Euro, Lower Rates and the Global Outlook

The euro zone economy is receiving a mix of stabilizing forces through lower rates, a weaker currency, and improving M1.

However, there are competing factors weighing against an improvement in the bloc’s economy.

There’s a growing trade conflict between the US and China. This hits economies with large percentages of their output generated from manufacturing, like Germany, the euro area’s largest individual economy. The German car sector is still lagging. There’s a struggling banking system hit by low rates (see: Deutsche Bank). There are Brexit-related risks and uncertainty delaying investment decisions. There’s Turkey and its dependence on high credit growth to keep its growth afloat in the short-term. Italy is coming up on a new general election.

Many rates throughout the euro zone are at all-time lows. Some yield curves are entirely below zero out 30+ years. Germany recently sold a 30-year bond at negative yields and the bid to cover ratio was 0.43. (Simply put, the demand for it was low.)

The market has high expectations for what the ECB’s future quantitative easing program can accomplish by buying longer-duration assets to lower the capital market rates at which governments, companies, and individuals can borrow at.

But the actual impact of further bond purchases on lowering rates will likely be limited. Accordingly, it would not be surprising if EUR rates bottomed around the ECB’s announcement of its new monetary easing initiatives in September.

The policy mix for September is likely to be:

– 10-basis point cut in the deposit rate

– €30bn per month in net asset purchases

– Increase issuer limit from 33% to 49%

– Forward guidance to change – rates will be at same levels or lower going forward

However, there is a limit to how negative bond yields can get. This means, broadly speaking, we’re at the point where longer-duration bonds are not that attractive relative to their risks. US yields can and will eventually fall further, but in countries like Switzerland, Germany, Japan, they are much closer to their limitations.

There’s about $55 trillion in sovereign debt in the world. The average duration is 8.3-8.4 years.

So, a 1 percent rise in yields would produce an aggregate decline by 8.3%-8.4%, which is about $4.5 trillion. That’s about 3x the amount of wealth that was wiped out in the 1994 spike in bond yields adjusted for inflation.

With the average sovereign bond yield currently at under 1 percent, that makes riskier assets look attractive in relationship to cash and bonds, but not attractive relative to their risks. And it’s especially true if currency volatility increases. As rates go lower, monetary policy’s transmission mechanism goes from the credit and rates channels to the currency channel.

When interest rates hit zero or slightly under zero, it becomes more difficult to lower them further to penalize the holding of cash and push investors into buying the types of assets that will finance spending. Additional asset buying by the ECB and other central banks will push asset prices higher to some degree, but savers will still want to save, and lenders and borrowers (i.e., creditors and debtors) will still be cautious with each other.

That makes alternative store-holds of wealth like gold attractive as an alternative to cash and bonds as their yields fall.

If we take the current yields on cash and bonds, which are both at about 2 percent in the US, and compare that to the expected return on equities, which will be some 4 to 6 percent moving forward, that extra 2 to 4 percent doesn’t offer much extra compensation for the amount of risk taken on. That can be lost in 1-2 days. Stocks can easily fall 5 to 10 percent in a week.

There’s also a feedback loop where a sell-off in the stock market has a feed-through effect on economic activity. And because central banks are very limited in the degree to which they can get the rate structure down, the risks are skewed to the downside.

Moreover, as interest rates decrease, the duration of assets lengthens. That means any uptick in interest rates has a non-linear impact on their valuations. In other parts of the world, like Europe and Japan, their interest rates are even lower and the extra risk premium associated with investing in equities is nearly gone, so the risks are even further skewed to the downside. Japan’s stock market has yet to recover from its 1989 highs and Europe’s is still below its 2007 highs.

When interest rate policy is exhausted – namely, interest rates can’t be lowered much further and relative interest rates can’t be changed – currency movements must naturally be larger. Or else it will spread into economic volatility.

When policy turns from rates and credit related channels to currencies, this creates “currency wars”. This essentially entails many different countries wanting a weaker currency because of its stimulative effect on exports and broader ability to ease financial conditions. Pegged exchange rate systems that are inconsistent with the market fundamentals become more difficult to sustain and are more likely to break up. Currency risk for traders increases more broadly.

But when all the world’s reserve currency countries can no longer ease rates, exchange rate shifts won’t provide much in terms of a global easing.

Instead, the third era of monetary policy is likely to consist of debt monetization – or central banks financing budget deficits through electronic “money printing” – or by distributing cash directly to households and circumventing the bond and financial markets as a transmission conduit and detach it from the lender / borrower relationship entirely.

This is not to describe what will happen in the near-term. But it illustrates that central bankers have a conundrum facing them in the years forward and with monetary policy tools limited, more of the brunt will need to fall back on fiscal policy.

This will impact all financial asset markets.

1. Stocks, which people traditionally assume will always go up over time and get them X percent of returns per year, will no longer provide the returns they once did.

2. Bonds provide very little return. Some yield negatively. Even in jurisdictions like the US where sovereign rates are still comparatively “high” at some 1.5 to 2.0 percent, that yields nothing in inflation-adjusted returns and after accounting for taxes. Moreover, there is duration risk, where low yields come with price volatility.

3. Currency volatility is likely to pick up now that the traditional channels of monetary policy transmission – rates and credit – are increasingly ineffective.

4. Commodities are a mixed bag. There’s a lot of dispersion in commodity movements because each is subject to its own supply and demand considerations. Some, like gold, act more as store-holds of wealth and alternative currencies that benefit from fiat currency depreciations and increasing debt and non-debt liabilities as a safe haven. Others are more sensitive to economic growth like copper and oil. Lower inflation-adjusted rates help to support commodity prices at a broad level.

Effects of lower rates on the economy

Lower rates will eventually have a supportive effect on the real economy. In particular, lower mortgage rates will support demand for housing. Though some macro data has deteriorated into contractive territory (e.g., PMIs), fears of recession in the US and globally are overblown.

If the US Federal Reserve eases based on what’s priced into the curve, then nominal rates will be low enough to support positive real growth for at least one year. They need to follow growth down step for step to minimize the economic impact and market volatility. (Markets are important for policymakers to pay attention to because they provide the capital that feeds into spending in the real economy).

One 25-bp rate cut per quarter would be a quality plan. They should have one for September, one for December, and one for March. It’s hard to forecast out more than 9-12 months with much precision. But bringing down the front-end of the curve 75-100bps makes sense in terms of the forward projection of nominal growth.

But you can’t predict what policymakers would do exactly, so any risk related to that it’s important to be immune to. For most traders, that means having a balanced portfolio that can do well in a range of environments rather than making a large amount of tactical bets, which is a difficult thing to do well.