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Ain't Living Long Like This

aint-living-long-like-this-615.jpgHave you ever started humming or singing a song to yourself that you haven’t heard in a while and wonder what made you start singing it? I do it all the time, and yesterday I started singing (to myself) Waylon Jennings’ “Ain’t Living Long Like This”:

“I look for trouble, and I found it son/ Straight down the barrel of a lawman’s gun/ I tried to run, but I don’t think I can/ You make a move, and you’re a dead man, friend/
Ain’t living long like this/ Can’t live at all like this, can I baby?”

The song came to mind shortly after I logged into my Bloomberg at 6:30 a.m. and saw the German 10-year Bond dipping below three basis points while I read this from Bloomberg News:

“By casting his net as wide as the program allows, Draghi ensured that the first day of corporate bond purchases made an impact. While the ECB has said it would buy bonds from companies with a single investment-grade rating, investors expected the central bank to start with the region’s highest-rated securities.

“‘It’s been an aggressive start to the program,’ said Jeroen van den Broek, ING Groep NV’s Amsterdam-based head of debt strategy and research. ‘The wide-reaching nature of the purchases shows Draghi means business.’”

(The ‘wide net’ refers to the fact that on the first day of the program, the ECB bought bonds rated as junk.)

The question is, what exactly is his business? If it is to completely destroy any notion of relative value, crowd out investors from most of the assets that are vital to meet their investment objectives, drain what little liquidity is left in the financial markets, and ruin his main transmission mechanism (European banks), he is doing one heck of a job! Two days ago, it was reported that German bank Commerzbank is seriously thinking about keeping excess cash in vaults rather than deposit it at the ECB where they would be charged 40 basis points.

While that greatly improves the risk-reward for bank robbers, what on earth does it do for the European economy?

When one of the world’s major central banks says they will buy bonds with negative yields, buy bonds that two of the top three ratings agencies has rated as below investment grade and continues a policy of negative interest rates that has major banks in its system considering stock-piling physical cash, one has to wonder: where is the outrage among fellow central bankers? I know this is a fantasy, but wouldn’t it be a little comforting to know that Janet Yellen or Stanley Fisher called over to the ECB and politely asked Mario Draghi just what the heck he is doing and tell him he is making a pretty rotten situation a lot worse?

I would feel better if I knew this thought had even crossed the minds of the leadership at the Fed.

Central bankers around the world, particularly the big three (the Fed, ECB, and BOJ), in my opinion, have done tremendous damage to the financial markets through their policies. Most of these leaders don’t even realize these policies are creating a legacy of havoc. The financial markets, for many seasoned traders, have just become untradeable. The more central banks meddle (like the ECB buying corporate bonds), the worse liquidity becomes, subjecting the markets to violent, one-way moves at increasing frequency. The concept of relative value has become a sort of quaint reminder of days gone by; days when we didn’t even know the Fed could have a balance sheet!

There’s a reason why so many hedge funds are either posting terrible returns or closing up shop. These hedge funds are, or were, led by some of the best traders in the world. They didn’t all suddenly become dolts. Maybe some weren’t as smart as we thought they were, but the main reason is that the financial markets are, in large part, broken.

Since the 2008–2009 financial crisis, whenever a central banker has been asked if programs like Zero Interest Rate Policy (ZIRP) or Quantitative Easing (QE) was the right mix of policy, almost unfailingly the answer has been "Of course! Things would be a whole lot worse if we didn’t do exactly what we have done and continue to do now." The central bankers continue to wrap themselves in this argument, even when the jury is still out. To me, that is kind of a straw man fallacy argument.

We have no idea what history might have been, nor do we know what it will be. What the central bankers have done, and continue to do, has serious ramifications that will last far beyond their terms at their respective institutions. A tremendous swath of financial constituents—from institutions tasked with meeting trillions of long-term liabilities (pension funds and insurance companies), to savers and retirees—have been forced to take risks they were never meant to take. They were slammed by a potent cocktail of ZIRP and QE. What is their fate?

The Fed has built a $4.5 trillion balance sheet funded by bank reserves. What happens when the Fed’s “lenders” (the banks that sold them Treasuries and Mortgage-Backed Securities) want to take their trillions of reserves out of the Fed? The bank’s reserves are real assets, not fantasy money. How does the Fed deal with that, and what are the ramifications?

Whatever the case, our calls to keep buying the long end of the Treasury curve, as well as long-dated municipals, continue to pay off. Since we reiterated our call on May 23 to buy 10-year treasuries at 1.84%, buy the long bond at 2.64%, and buy long-dated municipals, those positions have been greatly rewarded. Both the 10-year and the long bond have rallied 20 basis points and longer-dated municipals have tightened in spread approximately 20 basis points. This global rally in rates will continue in my opinion. However, in the short term, it feels like “the pain trade” is starting to look like a sharp back-up in rates.

The Fed meets next week, and I have a feeling they will try to jawbone the markets back a bit. Once they take back to their airwaves after next Wednesday’s meeting, who knows what they will say. As we learned last month, anything out of their mouths is possible. With that in mind, it could be a good time to take some winnings off the table and be ready to reload in a back-up.

Member SIPC & FINRA. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor.

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