years. I doubt this too.


3. The FOMC told the public what it wants to have done but forgot to tell its own people at the Trading Desk. I doubt that too.


4. There is willfulness in it – a sign that they’re not ready, or that they want to give the markets more time to get used to the idea of it, etc. And this could be the case.


5. They’re seeing something that worries them, and they’re holding off for now to get a clearer picture. But I doubt this because their decision to commence the QE-unwind on October 1 was unanimous, and since then nothing of enough enormity has changed.

While Wolf doubts the 5th point. I don’t as much. The reason I say that is because the yield curve seems to be sniffing out something.

Given current market valuations, exceedingly low yields on junk bonds globally, complacency elevated along with very high levels of both bullish sentiment and heavy investor equity allocations, the risk of a “policy related” error is extremely high.

The “Bond Bull” Ain’t Dead…It’s Just Resting

The recent “pop” in rates, after declining to near 2% this summer, has once again brought calls for the end of the “bond bull.” These calls have been, for the last 4-years, prime buying opportunities to add bond exposure to portfolios. The recent rise in rates came with the election of President Trump and hopes for “tax cuts and reforms.” Theoretically, these policies will boost economic growth and inflation as seen during the Reagan era leading to higher rates for bonds. However, as discussed previously, given the completely inverted state of economic dynamics, there is a high probability these reforms will fail to create the economic growth boost currently hoped for. (That is even if they come to fruition.)

But the Fed’s balance sheet reduction is also suggestive of lower, not higher, interest rates. In the past, despite what the Fed suggested would happen, rates rose during their QE programs as money rotated out of the “safety of bonds” back into equities. When those programs ended, rates fell. Rates also fell to lows after the end of QE, and despite the “Trump Bump” since the election, the further reduction of liquidity, and potential onset of a recession in the months ahead, will likely lead to a significant push lower as money rotates from “risk” back to the “safety” of U.S. Treasuries.

As I laid out previously:

“There is an assumption that because interest rates are low, that the bond bull market has come to its inevitable conclusion. The problem with this assumption is three-fold:

 

1. All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.


2. The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largesse in the future, the budget deficit is set to swell back to $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.


3. Central Banks will continue to be a buyer of bonds to maintain the current status quo, but will become more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion which will push the 10-year yield towards zero.”

 

In this past weekend’s missive “Yellen Speaks Japanese” and yesterday’s post “Debt, Deficits & Economic Warnings” I laid out the data constructs behind the points above.

With Yellen pushing the idea of more government spending, the budget deficit already expanding and economic growth running well below expectations, the demand for bonds will continue to grow. However, from a technical perspective, the trend of interest rates already suggest a rate of zero during the next economic recession.”

Here is the point, while the punditry continues to push a narrative that “stocks are the only game in town,” this will likely turn out to be poor advice. But such is the nature of a media-driven analysis with a lack of historical experience or perspective.

From many perspectives, the real risk of the heavy equity exposure in portfolios is outweighed by the potential for further reward. The realization of “risk,” when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.

In other words, I get paid to hedge risk, lower portfolio volatility and protect capital. Bonds aren’t dead, in fact, they are likely going to be your best investment in the not too distant future.

In the short-term, the market could surely rise further, especially if the Fed continues reinvesting the proceeds from their balance sheet. This is a point I will not argue as investors are historically prone to chase returns until the very end. But over the intermediate to longer-term time frame, the consequences are entirely negative.

As my mom used to say:

“It’s all fun and games until someone gets their eye put out.”

What The ECB Will Announce This Week: A Summary Of All QE Tapering Scenarios

The main risk event in the coming week, in addition to a barrage of corporate earnings, will be the ECB"s long-awaited announcement of what the central bank"s QE tapering will look like. Conveniently, thanks to a trial balloon released on October 12, we already know the general parameters of this phasing out of monetization: ECB officials are considering cutting their monthly bond buying by at least half, from €60BN to €30BN, starting in January and keeping their program active for at least nine months, with some potential reference to a lengthening of the maturity of purchases.

According to a Bloomberg survey, the ECB will likely keep buying for about nine months to take the program to just over €2.5 trillion, respondents said before the ECB’s Oct. 26 decision. That’s consistent with what some officials see as the limit in the market under current rules. ECB President Mario Draghi is predicted to announce his first interest-rate increase in early 2019.

According to Bloomberg, "such an outcome for quantitative easing would soothe the concerns of policy makers who want a definite signal that the program will end, while giving succor to those who want to keep stimulus flowing as long as the inflation outlook remains lackluster. It doesn’t resolve the question of what happens in a year if consumer-price growth still isn’t on track to the ECB’s goal."

“There has been no dissenting voice at the ECB ahead of the meeting on the need to scale down net purchases,” said Maxime Sbaihi, an economist at Bloomberg in London. “So the question is less ‘if’ they will taper than the details of ‘how’ they will do it.”

Why not taper more? Simple: Mario Draghi is terrified of starting another bond (or stock) tantrum, if investors are spooked that the ECB is withdrawing too much support: "The Governing Council seems concerned that a more aggressive tapering plan could harm financial conditions, especially by letting the euro appreciate even more,” said Kristian Toedtmann, an economist at DekaBank in Frankfurt.

Meanwhile, the major sticking point among ECB governors appears to be whether to commit to an end-date for QE. Draghi has expressed confidence that the region’s economic recovery will eventually help him and his peers to deliver on their mandate. Yet inflation was 1.5% in September and ECB’s own forecast doesn’t see it returning to the goal of below but close to 2% before the end of 2019.

“It seems that the hawks want a definitive end-date while the doves want it open-ended,” Alan McQuaid, an economist at an economist at Merrion Capital in Dublin. “I think we will get a compromise, with the ECB saying that it intends to end its QE scheme in September 2018, but if things take a dramatic turn for the worse on the economic or inflation front in the meantime, it will extend its scheme further until things have stabilized.”

Which is why many model QE as lasting beyond the 9 month horizon, and running through the end of March 2019.

In terms of market consensus, the following Barclays chart visualizes the most likely outcome, showing monthly QE declining by 50% in January through October, when it tapers by another 50% until March 2019, coupled with a modest increase in the ECB"s deposit rate around the end of 2018.

But, as Bank of America asks, what if things don"t turn out that way? In the table below, the bank"s rates analyst Erjon Satko attempts to respond to the many questions the bank has gotten regarding possible market reactions to different decisions in terms of QE size/length but also to changes in the three technical aspects that matter in our view: the rates forward guidance, the maturity of QE purchases and the split between safe and risky assets (periphery, private assets).

Here are BofA"s observations on the various scenarios:

• In the €40bn/6m, we assume the ECB would leave the door open to a further extension, ruling out a cliff end (from €40bn to 0). That scenario, as well as the €30bn/12m would ultimately represent a large total QE amount. We thus assume that flexibility will be engineered with technical changes that should imply greater support for risky assets (this would be bullish the periphery and could also fuel a steepening in long-end swaps).


• In the €20bn/12m and even more so the €20bn/9m, the first market reaction should be bearish as the quantum of monthly Bund purchases is lower than expected. However, as previously discussed, we think the behavior of the periphery and risky assets in general will then guide term premium in Bunds. Hence the "then see periphery" in Table 1.


• Purchases skewed towards risky assets: For example, if the ECB hints to more limited tapering of private asset purchases relative to PSPP, or if it increases the share of EU supras, implying greater potential for deviations from capital keys, in favor of Italy and France.


• Extension of the maturity of purchases: the ECB could suggest that reinvestments will happen at a longer maturity than recent net purchases, or it could make more significant comments to signal longer overall purchases. As discussed last week, on way for the ECB to make this concrete could be that it drops the 30y maturity limit on eligible bonds

Yet despite the ECB"s tapering trial balloon, one surprising market reaction has been the recent decline in Bund yields together with the BTP spread tightening which according to BofA has "taken many by surprise, especially in light of the ever-decreasing expectations of QE support next year." In fact, while market expectations for 2018 ECB QE have been edging lower from €60bn/month to €40bn/month and now to €20-30bn/m, current valuations fail to give evidence of major concerns ahead of the tapering announcement. Of course, that may change once Draghi"s media jawboning becomes fact; alternatively this may simply be more evidence of what Citi"s Matt King provocative claimed this past summer, namely that the "market" has become so distorted by QE, it has lost the ability to discount the future.

* * *

In modeling market reaction scenarios to the ECB"s October 26 announcement, nobody anticipates a major market shock. In fact, some - such as Citi - expect various permutations of the QE tapering to be actually seen as dovish for the market. As we discussed last Saturday, Citi"s EONIA-signaling driven model seeks to predict the near-term market impact (around one-week) across the euro swap and Bund curve for a range of QE scenarios.

Below are its key findings:

• For 10yr Bunds, yields fall around 25bp in the most dovish scenario (€40bn x 12mth) and rise around 24bp in the most hawkish scenario (€20bn x 6mth). Figure 1 above summarizes the full set of results for Bunds.


• The most market neutral scenarios, according to the model, are €20bn x 12mth, €30bn x 9mth and €40bn x 6mth.


• This is broadly consistent with the Reuters poll (taken 11-14 September) which suggested the consensus amongst economists was for €40bn (range €30- 50bn) over 6mths (range 3-12mths).


• Cross-checking the model output (based on policy signals) with the total size of APP extension shows a clear relationship (Figure 2). The model therefore assumes that there is less of a role for the ‘intensity’ of purchases.


• The market neutral size for APP upsizing appears to be around +€250bn


• The Citi house view is for an extension in the form of an ‘envelope’ (without specifying a monthly purchase rate) of €150bn (with upside risk of €210bn). That could lead to a near-term sell-off of around 15-20bp.


• The scenarios presented assume deliverability. But, the most dovish options undoubtedly would be more challenging to implement (see below) given scarcity constraints. In terms of likelihood, we would put less weight on these scenarios which skews the risk towards a bearish reaction on 26 October.

Finally how should one trade the ECB announcement? Here Barclays" confusion reflects the (confused) trader"s mindset best: "we do not see compelling risk-reward in pre-positioning in EUR ahead of the ECB announcement, given shifting expectations and difficult in gauging how the market is pricing the parameter changes."

Translation: stop trying to pretend you know how the market will react to the ECB, and just wait for the announcement. Here"s hoping you are faster to react to the news than the HFTs.... and mind the direction of the initial kneejerk reaction, which is usually just the algos taking out all the stops.

The Dollar Funding Shortage: It Never Went Away And It's Starting To Get Worse Again

Very quietly, in the last few weeks, cross currency basis swaps (CCBS) related to the dollar have reversed their rise and started moving deeper into negative territory… again. This might not be of much interest to buyers of global equity markets at this point, but it is signalling ominous signs of growing funding stress in the financial “plumbing”.

As Bloomberg notes   “cross-currency basis swaps, which money managers and corporate treasurers outside the U.S. can use to borrow in dollars, remain close to the widest levels since January even after quarter-end, when such financing strains typically dissipate. The market was a key indicator of stress during the financial crisis, and while it’s nowhere near the alarming levels of that era, it’s still garnering the attention of analysts.”  

In simple terms, the CCBS is the cost in basis points (typically for three months) of swapping these currencies into dollars over and above prevailing interest rate differentials. In a benign environment the CCBS should trade at zero, not in negative territory. The latter implies a shortage of US dollar balance sheet (credit) offered by the global banking system. As the chart above shows, dollar liquidity became extremely tight in December 2016, especially for Yen borrowers, although it not nearly as bad as what happened in May of 2015 when we first brought attention to this little followed corner of the financial system. Despite the weakness in the dollar during much of the current year, the dollar liquidity issue never completely disappeared.

There are several reasons why, like in recent years, financing in dollars is becoming more expensive.

Among the reasons cited by strategists, are the political tensions in Spain related to Catalonia’s independence push and the slow pace of Brexit talks, which may be heightening the perception of credit risk for the region’s banks. Combine that with the prospect that a U.S. tax overhaul could trigger dollar repatriation, and the outlook for monetary-policy divergence with the Federal Reserve starting to unwind its balance sheet, and analysts see the trend only worsening.”

"This is keeping a lot of people feeling uneasy,’ said Gennadiy Goldberg, an interest-rate strategist at TD Securities in New York. ‘This now seems more of a political story, with Catalonia, U.K. Brexit negotiations and potential U.S. tax reform and repatriation. Spreads could keep widening. While Republican efforts to get a tax plan through the Senate may be off to a rocky start, any framework that spurs U.S. companies to repatriate cash could compound the scramble for dollar financing. Although that’s probably a story that will play out in the second quarter, it may already be factoring into expectations."

While we couldn’t disagree, there’s one important factor they’re missing, the US Treasury’s account (Treasury General Account) with the Federal Reserve.

By running down this account by $400bn in the first quarter of 2017 (mainly due to the debt ceiling issue), the Treasury effectively increased dollar liquidity (bank reserves) by the same amount. This not only helped to ease the dollar funding problem, but was a factor in the dollar’s weakness.

Since last month, the Treasury has rebuilt the balance in its account at the Fed from $38bn on 6 September 2017 to $170bn on 11 October 2017, for a net increase of $132bn…not insignificant. Obviously, if and when the Treasury rebuilds its account at the Fed to the previous level, dollar liquidity could become extremely tight again, especially if the Fed is tapering its balance sheet at the same time.

We have been wondering whether the Fed governors fully understand this, although some of the boys at 33 Liberty no doubt do. Credit guys also understand it “there’s another reason the strain is set to grow. The Fed is set to boost the pace of its balance-sheet roll-off each quarter, potentially putting upward pressure on U.S. rates relative to Europe and making it tougher for global investors to get dollar funding," according to Mark Cabana, head of U.S. short rates strategy at Bank of America Corp.”

Clearly the issue is attracting the attention of investors as BoA analyst, Cabana writes in a recent report, and explains that “we have received a number of client questions recently about the outlook for banking reserves both in the near and medium term due to the Fed"s balance sheet unwind and potential swings in Treasury"s cash balance.”

In summary, Cabana expects a large reserve drain in Q2 2018 with banking reserves dropping by more than $1 trillion by the end of 2019, which “highlights the potential for funding strains to emerge around Q2 next year and uncertainties around the Fed"s longer-run policy framework… This reserve drain and the Fed’s portfolio unwind should pressure funding conditions tighter through wider FRA-OIS and more negative XCCY (cross currency basis swaps) levels.”

Here are his views in more detail for the rest of this year, next year and 2019-20.

Reserves through Year End: The aggregate amount of reserves outstanding will decline only modestly between now and the end of the year, minimizing any near-term funding pressures. The $30 bn reduction from the Fed"s portfolio this quarter along with near-term fluctuations in Treasury"s cash balance due to the debt limit will result in only modest swings in overall reserve levels. Treasury"s cash balance will need to decline ~$100 bn between now and December 8, but should rebound to ~$200 bn by year end via corporate tax receipts and ~$70 bn in bill supply during the last 3 weeks of the year.

Reserves in 2018: A more material drain of over $600 bn bank reserves during 2018 should occur due to the increased pace of Fed portfolio unwind and build in the Treasury cash balance post debt limit resolution. The Fed is projected to have $381 bn in Treasury and agency MBS roll off of their portfolio next year with the pace of reduction accelerating to $90 bn in Q2 and around $115 bn in each of Q3 & Q4 (the Fed is expected to have monthly redemptions below the cap in these quarters).

The sharpest reserve drain is likely to come from a boost in Treasury"s cash balance after the debt limit resolution in March. Treasury will likely increase the cash balance to $350 - $400 bn early in Q2 through tax receipts and higher bill supply. This reserve drain and the Fed"s portfolio unwind should pressure funding conditions tighter through wider FRA-OIS and more negative XCCY basis levels.

Reserves in 2019 & 2020: Large reserve drains of $400 - $500 bn are expected in each of these years. This will primarily be driven by the expected $425 and $337 bn Fed portfolio reduction as well as growth in currency in circulation, which we project to average around 5% per year ($80-90 bn / yr). We also expect slightly lower usage of the Fed"s reverse repo facilities as the Fed"s balance sheet shrinks due to more attractive short-term investment opportunities amidst higher Treasury supply.

We expect to see signs of reserve scarcity emerge at some point over the course of 2020 or in early 2021. While the total amount of required reserves is currently unknown we have previously estimated that required level of reserves in the system is likely between $600 bn - 1 tn. This is consistent with the NY Fed"s surveys of primary dealers and market participants where the median respondent believes reserve balances will total $613bn, while the 75th and 25th percentile of responses were $1tn and $406 bn. As reserve scarcity is reached, we expect to see continued upward movement in LIBOR as well as higher rates and volumes in the fed funds / OBFR markets.”

Cabana finishes with a discussion about how bank reserves will fit into monetary policy and the potential appointment of a new Fed Chairman.

Framework question: A key question in thinking about the longer-term outlook for reserves is the monetary policy operating regime that the Fed will employ, which will be heavily influenced by the next Fed Chair. As our economists recently noted, if Chair Yellen or Governor Powell leads the Fed they would likely be in favor of maintaining a "floor" regime (relying on IOER & ON RRP). In contrast, Fed Chair contenders Warsh and Taylor would likely favor a "corridor" system that relies on a scarcity of reserves that would reduce IOER usage, increase fed funds trading activity, and require frequent open market operations to adjust reserves in order to hit the Fed"s target.

It seems current staff at the Fed have a strong preference to maintain a "floor" regime. The November 2016 FOMC meeting minutes noted a number of advantages of such a system and recent Fed research has highlighted that abundant reserves can smooth interbank payments, reduce daylight overdrafts at the Fed, and lead to less discount window usage. A "floor" system would also aid in satisfying bank LCR HQLA requirements while reducing the need for frequent open market operations to smooth volatility in Treasury and financial market utility deposits at the Fed. This regime would keep fed funds below IOER and likely ensure that the ON RRP remains a key fixture of the Fed"s monetary policy well into the future.

Negative cross currency basis swaps indicate that the structural tightness in dollar liquidity never disappeared despite the weaker dollar. If dollar funding markets get a lot tighter again, this won’t be good news for EM markets with offshore (Euro) dollar debt in the region of $10 trillion. Rolling over dollar debt periodically will be uncomfortable, to say the least, for some of the region’s banks.

$1 Trillion In Liquidity Is Leaving: "This Will Be The Market's First Crash-Test In 10 Years"

In his latest presentation, Francesco Filia of Fasanara Capital discusses how years of monumental liquidity injections by major Central Banks ($15 trillion since 2009) successfully avoided a circuit break after the Global Financial Crisis, but failed to deliver on the core promise of economic growth through the "wealth effect", which instead became an "inequality effect", exacerbating populism and representing a constant threat to the status quo.

Fasanara discusses how elusive, over-fitting economic narratives are used ex-post to legitimize the "fake markets" - as defined previously by the hedge fund - induced by artificial flows. Meanwhile, as an unintended consequence, such money flows produced a dangerous market structure, dominated by both passive-aggressive investment vehicles and a high-beta long-only momentum community ($8 trn and rising rapidly), oftentimes under the commercial disguise of brands such as behavioral Alternative Risk Premia, factor investing, risk parity funds, low vol / short vol vehicles, trend-chasing algos, machine learning.

However as Filia, and many others before him, writes, only when the tide goes out, will we discover who has been swimming naked, and how big of a momentum/crowding trap was built up in the process. The undoing of loose monetary policies (NIRP, ZIRP), and the transitioning from "Peak Quantitative Easing" to Quantitative Tightening, will create a liquidity withdrawal of over $1 trillion in 2018 alone. The reaction of the passive community will determine the speed of the adjustment in the pricing for both safe and risk assets.

And, echoing what Deutsche Bank said last week, when it warned that central bank liquiidty injections will collapse from $2 trillion now to 0 in 12 months, a "most worrying" turn of events, Fasanara doubles down that "such liquidity withdrawal will represent the first real crash-test for markets in 10 years." 

Filia concludes that "the big opportunity in today"s markets is to position for such moment of adjustment, as it is totally priced out despite its potential for severe disruption, thus offering the most pronounced asymmetric profile."

Below are the key slides from Fasanara"s presentation:

The full, must read presentation is below (link):

Putting America's Record-Breaking $20 Trillion Debt In Global Context

The U.S. federal government just passed a record $20 trillion in publicly held debt. That’s bigger than the entire economy of every country in the European Union, combined.

As HowMuch.net notes, the debt will only grow higher unless President Trump and the U.S. Congress can agree to unprecedented spending cuts combined with tax increases. 

Don’t count on that happening anytime soon. Most people think that an eye-popping $20+ trillion debt is insurmountable, and in fact, it is the largest in the world by far.

But when you look at another fiscal measure - the ratio of debt-to-GDP - the U.S. is not in the worst situation...

Source: HowMuch.net

HowMuch.net"s visualization allows you to quickly see how the U.S. government’s debt compares to other countries around the world. The size of the country correlates to the size of the debt. The U.S. and Japan stand out because they have the highest debts in the world ($20.17T and $11.59T, respectively). Other countries, like Germany and Brazil, appear much smaller because their debts are comparatively tiny ($2.45T and $1.45T, respectively). We then color-coded each country according to its debt-to-GDP ratio. Green countries have a healthy margin, but dark red and fuchsia countries have debts that are even bigger than their entire economies.

Top 10 countries with the Worst Debt-to-GDP Ratios 

1. Japan (245% at $11.59T)


2. Greece (173% at $338B)


3. Italy (138% at $138B


4. Portugal (133% at $274B)


5. Belgium (111% at $111B)


6. Spain (106% at $106B)


7. Canada (106% at $106B)


8. Ireland (105% at $105B)


9. France (98% at $98B)


10. Brazil (82% at $82B)

The debt-to-GDP ratio is a critical metric for evaluating a country’s fiscal health. It makes a lot of sense for the American government to have a higher debt than a much smaller country, like Germany. Think about it like this: Bill Gates is worth $86 billion, so he can afford a much higher credit card bill than me or you.

That’s why it’s important to consider the Gross Domestic Product (GDP) of each country, a number which represents the sum of all transactions occurring in the economy.

Once you understand the public debt as a percentage of GDP, you get a level playing field for countries on different economic scales. When you think about it like this, the U.S. isn’t even among the ten worst sovereign debts in the world.

Why Quantitative Easing In The Eurozone Will Be Extended

The staff of the European Central Bank has now released the new macro-economic projections for the Eurozone and whilst the introduction sounds optimistic about an ever-increasing GDP and a relatively stable GDP growth rate, reading between the lines suggests we could see an extended Quantitative Easing program.

The ECB is probably correct when it claims the economic recovery will remain ‘robust’, but it also mentions the ‘favorable financing conditions’ as one of the main drivers of this economic recovery. This is quite the ‘catch 22’ scenario. The economy is recovering due to the low interest rate policy of the ECB, but without this ‘easy money policy’, the recovery would be either much slower or non-existing at all. Whilst we have heard several voices from ECB committee members the central bank is getting close to the point it will start to increase the interest rates again, the working paper from the ECB staffers is pretty clear on the need for continuous (monetary) support to protect the current economic recovery.

Source: ECB paper

What’s even more intriguing is the fact the ECB’s assumptions are taking an even LOWER interest rate into account. The study was based on the market circumstances and market expectations as of half August, and back then, the market was taking an average 10 year government bond yield of 1.3% in 2018 and 1.6% in 2019 into consideration. However, this has now been revised downward with approximately 10-20 basis points. This could indicate the market has started to price in a longer period of easy and free money.

And that’s an important starting point. As the loans to businesses (and individuals) are priced based on the anticipated ‘risk-free’ interest rate of a government bond, the lower expectations for sovereign debt yields will trickle down to the ‘real’ economy (underpinning the growth expectations), but it’s unlikely this effect will still be noticeable should the ECB reduce its QE program. That’s probably why the market is now expecting the three month EURIBOR interest rates to continue to be low, and even lower than when the previous quarterly survey was completed.

Source: ECB Paper

As you can see on the next image, even keeping the Quantitative Easing program unchanged, the GDP growth rate will slow down whilst the anticipated inflation rate will decrease as well to less than half of the ECB’s desired 2% rate.

Source: ECB Paper

The ECB comments this is due to a lower oil-related inflation impact and it expects the underlying inflation rate to increase again from 2019 on, but we do not necessarily agree with that view. After all, the weaker than expected US Dollar might increase the impact of the low oil price and extend the period wherein this impact will be felt.

Source: Danske Bank

Whilst most eyes have been on the Federal Reserve lately, the upcoming decision of the European Central Bank in October might be even more important. Several executive committee members have claimed the Eurozone is strong enough to sustain the recovery on its own, but we think it might be too soon for the Eurozone to stand on its own legs.

A reduction of the size of the Quantitative Easing program is definitely a possibility but this isn’t Utopia. The continuous support of the Central Bank is still needed.

Would you like to maintain your purchasing power? Read our Guide to Gold right now!