One of the themes that we have been highlighting this year is the growing bubble in corporate bonds. It is pointless in the first instance to discuss whether super easy monetary policy that has fueled this bubble is appropriate or not. The main thing for investors to countenance is that the current monetary policy regime is having unintended consequences through the formation of a bubble in increasingly scarce liquid fixed income instruments.
The economy and financial markets remain in the grips of the most easiest monetary policy the world has ever seen. The balance sheets at the Fed and the BOJ continue to expand at record pace and global real rates have been negative for over 3 years now. Negative real rates create tremendous incentives for borrowers to lever up and often create asset bubbles in debt, equity and property.
No-one ever said that investing was easy, but when textbook correlations start to break down it can be outright painful. Such of course has been the environment in recent couple of months with stocks and bonds falling in unison. It won’t last forever, but it may persist for a while longer.
Employment in the US is closely watched, especially as the Fed has marked it out as an important factor in how it will judge its stance in monetary policy. Payrolls have improved and the unemployment rate has declined, but structural issues stubbornly remain. The Fed will be alert to these issues, and thus the bar for the removal of stimulus is very high, despite repeated murmurings of ‘tapering’ and a tightening in monetary conditions.
The Euro is making headlines again, this time not due to its possible imminent disappearance as a currency but rather as a result of what many regard as its undue strength. Last week’s press briefing comments by ECB President Mario Draghi to the effect that “The exchange rate is not a policy target but it is important for growth and price stability,” had put markets on their guard that the central bank was taking note of recent currency movements, and especially those vis-à-vis the Japanese yen.
The Japanese economy continues to weaken and a recession is now the main consensus. The country’s trade balance, which was long in surplus, is now moving deeper and deeper into deficit and the third quarter numbers almost certainly will show contraction, and these are more than likely to be followed by another set of negative readings for Q4
The SNB lately reiterated its stance to maintain a EURCHF floor of 1.20. In the process, the SNB has amassed billions of foreign currency-denominated assets, about half of which is EUR, and certainly some of dubious quality (some of the recent moves tighter in French yields have been due to Swiss central bank buying, who have been deterred from channelling any further flows into short-term German bonds paying negative yields).
The US CPI is currently just above target at 2.3%, and long-term market expectations of inflation measured by the US inflation swap curve remains mid-range. This is in stark contrast to all-time lows in nominal treasury yields which appear to be pricing in almost the end of the world.
In our view, the Spanish banking system is in need of wholesale recapitalisation to deal with the sizeable losses in the country’s property market. This will likely include a bad bank provision. Before that happens, the ECB’s open market operations will mainly buy time in the form of liquidity as well as provide banks with money to exchange bad loans for lending to the government.
Since early September the ECB’s balance sheet has expanded by 589 billion euros (about 750 billion USD) and the Fed USD swap lines are currently sitting at around 100 billion USD. The second LTRO to be conducted towards the end of February is then very likely to take this number well past 1 trillion USD of liquidity to the European banking system.