This has been a pretty rough June so far. I think it is safe to say that we breached the limits of positive monetary policy effectiveness about two years ago. Now, we are in a world where the major central banks are doing well if they just make a lot of noise without actually doing things that harm the global financial system—like Negative Interest Rate Policy (NIRP) and new iterations of Quantitative Easing (QE). In last week’s post, I spoke about my jaw dropping upon seeing the 10-year German Bund fall to a yield of three basis points. This week that yield is now negative 2.5 basis points. The Japanese 10-year government bond currently yields negative 20 basis points. Can you even use the word yield if it is negative? Maybe it should be called “the take” or something like that.
It was a pretty humbling beginning of the month for the Federal Reserve (the Fed). After some influential reserve bank presidents spoke of monetary shock and awe at the end of May, the Fed had to take a few steps back when the May employment figures came out shockingly weak on June 3. The weak employment report led to what was widely viewed as a very “dovish” Federal Open Market Committee (FOMC) statement on June 15. The Fed was forced to backtrack on their labor market optimism when they said, “The pace of improvement in the labor market has slowed. Although the employment rate has declined, job gains have diminished.”
You could have heard a pin drop after that statement if it were not for the screaming of traders trying to buy anything that resembled a Treasury note or bond! Traders promptly took all FOMC tightening out for 2016 and essentially pushed them out well into 2017. The five-year Treasury note got as low as 1.06%, which implies a Federal Reserve on hold until sometime in 2020! This Thursday, the 10-year Treasury note dropped as low as 1.51%.
However, it should be noted that the shockingly low yields, especially on the five-year note, have less to do with the Fed and more to do with just how much worse off the rest of the world is. Between the very real threat of Great Britain voting to leave (BREXIT) the European Union (EU) on June 23, and the frightening conditions of major European banks (the stock of both Deutsche Bank and Credit Suisse fell to multi-year lows on Tuesday), Europe is in dire straits. If Great Britain leaves the EU, the two-year negotiated divorce can be a constant source of volatility, and will certainly cost Great Britain and the EU dearly at a time where neither can really afford it. Even if the citizens of Great Britain vote to remain, after a brief period of euphoria, Europe will still be struggling as they were before the world added the additional risk of BREXIT three weeks ago.
Meanwhile in Japan, the nation’s banking system and economy is being tortured with NIRP as well as a currency that keeps strengthening, as opposed to weakening. This is one of the reasons the Bank of Japan went down the path of NIRP in the first place, although they won’t admit it (but many believe that is true). The only reason the BOJ did not cut their policy rate further Wednesday night was because they are trying to keep some dry powder on hand in case of BREXIT. If BREXIT occurs, many think that the Yen can strengthen against the U.S. Dollar (USD) through 100 (currently 104.24), or even more. With regard to Euro/Yen, no one even wants to guess at how much the Yen can strengthen versus the Euro. Whatever the case, the Japanese have lost control of their currency, and that is a very bad thing for the global financial system.
And finally, there is China. About the only good thing that has happened this month—by the Fed showing that they were putting off tightening monetary policy—is some pressure was taken off of the Chinese Yuan, which had fallen to an all-time low against the USD on Tuesday. The world is pretty convinced that there’s a lot of bad things going on in China; things that eventually have to come out and inflict pain on risk markets. I think we should thank the Chinese for having the decency to keep their problems under wraps for the time being. I’m not sure the financial markets or the global economy could take it right now.
As I write this, Treasury yields are backing up from the lows they reached last Thursday morning. Tragically, much of this is the result of the terrible murder of British Member of Parliament Jo Cox on Thursday afternoon. Both sides of the BREXIT argument put the campaign on hold shortly after. This halt in discussing BREXIT brought some calm to risk markets. However, I believe this calm is temporary. The BREXIT vote is now less than a week away.
We have been calling for the 10-year Treasury to get to the low 1.60s in yield by the end of June and here we are a couple weeks early. While my long-term call is for the long end of the Treasury curve to continue to rally through 2016, I think it would be wise to either take some profits (if you have been long) or buy protection in front of the BREXIT vote next week. If the vote is to remain, we could see a very sharp, violent sell off in bonds globally. BREXIT is a very big deal. If Great Britain choses to remain, it will be seen as a stay of execution for the financial system and global economy.
As an investor, you don’t have to be in front of that train. Take profits from long duration positions or protect yourself with hedges. It is better to forgo some future profits than take the risk of losing all the current ones. With this in mind, the title of this week’s piece is from the great comedian, Steven Wright. Steven also said, “When everything is coming your way, you’re in the wrong lane.”
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