Earlier today we discussed how the Bank of England and the ECB’s corporate bond buying programs are likely to drive demand for US investment grade credit.
The rationale is pretty simple. Here’s BofAML:
“We find that, by deflating sterling and euro credit spreads, the BOE and ECB corporate bond QE programs are creating a lot of attractive relative value in the dollar market. The relative cheapening of dollar spreads in general is bullish as investors reach for yield.”
Note that this is the same dynamic that’s keeping US Treasurys bid. There’s no yield to be found in overseas high quality government bonds, so investors are flocking to US debt despite the fact that yields are pretty meager stateside as well. Here’s a good set of charts that demonstrate how Japanese investors are being driven into US debt:
(Charts: BofAML)
Essentially then, the US is importing QE.
As Goldman notes, incessant asset monetization by central banks has created an enormous amount of duration risk as governments and corporate borrowers are compelled to issue longer-dated debt to satisfy investors’ thirst for yield. Here’s some color:
“Given the flatness of the curve, both the government and corporates have been issuing longer maturity bonds. For example, the average duration of outstanding UST debt has increased to almost 70 months vs. less than 50 months in 2008. Longer duration means that prices are more sensitive to increases in rates. We estimate that an investor in US bonds could lose 7% between now and the end of the year if the 10-year moved back to just its 12-month high (2.3%). The principal at risk is even higher across Eurozone countries. “
(Charts: Goldman)
That’s actually pretty scary when you take a second to think about it. If you’re in gilts, you’d lose 12% if yields rise just to their 12-month high.
So at this point, normalization would be a bloodbath for bond holders.
Thankfully, we got at least one data point on Tuesday that the Fed can trot out as a reason why the US economy isn’t ready for a hike. As you probably noticed, the economy has a labor productivity problem. Today we learned that in Q2 productivity fell 0.5%, off sharply from the consensus estimate of up 0.4%. Deutsche Bank didn’t like that one little bit. Here’s what Joseph LaVorgna had to say:
“Latest productivity data corroborate our worst fears. As we wrote last week, strong employment growth and weak GDP growth together imply depressed underlying productivity and strained profit margins.Today we learned that productivity was down -0.5% annualized in Q2. As a result, the year-over-year rate slipped to a very disappointing -0.4%, the slowest rate since Q2 2013 (-0.6%). Productivity gains can be bolstered by reducing labor input, likely precipitating an economic downturn, or significant capital deepening, which would spur a smart acceleration in output. The recent resilience of the labor market alleviates near-term fears of the former outcome. However, a sustained pick up in capital spending appears unlikely until after the US Presidential Election. Hence, we expect the economy to muddle through over the next couple of quarters, growing well below its current-cycle trend rate of about 2% due to continued weakness in productivity and slowing job growth as the labor market stabilizes around full employment. “
There you go Janet. That’s your no hike narrative courtesy of a bank which may or may not be around when the next hike finally does come.
Of course investors couldn’t care less about any of this. Stocks only go one direction: up. A down day feels like someone has ripped a hole in the space-time continuum. So naturally we closed at fresh record highs.
As we wrote on Monday, the problem here is that someone else is going to have to normalize first, or at least alongside the Fed. The dollar makes this whole thing effectively impossible. If they hike, it won’t just tank stocks and result in big losses for bondholders, it will also cause the dollar to soar given the policy divergence between the FOMC and everybody else. That, in turn, would be a gut punch for emerging markets and might well compel the Chinese to start “guiding” the yuan significantly lower. Oh, and you’d probably see oil crash again too.
So at the end of the day, every little negative data point helps. Now if only the BLS would stop printing these blockbuster jobs numbers, we could all rest easy knowing that rates are going to stay at zero in perpetuity.
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