Monday, July 16, 2012 – Strong Demand for Negative Interest

Strong Demand for Negative Interest
-by Sinclair Noe

DOW – 49 = 12,727
SPX – 3 = 1353
NAS – 11 = 2896
10 YR YLD -.03 = 1.46%
OIL -.32 = 88.11
GOLD – .80 = 1589.60
SILV – .03 = 27.41
PLAT – 15.00 = 1423.00

The International Monetary Fund cut its forecast for global economic growth and warned that the outlook could get worse if policymakers in Europe do not act with enough force and speed to control the financial crisis. The IMF said emerging market nations, long a global bright spot, were now being dragged down by Europe. It said a drop in exports in these countries would combine with earlier policies meant to prevent overheating and slow growth more sharply than hoped. 

The IMF cut its 2013 forecast for global growth to 3.9 percent from the 4.1 percent it projected in April, trimming projections for most advanced and emerging economies. It left its 2012 forecast unchanged at 3.5 percent. The IMF said advanced economies would only grow 1.4 percent this year and 1.9 percent in 2013.

It also trimmed its forecast for emerging economies, projecting they will expand 5.9 percent in 2013 and 5.6 percent in 2012. Both figures are 0.1 of a percentage point lower than in April. The IMF cut its 2013 growth forecast for the crisis-hit euro zone to 0.7 percent, while maintaining its projection of a 0.3 percent contraction this year.

The IMF cut its US forecasts slightly, largely based on concerns over a political battle brewing in Washington over how to avoid painful automatic spending cuts and tax increases at the start of next year.

The IMF says the United States faces a “fiscal cliff” with the scheduled expiration of Bush-era tax cuts and $1.2 trillion in automatic spending reductions – enough budget tightening to knock the still-weak US economy back into recession.

Washington is also expected to run into the statutory $16.4 trillion cap on its debt before the end of the year, raising the prospect of a default absent congressional action to raise it.

While financial markets believe Congress and the White House will find a way to avoid a fiscal train wreck, the IMF warned of the “potential for a significant adverse market reaction” if that consensus view began to falter.

When Standard & Poor’s downgraded the government’s credit rating last August, which was the first jump off a fiscal cliff, predictions of serious fallout soon followed. Republican presidential candidate Mitt Romney described it as a “meltdown” reminiscent of the economic crises of Jimmy Carter’s presidency. He warned of higher long-term interest rates and damage to foreign investors’ confidence in the US. House Budget Committee Chairman Paul Ryan said the government’s loss of its AAA rating would raise the cost of mortgages and car loans. Mohamed El-Erian, chief executive officer of PIMCO, said over time the standing of the dollar and US financial markets would erode and credit costs rise “for virtually all American borrowers.” They were wrong. Almost a year later, mortgage rates have dropped to record lows, the government’s borrowing costs have eased, the dollar and the benchmark S&P stock index are up, and global investors’ enthusiasm for Treasury debt has strengthened.

Yield changes during the last year probably had nothing to do with the downgrade, but it had to do with everything else pushing yields lower. On the top of that list you have a massive flight to quality out of Europe. The US is the prettiest horse in the glue factory. Investors outside the US owned $5.16 trillion of US government debt as of April 30, compared with $4.7 trillion at the end of July 2011 before the credit-rating cut. The Treasury market remains liquid. That liquidity premium is not going to disappear no matter how many downgrades Moody’s or S&P give to it. Further, we should probably question who in the heck S&P is to be giving the country a credit rating. If S&P really wants to cut the credit rating to C+, go ahead, maybe we’ll just send in the Navy Seals and then we’ll see what kind of rating we get. Actually, there isn’t much chance of a full fledged default; inflation – yes, some form of devaluation -yes. Actual default – not so much. 

 Merrill Lynch issued a revised projection for US second quarter GDP growth. Today’s weak retail sales report leaves Q2 GDP tracking at just 1.1%. They expect the economy to remain weak through the rest of the year with growth of only 1.3% in Q3 and 1.0% in Q4. This translates to GDP growth of only 1.3% Q4/Q4, significantly below the Fed’s forecast of 1.9-2.4%.  Separately, Merrill Lynch writes in a memo to wealthy clients (I can’t explain how I got my hands on it): “It is time to abandon the idea that treasuries are a special asset class, let alone “risk-free”; this no longer makes sense in a G-zero world.” a G-zero world refers to the G-7 or the G-20, but in a G-zero world, no government really has the fortitude to lead. 

Federal Reserve Chairman Ben Bernanke delivers his semiannual report to Congress over the next two days. Do not expect Bernanke to announce QE3. Do not expect any pronouncements above passing out free money to Wall Street bankers.  Do not trade on Bernanke’s utterances. Do not expect Bernanke to accept responsibility for failure to regulate Libor. Really, the only reason to watch is to  see whether the politicians can beat up on Bernanke for failure to regulate, or whether Bernanke beats up the politicians for running like lemmings toward the fiscal cliff. 

You’ve got to wonder when people will finally accept the idea that the big banks can’t be trusted. The list of failures is long: subprime mortgages, fraudulent ratings, casino-like wagering on derivatives, selling clients one thing and then betting against it, robo-signing, MF Global, and just when you think they’ve can’t get any worse – Libor manipulation. Prosecutors in New York and Connecticut are investigating whether their states incurred losses as a result of interest-rate manipulation by banks, a probe that could lead to a wider multi-state enforcement action. But the Federal Reserve has done a lousy job as a regulator. Someone has to ask Bernanke what the Fed knew about Libor and when they knew it, and why they didn’t respond.

The Fed has also done a lousy job in their dual mandate of price stability and maximum employment. The price stability part is doing fine for now; the employment part is lousy. If the Fed’s targets call for an inflation rate of 2% and an unemployment rate below 6%, then any balancing of the tradeoff between the two objectives would imply we’d want to see an inflation rate above 2% as long as unemployment remains at its current high levels.

A lower inflation rate is relevant for anticipating the Fed’s next step. While the hawks on the FOMC are generally perceived as wanting to avoid inflation, they also are committed to avoiding deflation. Although we may disagree about how much a higher inflation rate might benefit the economy, there is much wider agreement that deflation would make our problems worse and is something the Fed can and should avoid. I don’t get the sense that the Fed is overly concerned about unemployment but they are scared about deflation. Part of the response to deflation should also be positive to bringing down unemployment. 

Whatever the Fed is thinking, they are running out of options. In the press conference last month, Bernanke made it clear that further accommodation is very likely if employment indicators don’t improve soon. He also pointed out that the Fed can’t do any more “twisting” because of the lack of short duration securities.

And that strongly suggests QE3 sooner rather than later. Not at the Congressional testimony this week, that will mainly just be contentious, but Bernanke might offer metrics that he considers important, and then we can fill in the blanks. 

Let’s look at the Real Libor Scandal and why it really poses some bigger problems. It is pretty clear that the big banks manipulated the Libor rates; the Bank of England and the Federal Reserve were complicit, at the very least in their failure to step up and stop the manipulation. The banks benefitted from the impression of financial strength during a trying time, also from borrowing at low rates. But wait, there’s more.

Banks are not the only beneficiaries of lower Libor rates. Debtors (and investors) whose floating or variable rate loans are pegged in some way to Libor also benefit. One could argue that by fixing the rate low, the banks were cheating themselves out of interest income, because the effect of the low Libor rate is to lower the interest rate on customer loans, such as variable rate mortgages that banks possess in their portfolios. But the banks did not fix the Libor rate with their customers in mind. Instead, the fixed Libor rate enabled them to improve their balance sheets, as well as help to perpetuate the regime of low interest rates. The last thing the banks want is a rise in interest rates that would drive down the values of their holdings and reveal large losses masked by rigged interest rates.

But wait, there’s more than big banks simply borrowing from one another at lower rates, banks gained far more from the rise in the prices, or higher evaluations of floating rate financial instruments (such as CDOs), that resulted from lower Libor rates. As prices of debt instruments all tend to move in the same direction, and in the opposite direction from interest rates (low interest rates mean high bond prices, and vice versa), the effect of lower Libor rates is to prop up the prices of bonds, asset-backed financial instruments, and other securities. The end result is that the banks’ balance sheets look healthier than they really are.

On the losing side of the scandal are purchasers of interest rate swaps, savers who receive less interest on their accounts, and ultimately all bond holders when the bond bubble pops and prices collapse. Libor rates were manipulated lower as a means to bolster the prices of bonds and asset-backed securities. In the UK, as in the US, the interest rate on government bonds is less than the rate of inflation. The UK inflation rate is about 2.8%, and the interest rate on 20-year government bonds is 2.5%.  The US inflation rate is about 1.8% and the interest rate on 10-year treasury notes is about 1.5%. In both countries, the government debt to GDP ratio is rising. 

Why do investors purchase long term bonds, which pay less than the rate of inflation, from governments whose debt is rising as a share of GDP? One might think that investors would understand that they are losing money and sell the bonds, thus lowering their price and raising the interest rate.

Why isn’t this happening? Why has there been a huge, bullish demand for less than nothing? Well, despite the negative interest rate, investors were making capital gains from their Treasury bond holdings, because the prices were rising as interest rates were pushed lower.

What was pushing the interest rates lower? Wall Street has been selling huge amounts of interest rate swaps, essentially a way of shorting interest rates and driving them down. Thus, causing bond prices to rise.

Secondly, fixing Libor at lower rates has the same effect. Lower UK interest rates on government bonds drive up their prices.

In other words, we would argue that the bailed-out banks in the US and UK are returning the favor that they received from the bailouts and from the Fed and Bank of England’s low rate policy by rigging government bond prices, thus propping up a government bond market that would otherwise, one would think, be driven down by the abundance of new debt and monetization of this debt, or some part of it.

How long can the government bond bubble be sustained? How negative can interest rates be driven?Can a declining economy offset the impact on inflation of debt creation and its monetization, with the result that inflation falls to zero, thus making the low interest rates on government bonds positive?

According to his public statements, zero inflation is not the goal of the Federal Reserve chairman. He believes that some inflation is a spur to economic growth, and he has said that his target is 2% inflation. At current bond prices, that means a continuation of negative interest rates. Unless bond prices can continue to rise as new debt is issued, the era of rigged bond prices might be drawing to an end. It would seem to be only a matter of time before the bond bubble bursts.

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