It is a big mistake to be looking for a top in the dollar, which is what typically happens when the Federal Reserve starts a cycle of interest-rate cuts.
It is also a mistake to expect outperformance of emerging markets, which may happen temporarily as those countries tend to benefit from the perception of a weakening dollar due to their long-standing inverse correlation. (Still, emerging markets may get a boost if there is a China trade deal.)
The Fed may be delivering an interest-rate cut at the end of July and reportedly stopping the runoff rate of bonds from its balance sheet this year — in effect, stopping quantitative tightening — but the rest of major developed-world central banks are still in quantitative-easing (QE) mode and in some cases accelerating it.
I am having trouble seeing light at the end of the tunnel for the great global experiment called quantitative easing. With $13 trillion of global government bonds now producing negative yields, the question that begs to be asked is how low is too low for interest rates and what is the end game?
It is commendable that the Fed tried to normalize monetary policy, but such a maneuver is difficult to do in a world where all of the other central banks are doing the opposite. Just as Fed policies affect the rest of the world — particularly due to the reserve-currency status of the U.S. dollar — the opposite actions by other major world central banks also affect the U.S. economy, whether we like it or not.
The 10-year Treasury note TMUBMUSD10Y, +0.00% probably wouldn’t be near 2% if it were not for the growing pile of $13 trillion in negative-yielding world government bonds, where investors chasing risk-free yields end up in the U.S. Treasury market, as there is nowhere else to go for positive yields. That global bank QE activity supports the Treasury market and the U.S. dollar, despite rising federal deficits due to the Trump tax cuts as well as the Fed’s QT. It would be difficult for the dollar to decline in an environment where QE policies are abundant globally while only the Fed is shrinking its balance sheet. In other worlds, the net differential of global QE (see chart) is much bigger than the effect of the Fed’s QT (see chart).
Quantitative easing is like printing money, but for financial institutions only. It differs from the Weimar Germany version of printing money as only banks have access to those electronic dollars, or euros or yen. As excess reserves are abundant in the system, they find shelter in government bond markets. In the U.S., QE worked as excess reserves first found homes in Treasuries and mortgage bonds and then trickled down to riskier fixed-income instruments. It’s like pulling the economy out of a deflationary hole by the force-feeding of credit into an overleveraged system that was otherwise going to deleverage naturally.
As credit spreads narrow, interest rates remain suppressed under QE, which helped riskier borrowers who otherwise might default on their debts or not be able to roll over their debts. Also, under QE the Fed did monetize Treasury debt — one degree removed from outright monetization. Even if primary dealers bought newly issued Treasuries, at one time they knew that 80% to 90% of those newly issued Treasuries would be immediately taken on by the Fed. That dynamic facilitated federal government deficit spending.
The question on monetizing federal debt did come up in many public hearings that Fed bosses Ben Bernanke and Janet Yellen were part of on many occasions, and the answer always was, “That’s not why we are doing this!” Sure, that may not be why, but it did facilitate deficit spending at lower interest rates and with a guaranteed bid for new Treasury issuance.
The stealth credit multiplier effect
While excess reserves have no credit multiplier effect, due to the way they were never lent into the fed funds market, they do have a de facto spending and credit multiplier effect. As deficit spending trickled down through the economy facilitated by QE, people got paid, they deposited the money in their banks, banks lent much of that money out, it was spent again, and the credit multiplier cycle did help economic activity in the U.S.
Regrettably, the same QE dynamic has not been able to produce similarly good results in Europe or Japan. Subpar economic performance on the Old Continent and the Land of the Rising Sun is demanding that central banks keep their QE policies, in effect keeping interest rate differentials in favor of the dollar.
As the world awaits the Fed cutting the fed funds rate by 25 basis at the end of July, the investor community, helped by global central bank QE policies, has already driven the 10-year Treasury yield from a high of 3.24% in early November to a low of 1.94% in June 2019, or a 130-basis-point decline in only seven months. As far as I am concerned, the market has already delivered a heckuva cut in longer-term risk-free rates in the United States, yet the dollar is still firm. One could say that the Treasury market is forcing the Federal Reserve to cut the fed funds rate to become more in tune with market-driven rates, but are those rates really market-driven if global QE policies helped them get there?
So far, there has not been a 10-year government bond that has printed a negative yield of a whole percentage point, although there is one that has come close, at -0.76% in Switzerland (see chart). Closely related to the Swiss bonds are the German bunds, which closed last week at -0.32%. Other 10-year government bonds with negative yields include the Netherlands (-0.21%), Japan (-0.13%), France (-0.07%) and Belgium (-0.01%).
Will more countries join the negative yield club? It sure is possible, as the European Central Bank did a U-turn on balance-sheet normalization, and Spain and Portugal 10-year bonds closed at 0.39% and 0.46%. Italy, which after its populist government victory last year saw its 10-year bonds yield as high as 3.78% due to friction with the European Union over deficit spending, saw interest rates plummet last week to 1.61%.
The moral here is that central banks policy has its limits. Europe and Japan have some very serious structural and demographic issues that central-bank policy alone cannot solve. I am worried that trying to do too much QE will backfire in Europe and Japan as administering more monetary medicine on a sick patient after it has not yet worked is probably not the way to proceed. For the time being, the dollar is likely to remain strong and returns from U.S. financial markets, be it the S&P 500 SPX, +0.74% or the 10-year Treasury, should continue to be better than anything in Europe or Japan.
Also, if there is a U.S. trade deal with China — and that is a very big “if,” as I am not sure they are negotiating in good faith — global trade volumes may improve and the dollar may sell off due to its safe-haven status, which should help emerging markets, given their inverse correlation with the dollar and dependence on trade with the U.S. If a trade deal is announced in 2019, that may pressure the dollar somewhat as we would enter a risk-on environment. But a trade deal will also help the U.S. trade deficit, which would be a big positive for the dollar.
Ivan Martchev is an investment strategist with institutional money manager Navellier and Associates.