There are few things as impressive in nature as the power of a flowing river. The river goes where it wants to, and if man messes with its direction, the river just goes elsewhere, often with environment-altering force. I think of global capital flows just like a powerful river, a money river if you will. Trillions of dollars of global capital flowing from the headwater to the mouth, picking up more capital at some spots and depositing it in other spots along the way. The money river, left alone, flows down its natural path, picking up and depositing capital where it needs to go.
The river is made up of insurance premiums, pension contributions, sovereign wealth inflows, government tax receipts, trade surpluses, individual wealth and savings, etc. Some of the river goes to government and agency debt, some to corporate debt, some to stocks, some to super-safe government-backed funds (like FDIC insured CDs) and some to high-risk assets. You get the idea. What Quantitative Easing (QE), Zero Interest Rate Policy (ZIRP), and now Negative Interest Rate Policy (NIRP) represent are the attempts of man to control the river, to divert it away from its natural path. The central banks have used QE, ZIRP, and NIRP to essentially build dams that divert the capital that normally goes to safe investments to more risky investments. The greater risk may come in the form of relatively worse credit, inferior liquidity, or higher interest rate duration. In many cases, the diverted money ends up deposited in areas that are a combination of all three heightened risk metrics.
Let’s think about what has happened in the United States since the Federal Reserve (Fed) embarked on QE and NIRP. Because the Fed bought trillions of agency mortgage-backed securities (Freddie, Fannie, and Ginnie Mae), mortgage rates have remained at or near historic lows for nearly six years. This has enabled the housing market to recover and has put more money in mortgage borrower’s pockets through refinancing opportunities. In addition, it has enabled the government to successfully implement programs that have allowed borrowers, with good credit but negative equity in their homes, to refinance in order to lower their debt burdens and keep their homes off the market. The Fed’s policies also redirected billions of dollars into the high-yield and investment grade bond sectors that essentially funded the United States reemergence as an energy producing super-power. Further, the Fed’s policies fueled a tremendous bull market in equities as money poured into high dividend-paying stocks such as Mortgage-Backed Security REITS (MREITS) and energy-related Master Limited Partnerships (MLPs).
That was the good. The bad, however, is QE and NIRP helped create an oil and gas bubble that has popped, with pretty devastating results for instruments like MLP debt and equity. In my opinion, too much of the money river that normally flowed into relatively safe investments was diverted by the Fed’s policies, and was instead deposited into higher risk investments. This is why I believe we have a huge potential problem with too many savers invested in credit risk, interest rate risk, and liquidity risk that they don’t understand. Moreover, in Europe and Japan, the European Central Bank (ECB) and Bank of Japan (BOJ) have embarked on similar policies as the Fed, albeit at different times. The ECB and BOJ’s use of NIRP and QE are having the effect of pushing more of the money river into the United States as NIRP punishes anyone seeking a positive yield (currently there’s about $9 trillion bonds in the world that have negative yields), while QE crowds investors out of many home markets. For example, since the ECB announced they will buy Euro-denominated corporate bonds, there is a real worry that too many bonds will end up with the ECB. As a result, normal investors will be unable to compete, and eventually, the long-term liquidity of the European corporate bond market will suffer as an abnormal amount of bonds will be taken out of “the float” by the ECB.
The ECB and BOJ are embarking on policies that are driving too much capital into the United States for the simple reason that the U.S. is the only market that has enough “financial things” to buy. What this also means is that many global investors are probably taking a lot more currency risk as they buy U.S. government, corporate, and mortgage bonds, and are not swapping the flows back into their local currency. A lot of this activity is being done by Japanese banks, who are buying large amounts of U.S. Treasury bonds and essentially ending up short Yen. This is one of the reasons why the Yen has been so volatile. As I have said in past writings, a hyper-volatile Yen is not a good thing for the global financial markets and economy.
The effects of the artificially diverted money river were on full display last week. Between investment grade and high-yield corporates, new issuance was approximately $62 billion. New issue Municipal debt was approximately $7 billion, and the U.S. Treasury issued $62 billion. In duration equivalents, that is about $90 billion 10-year equivalents. That is a tremendous amount of duration for one week and yet, investors took it all down and seemed to hunger for more. At week’s end, Treasury yields are slightly lower and investment grade, high yield, and municipal spreads are all tighter. You can unplug your relative value model because right now it is completely irrelevant. The central bank-diverted money river is flowing stronger than ever.
There are going to be consequences to what I have described. We got a glimpse of those consequences this February. The global economy seems to be slowing down, including the United States. Eventually, poor earnings and increasing corporate credit events will take a toll on risk markets. This is why I continue to like Treasury duration, especially the 10-year and out part of the curve. I think we will see 10-year treasury yields in the low 1.60s to high 1.50s by the end of June. I also believe that, despite record low yields for municipals, there will be plenty of crossover buying of high-quality names. I like the longer end of the municipal yield curve as well. After all, the money river has to go somewhere.
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