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“This is a big, big gamble to be manipulating the most important price in free markets, interest rates. These purchases are canceling market signals. The bond market and the stock market have provided wonderful signals for many years as to potential problems. And when you cancel those signals, you could run into a problem. I don’t know when it’s going to end, but my guess is it’s going to end very badly.” – Stanley Druckenmiller, March 2013
What happens when the most important price in free markets – interest rates – are manipulated by central banks throughout the world?
For starters, you see some crazy things.
Like the 50-year government bond in Switzerland with a negative yield.
And 8 countries with at least a negative 8-year yield: Switzerland, Japan, Germany, Netherlands, Finland, Austria, France, and Belgium.
You also see strange intermarket relationships, like an all-time low in the US 30-year Treasury yield (2.09%) at the same time as an all-time high in the S&P 500.
That’s an all-time high in U.S. stocks while the yield curve in the U.S. flattens to its lowest level of the expansion (for our research on bonds, click here).
Such behavior in the U.S. Bond market would traditionally be signaling, at the very least, a slowdown in the rate of growth. And given the extent of negative yields throughout the developed world, one would assume there to be a deflationary depression in those regions.
But is that really the case today or are central banks instead canceling historical signals with their extreme policies? We’ll only know the answer in hindsight, but for now it seems to be more of a case of excessive manipulation than true market forces at play.
When central banks are pushing short-term interest rates to levels we have never seen, you need to expect the unexpected. As I wrote two years ago, the predictive power of interest rates and the yield curve have been wildly distorted. The traditional signal of yield curve inversion preceding U.S. recessions (preceded last 9 U.S. recessions) may not hold this time around because it is difficult for the curve to invert with short rates being held near 0%. One only need to look at Japan to find a country that has entered recession time and again over the past twenty years without an inverted yield curve.
Does that mean the negative behavior in the bond market should be completely ignored? Certainly not, but it cannot be taken at face value as long as manipulation is taking place. Other factors must be evaluated to confirm that the historic plunge in yields is indeed indicative of a deflationary collapse.
I have been reluctant to join the bearish chorus in recent months due to strength in some of these other factors, including high yield credit. The U.S. high yield bond market continues to hit all-time highs (total return) while credit spreads over treasuries have tightened to 11-month lows. If we were truly in a global depression, would investors be bidding up junk bonds? Probably not.
Now, to be sure, only in the ivory central banking towers are negative yields a good thing. In the real world they are a scourge and a direct affront to capitalism. We should all hope to see long bond yields begin to rise and the yield curve steepen. We should all want to see the Fed raise rates again as I argued back in February. Higher rates and a steeper yield curve would likely coincide with higher growth, something this expansion has been sorely lacking.
But as we have seen, “normal” conditions are not a prerequisite to economic growth (now the seventh year of expansion in the U.S.) nor higher short-term stock prices (S&P 500 and Dow Jones Industrial Average at all-time highs). For there is no such thing as “normal” or “has to happen” in the economy or markets. There are only historical tendencies and as we have seen such tendencies can remain distorted and seemingly irrational for longer than those betting on an imminent collapse can remain solvent.
This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as a Credit, Equity and Hedge Fund Analyst at billion dollar alternative investment firms.
Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.
You can follow Charlie on twitter here.
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