For you youngsters out there, my title is from the classic Three Dog Night single, “One.” The title also refers to a couple of items I want to deal with today. This morning, the Bank of Japan (BOJ) moved the rate it will pay on new reserves placed at the BOJ to negative 10 basis points. With this move, they have joined the European Central Bank (ECB) in the twilight zone world of negative interest rates. Last week, the ECB kept their overnight deposit rate at negative 30 basis points, with a strong indication that further moves are coming in March. Therefore, if we play the game of “which one doesn’t fit with the others?”, we come up with the Fed.
The Federal Open Market Committee’s (FOMC) statement last Wednesday was essentially a “damn the torpedoes, full speed ahead” statement with regard to their desire to normalize monetary policy in 2016 with three to four more rate hikes this year. Some have said that the statement was dovish because they said this:
“Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2% over the medium term, as the transitory effects of declines in energy and import prices dissipate, and the labor market strengthens further. The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.”
To me, that is not dovish at all. The FOMC seemed far more worried about global economic and financial developments last September when they surprised the markets by not raising rates due to their worry. It can be pretty easily argued that things have gotten worse in the global economy and financial markets since that meeting. The statement ignored that. The Committee’s move to continue to label the collapse in the energy markets as a transitory effect on inflation, which is, in my opinion, a serious misread of the situation. The ugly scenario for oil producers and exporters was a sustained price of below $50 a barrel of oil. We haven’t seen $50 a barrel since last July. We’ve been below $40 since the beginning of last December.
Personally, I still believe the Fed will not be able to raise in 2016. Moreover, the bond market also doubts it. The two-year Treasury note is yielding 77 basis points this morning. A yield of 77 basis points has pretty much assumed that the Fed is out of the picture in 2016. Maybe you can assign one 25-basis point hike because, after all, the bid for the two-year is partially made up from global flows that would actually like to receive interest as opposed to paying it (the German two-year is currently negative 49 basis points). These folks have bigger things to worry about (like their rapidly depreciating home currencies) than the Fed hiking rates once or twice in 2016.
This brings me back to our theme: “One is the Loneliest Number.”
All throughout this month, investors have been alarmed that seemingly every risk asset, especially stocks, are trading to a correlation of nearly one (perfect correlation) to crude oil, and hence, to each other. We should be alarmed by this because when all risk assets trade to a correlation of one, that is a sign that really bad things are happening. The last time this happened for a prolonged period of time was June 2008 to March 2009, a period fondly remembered as The Global Financial Crisis (GFC).
If you needed an indicator that things are not very dissimilar to 2008, check out what the rating agency Moody’s did with global commodity giant Freeport McMoran earlier in the week. Moody’s cut their unsecured debt four notches, from investment grade Baa1 to non-investment grade B1! It is frightening to see that one of the chief enablers of the GFC is back in action, not doing its job. Commodities have been collapsing for nearly a year now. Freeport is not like Enron, where we woke up one day to realize that there wasn’t a company there.
Instead, when Moody’s ran their models to rate commodity based companies (and countries), they did not assign any serious probability to crude falling to where it is now. Sound familiar? Last time, it was housing; this time it is oil and other industrial commodities. The reason the S&P trades with a near perfect correlation to crude is because when commodity-based investment grade (soon to be non-investment grade) and high-yield bonds get hit, there’s no bid for them. So, to reduce risk, investors are forced to sell something. So, they sell S&P and crude futures. There’s no need for higher math or deep fundamental analysis here. It is what happens in a liquidity crisis. This will, in my opinion, continue for the foreseeable future.
Right now, commodity-based companies that comprise a good chunk of the high-yield market are in a furious race to somehow keep pushing out debt maturities in the face of serious negative cash flow. The high-yield desk at Credit Agricole had a great analogy for the furious debt swapping that is going on.
“We think investors are starting to view the bond exchanges like Russian nesting dolls. You end up with something much smaller than what you started with and your recovery prospect may not be appreciably better.”
The only good news that I can think of right now is: I don’t think this slowly unfolding crisis will be as bad as 2007-2009. Banks will take hits, but I do not believe there is the risk of our financial circulatory system (commercial paper, interbank lending) getting blocked up to the point where our financial system has what it had in 2008-2009: a massive heart attack. The “heart attack” is what allowed the financial market crisis (like we had in 1997-1998) to turn into a full-blown economic crisis. In the meantime, however, for those who have dry powder, hold on to it. In liquidity crises like we noted above, proverbial babies get thrown out with the bath water. There will be great opportunities in risk assets, but not now. One is still the loneliest number.
Member SIPC & FINRA. Advisory services offered throughSWBC Investment Company, a Registered Investment Advisor.
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