The view from Seat 34A. Photo by Elisabeth Dellinger.
Greetings from the sky, where yours truly is spending her 6 AM flight poring over the latest market maelstrom, powered by three cups of coffee and in-flight wifi. Banks have replaced China as the epicenter of financial fear, with Thursday's jolt coming courtesy of Sweden's central bank, which cut rates deeper into negative territory. Even though Sweden's economy is growing just fine. And even though negative rates haven't stimulated anything, anywhere, ever. But in a fresh twist, investors are starting to realize all this monetary gimmickry is feckless—an about-face from seven-ish years of central banker deification. Seeing the emperor in his underpants is scaring the, um, pants off the market, but in the long run, I suspect it can only be good. If markets shift focus to the too-long-forgotten yield curve, central banks just might do the same, perhaps ending the monetary madness and getting back to growthy basics.
Central bank sentiment has been upside down since 2010, when the Fed launched QE2 (less colloquially, the second round of quantitative easing) and everyone made jokes about fancy ocean liners. The first round of QE boosted the monetary base and liquidity when markets needed it most—late 2008/early 2009. After markets bottomed in March, then-Fed head Ben Bernanke was branded markets' savior, and QE gained a reputation as a magic, growth-restoring elixir.
However, successive rounds didn't work so well. Nor did the UK's or Japan's QE adventures. But few noticed. They presumed QE must be the only thing keeping markets rising and economies growing, and without it, fragile growth would become no growth. Almost everyone ignored the yield curve, including central bankers. Anything central bankers claimed was monetary stimulus was seen as good stimulus. For example, when the Fed performed “Operation Twist” in 2011, it was seen as stimulus, even though the Fed selling short-dated bonds and buying long-term ones didn’t even bump up the monetary base and only flattened the yield curve.
Onto this stage stepped ECB Chief Mario Draghi, who introduced negative interest rates in late 2014. Everyone assumed it must be a brilliant move, because Draghi was a euro-saving genius. When they didn't work, obviously the solution was even more negative interest rates, coupled with QE. When QE didn't boost inflation, more QE was the answer. Ditto for Japan, which piled negative rates on top of a massive QE program late last month.
If you think about banks' business models, none of this central bank trickery was ever going to work. We've written about QE's fecklessness for years. When central banks traded new reserves for long-term bonds, they flooded bank balance sheets and lowered long-term interest rates. Low rates were supposed to make households and businesses eager to borrow, and new reserves were supposed to give banks ample cash to lend. But lower long-term rates also flattened the yield curve, shrinking banks' net-interest margins (banks borrow from us and each other at short-term rates, lend at long-term rates, and profit off the spread). Simultaneously, regulators whacked banks with higher capital requirements and forced business model changes, making them more risk averse and incentivizing them to hoard cash. Regulatory risk plus tiny loan profits discouraged banks from lending to all but the most creditworthy. Lending and money supply fell for long stretches, growth crawled, and inflation stalled.
Negative rates aren't any better. Theoretically, they're supposed to goad banks into pulling reserves from the central bank—where deposits carry a penalty—and use them to fund abundant new loans instead. But negative central bank deposit rates don't change the risk/(lack of) reward dynamic in commercial lending. Banks still had incentives to park all the spare cash they could. They just needed to move it from something with a penalty to something with a return, so they pulled reserves and bought sovereign debt instead. Problem solved! Except higher demand pulled down long-term rates even more. This happened in Europe last year, and as our own Tim Schluter wrote yesterday, it's now happening in Japan, where even 10-year yields are now negative.
Enter Sweden, which cut its main policy rate to -0.5% (from -0.35%) Thursday morning. Sweden's economy is among the developed world's fastest-growing, with GDP up 3.4% annualized in Q3.[i] It is not a country that needs stimulus. But inflation is crawling, and the Riksbank said it had "weakening confidence" in its ability to hit its 2% annual inflation target. Sweden already had negative rates and a small QE program. Believing a -0.5% interest rate plus QE will do what a -0.35% interest rate and QE couldn't fits the legendary definition of insanity often attributed to Albert Einstein. The further short rates fall, the more they will drive demand for long-term bonds, pushing negative yields further and further down the yield curve. None of this will stimulate inflation. Nor will the ECB's blend of QE and negative rates. The biggest drag on inflation is oil prices—excluding energy costs, CPI is running around 1.1% annually in the eurozone and 1.2% annually in Sweden.[ii] Getting headline CPI up in the near term would require higher oil prices, and last I checked, central banks don't control oil production.
Markets are finally getting hip to all this, and it's causing short-term volatility galore. Within the walls of Fisher Investments, we've long had the theory that when the rose-colored glasses finally came off and investors realized all this stimulus wasn't actually stimulative, it could whack sentiment upside the head for a bit as investors reoriented themselves. That may be happening now. Fundamentally, nothing has really changed in the global economy. Flatter yield curves hurt, but the US and UK have already proven they can muddle through similar environments. Ditto the eurozone, which survived über-flat yield curves last year. Outside commodity-reliant Emerging Markets, most of the world is growing fine. Manufacturing is in a bit of a soft patch, but the developed world is predominantly service-based, and services are in good shape. Net commodity importers like the US, UK and most of Europe should receive a net benefit from cheap oil, which reduces businesses' costs. The commodity downturn hit US business investment last year, but with the oil & gas industry representing less than 1% of US GDP, most of the pain should be behind us. Some energy producers will go under, but the biggest US banks' collective exposure to the Energy sector is about 2% of total loans. These loans are also collateralized by tangible assets, like oil reserves and infrastructure (e.g., pipelines). This isn't 2008, when banks took a beating from writedowns on illiquid, hard-to-value mortgage baskets and credit derivatives that few wanted to buy, even for pennies on the dollar. As the oil industry consolidates, there should be plenty of competition to buy. In the long run, markets weigh fundamentals, and there is plenty of good to weigh.
But in the short run, sentiment rules, and realizing central banks are pushing on a string hits sentiment. Eventually, this correction will run its course, and in all likelihood, long-term bond yields will probably bounce a bit. Treasury markets are volatile, like stocks, and prone to overreacting. Yields took a big dive in early to mid-2015, as the ECB launched QE, then bounced back to finish the year flattish. We probably see the same this year, as the forces tugging at supply and demand haven't changed.
And there could be a silver lining once the mayhem dies down: Central banks might finally learn from their mistakes and stop their monetary meddling. Imagine, for a second, that Mario Draghi comes out and says "Oops, we just noticed what we did to the yield curve and our banks, sorry about that, we'll get rates back in the black and stop QE so banks' business models can work again." A little accountability and humility could help restore central banks' credibility, and yield curves could finally steepen. A little monetary shock therapy could go a long way.
[i] Source: FactSet, as of 2/11/2016.
[ii] Source: FactSet, as of 2/11/2016.