Bianco: "The Repo Market Has Been Drugged Into Submission"
Authored by Christoph Gisiger via TheMarket.ch,
Jim Bianco, founder and chief strategist of Bianco Research, warns that the Fed’s massive liquidity injections could make the problems in the short-term funding markets even worse. He fears that the risk of a recession in the US is underestimated and he expects further downward pressure on interest rates.
Investors are hearing encouraging news. The trade dispute between the US and China seems to cool off. The risk of a chaotic Brexit is receding. The yield-curve is back to normal.
Nevertheless, the reaction of equities and bonds remains relatively modest.
«The markets are still kind of in this no-man’s-land trying to figure out what’s going to happen next,'» says Jim Bianco.
According to the internationally renowned macro strategist, the lack of a powerful breakout could be a hint that the impact of trade may be overstated and that other factors are keeping the financial markets in check.
For example, trust in the repo market remains fragile, even though the Federal Reserve is intervening with ever bigger liquidity infusions. In addition to that, the likelihood of a recession in the US is significantly greater than most economists think, notes Bianco.
In this at-length interview with The Market, the President of Chicago based Bianco Research explains why he expects government bond yields to continue to decline over the next few months and what he thinks could pop the monster bubble in European sovereign debt.
Mr. Bianco, prospects of a partial trade agreement and a Brexit deal are generating support for financial markets. Is the worst in terms of uncertainty now behind us?
Many strategists keep talking about uncertainty as if there was never any uncertainty in the markets before and we just invented that word last year. For the moment, it looks like we have avoided a hard Brexit and that we’re heading towards phase one of a trade agreement between China and the US. So there may be a bit more clarity on the horizon. But despite these headlines, markets have yet to respond. The S&P 500 and the yield on ten-year treasuries are moving towards the higher end of their range. But so far, they haven’t broken out nor negated the news. So the markets are still kind of in this no-man’s-land trying to figure out what happens next.
Why do you think that is?
I suspect that people are overstating the impact that trade has on the financial markets. There is more that holds the markets back than just trade, although that’s what strategists have been telling us for a year and a half. The old saying on Wall Street is price drives news and so far, stock prices and bond yields have not yet broken out to confirm the recent good news. The longer a breakout takes, the more concerned we become that it might not materialize. Therefore, the coming days are going to be critical.
Taking this into account, next week’s FOMC meeting could play an important part. What is the Federal Reserve going to do?
I think they are going to cut interest rates for a third time and they will do it like they have done it all throughout this cycle: They will try to make noise that they want to stop cutting rates because they never really wanted to start cutting rates in the first place. We will see whether or not the market agrees with that. One of the problems the Fed has had is that they can’t really explain why they are cutting rates. The reason they are doing it is that the market is demanding it and they are afraid to fight the market. So if the market wants more rate cuts it will get more rate cuts.
What’s more, the yield curve has moved back into positive territory. How significant is this development?
The big thing that has pushed the yield curve positive has been the announcement that the Fed will be buying $60 billion worth of Treasury bills every month to solve liquidity problems in the repo market. They have created a new demand for the front end of the yield curve and the market is responding accordingly. There has been a discussion in Fed circles that even though they are increasing bank reserves we shouldn’t call it «Quantitative Easing» or «QE». Yet, the front end of the yield curve is acting exactly as if it was QE; exactly as if they were doing something that was going to be stimulating. So the market is behaving in kind and I’m not surprised that the yield curve is un-inverting.
The yield curve is perceived as a leading indicator for the economy. What does it mean for the outlook when the curve goes back to normal?
I think the curve will steepen out a lot more when all that buying kicks in. This is the way the curve typically un-inverts. In a massive way: very hard and very fast. I like to refer to it as a «wheelie» and when the yield curve is doing that wheelie it’s usually right into the teeth of the slowdown: It’s the moment when the market and the Fed realize that they’ve made a mistake, that the economy is much weaker than we thought, that there is a big problem and that more stimulus is required. That’s when you get that massive steepening of the yield curve. But maybe this one is different because we’ve got the Fed stepping in and just manipulating the curve steeper.
To calm tensions in the short-term funding markets the Fed is pushing more and more liquidity into the system. What do you think of this approach?
The repo market has been drugged into submission by the Fed. It has medicated the problem for now, but the problem has not gone away. This situation is becoming larger and more complicated. No one is sure how this is going to play out. If we knew how to fix this problem, it wouldn’t have happened in the first place. Temporary injections of money can help for a while. But the longer the Fed is doing this - I mean months or years - the more they risk another set of problems coming in. So sooner or later the markets must be taken off this drug. Relaxing burdensome regulations for banks would help, but this does not appear to be on regulators’ radars.
The Fed’s reputation is already at risk, especially with regard to President Trump’s vocal criticism of Chairman Jerome Powell. To what extent are the problems in the repo market undermining trust in the world’s most important Central Bank?
It’s really the New York Fed that runs these operations. And according to all the insiders, Jay Powell had a real strong hand in getting John Williams to the New York Fed from the San Francisco Fed when his predecessor Bill Dudley left. And then, Simon Potter, the architect of all the QE programs, was pushed out the door at the end of May. Sure, there are other competent people at the Fed, but it’s like: The guy who was running everything left and then we get these problems in the repo market. So it really does beg the question if there are too many academics at the Fed and if they have lost touch with the market.
Meanwhile on the other side of the pond, Christine Lagarde takes over for Mario Draghi at the ECB. How will this change of leadership affect monetary policy in the Eurozone?
We are not fans of Ms. Lagarde and think it’s a mistake putting her at the helm of the ECB. Here’s why: If I was to put Mario Draghi under truth serum and ask him why do we have negative interest rates, his answer would probably sound like this: «I thought when we went there in 2014/15 that it would be a shock therapy and everybody will start spending money like crazy. The hope was that we just shock the market into higher growth and we could then raise rates off negative. Instead, we confused everybody and negative rates became six months, two years and now almost five years. But if you are a central banker you can’t admit a mistake. So we are kind of stuck with this policy.» That’s what I think he would say.
And what would Ms. Lagarde say if she was put under truth serum?
I think she would say that negative rates are a good idea and that more negative rates are even a better idea. She genuinely believes that. I’m giving Mario Draghi the benefit of the doubt: He got stuck with this of his own making and he’s trying to make lemonade out of a bunch of lemons. But in her view, this is lemonade.
Then again, how much further can the ECB go in terms of negative interest rates and QE? What do you think about the idea that Ms. Lagarde is going to promote a closer alignment of monetary and fiscal policy in Europe and some kind of fiscal stimulus?
Here’s the problem with that: What do the populists in Europe not want? Fiscal union. No one is ready to say: «I’m European and my capital is Brussels.» If I’m French my capital is Paris, if I’m German my capital is Berlin, and if I’m Spanish my capital is Madrid. So they want her to help usher in something that is deeply unpopular. Therefore, I worry that she’s got a policy idea - negative rates - that is out of step and I also worry that they want her to push something that’s unpopular. This could be very bad in the long run for the ECB.
Looking at a broader picture, the risk of a global recession is rising. How healthy is the world economy?
It looks pretty bad for the globe. Germany might be in recession and Italy already had two quarters with negative GDP growth. The ECB has pushed rates into negative territory and I don’t know what more they can do. Meanwhile, China is at a 28-year low in GDP growth and Japan’s GDP growth is forecasted to be negative in Q4. So far, the data for the United States looks OK. But - to use the old metaphor - it’s like you have a nice, well maintained house and every other house in your neighborhood is on fire. That’s not a good place to be. I don’t believe the US can survive if all those bad stories everywhere else continue.
What are the odds that a recession is coming to the US?
There is a lot more risk of a recession in the United States than people are giving it credit for. Today, I would put the probability at 40 to 50%. So just below 50-50, and that’s pretty high. I’m willing to give the economy the benefit of the doubt and be on the good side of 50-50. But we’re right on the limit and we’re running out of time to stop a potential recession. If the global economy could bottom and recover that could help the US avoid a recession. But the longer we go without that happening and the more we see global PMI data disappointing we’re not going to that right away.
How does this impact the outlook on the financial markets?
Central Banks are easing and that’s dragging rates lower. This will affect the US eventually because we are all globally connected in a connected world: People have a hard time understanding that our rates are tied to everybody else’s and they are going to pull us down. Today, in the G20 there is only one interest rate left that has a 2-handle on it: The US 30-year bond which is at 2.26%. Everything else is one, zero or negative. So if you’re reaching for yield and you want a really high yield, it’s 2.26%. This is a new area because we all remember when yields were double digits or at least 5%. Now, in Europe zero percent is a reach for yield. So you need to adjust to the relative world we live in and stop thinking about the world in absolute terms.
What does this mean for investors?
I’m bullish on bonds because the global economy is slowing. So, over the next several months, one of the best investments in its history might be sovereign debt. Even in Switzerland, the king of negative yields, total returns on those negative yielding bonds are up 30% or more. These are some of the best returns we have ever seen and over the next several months that will continue. That said, there’s something I worry about: One of the most mean-reverting things in finance are total returns in fixed income. In other words: If you have one of the best years in terms of total returns, one of the worst years usually is the year before or the year after. Right now, fixed income managers in Europe and especially in Switzerland are knocking the cover off the ball because their portfolios are up 20% to 40% if they are really long bonds. But next year, or 2021 at the latest, could be one of the worst years ever.
How can investors navigate this challenging environment?
One of the things we learned from 2000 and 2008 is that the best thing to buy is to buy into a bubble: You make a ton of money real fast. The problem, of course, is trying to get out in whole and that’s where we are with sovereign debt: I think that this negative yielding environment has some legs to run, but it is a very, very high risk / high reward type of environment.
What’s going to happen when this monster bubble pops?
That’s another perversion of negative interest rates: Negative interest rates could mean that the thing that the ECB wants - an economic recovery - creates such losses in European sovereign debt that you have a financial crisis. That’s because when you get to low, zero or negative rates, little movements in interest rates mean gigantic price movements. In a recovery that shoots rates up, you could lose 20% or 30% of the value of your portfolio. You could be looking at horrific losses. So very short term, European sovereign debt as a trade is working. But when the economy bottoms that trade will blow up big time.
In that context: What’s a promising trade if the economic picture brightens up?
What will work big time in Europe when the economy recovers is financial stocks. Right now, financials are the opposite: If you’re in financials, you’re suffering horribly, you’re a masochist. But eventually, when the economy turns and rates go back positive, financials will be the best performer. So the trade in Europe is long sovereigns, and when things turn and the economy looks like it’s recovering move into financials because they are going to be the biggest beneficiary of higher rates.
To get the timing exactly right is next to impossible. Why not buy European bank stocks right away?
The European bank stock index is at a 40-year low and so is the Japanese bank index. From a value perspective, they are extraordinary values. The problem is they were that three years ago, too, and you lost 60% of your money. Today, Deutsche Bank is trading at the same price it was trading at in the late 1970s, adjusted back to Deutschmark. So the last time Deutsche Bank was at these levels it wasn’t located in the same country and it wasn’t priced in the same currency. But when you have stocks that are down 90% and you buy them now and you’re early, you can still lose two thirds of your money before they turn around. I would rather give up some of the downside and buy them on the other side when they are recovering - instead of the other way around, assuming I’m still employed as a money manager.
Where else do you spot opportunities?
You also want to play gold. If you look at a chart of the gold price over the last four years, it’s identical to the amount of negative debt in the world. For 5000 years of human history, the argument against gold was that it had no yield. So why buy it? Well, in 2019 the argument for gold is that it’s the high yielding alternative at zero.
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