Where are we now?
The Fed's June meeting and the BOJ meeting are behind us, as are BOE and SNB. The major central banks are all frozen. (Of minor significance, Indonesia surprised with a rate cut.)
So where are we now?
Remember that the High-Quality Liquid Asset (HQLA) test is now driving the marginal transaction for a bank. And remember that the reserve deposit at the central bank is the marginal and threshold element in meeting that bank's liquidity coverage ratio (LCR).
In America, a bank starts out by meeting both HQLA and LCR with an overnight deposit at the Fed. The bank is paid 50 basis points (bps) at an annual rate. Thus 50 bps becomes the floor for that bank. And the risk for that bank is time.
If the bank decides it wants to place HQLA to meet LCR for longer than one day at a time, the bank will want a higher interest rate. That is why, if the bank wants to take the risk of lengthening its time horizon, it will buy a US Treasury bill instead of depositing at the Fed – as long as the rate earned is higher than 50 bps. For a deeper dive into this issue, please see my June 9 commentary, “LCR: Is the Fed’s Balance Sheet Too Small?” (http://www.cumber.com/lcr-is-the-fedas-balance-sheet-too-small/).
Note that when the bank buys the Treasury bill, it transfers the cash to the security dealer who sold the T-bill to the bank. Hence the dealer's bank now has the deposit at the Fed, and that bank then faces the same decision tree as the earlier bank.
Banks have many other options. They compare those against the riskless option of a Fed reserve deposit or T-bills. They need to calculate the HQLA status of each option and the capital requirements to support owning each option. After they do the math and adjust for risk, they make a business decision to alter their portfolios or not. Thousands of bankers are making these decisions every day.
Notice the result of this construction. All Treasury bill, note, and bond yields are driven lower, in the direction of the 50 bps threshold. That is why the American US Treasury yield curve is flattening. And it will continue to flatten until it reaches some new equilibrium term structure that balances the risk of time against the incremental yield earned by extending time.
Also note that there are four types of banks: huge ones ($250bn or more), large ones ($50–$250bn), close-to-large ones (under 50bn but approaching that threshold), and all others. And notice that there are other agents that are not banks (like GSE) and therefore do not have access to the Fed to make a riskless reserve deposit. All these players collectively define the front end of the yield curve.
In the eurozone the same thing is happening, but the starting point is minus 40 instead of plus 50. So we now see German government debt at many maturities trading at less than a zero interest rate and heading lower. The yield curve in Germany is flattening as negative rates proliferate. As in the US, that trend will continue until some new equilibrium is reached. In Germany, too, the issue is relative return (less negative than 40) versus the risk of time.
In sum, yield curve flattening is happening worldwide. HQLA and LCR are determining bond yields. And old models based on inflation expectations and economic outlook are failing.
We are tracking worldwide rates and yield curve shapes daily. We look at the spreads between and among them. And we remember that other forces besides central bank policy influence these rates. Brexit is an example. South China Sea geopolitical risk is another. Global commodity prices like copper or oil are a third influence. Emerging-market rate cuts like Indonesia’s are a fourth factor. And there are many others.
Globally, we continue to see lower rates for longer periods. That trend means higher volatility in currency exchange rates and in financial markets. It also means stocks in certain markets are very cheap.
Japan is an example where the interest rate will be zero for many years, and the earnings yield on a basket of Japanese stocks is approaching 7%. But no one is buying those stocks because they are afraid of the volatility. And they do not understand the decisions made by the Bank of Japan.
This world faces a remarkable financial market structure. To invest in this environment takes an iron will. Suppressed emotions. A steel stomach. TUMS or Nexium can help those who are less experienced. Investors must be open to thinking about this new paradigm and not get trapped in the antiquated regime that is being replaced.
At Cumberland, we have a cash reserve in our US and US core portfolios. We may redeploy at any time, including today. That flexibility is the case in all ETF strategies, not just those for the US.
In bonds we continue to make incremental defensive changes. When the current adjustment process in the market ends, we think it will end badly.
The first of our summer gatherings focused on fishing, economics, and financial markets will take place at Leen’s Lodge next week. Chris Whalen has helped assemble this gathering, and Sharon Prizant of Cumberland has handled the organizational elements. We may have last-minute spaces open up as a result of a cancellation or two, so readers may send an email to me if they wish information.
The conversations will be as delicious as the lunch cooked over the fire. We will toast the outcome of the Brexit referendum together in Maine.
by Cumberland Advisors