I’ve been getting some great and thoughtful comments on Sure Money and Money Morning lately – and I plan to address a whole slew of them next week.
But Bryan’s was so uniquely well-thought-out and provided such great fodder for discussion that I’ve decided to devote an entire weekend issue to it point by point.
Of course, I didn’t agree with all of it! But that’s the fun of it!
Bryan, thank you for showing us that intelligent market dialogue is not dead. You, sir, are a class act.
Bryan Canter April 4, 2018 at 5:52 pm: Lee, I really appreciate your knowledge of fund flows and its impact on the markets. I am trying to get some of these relationships straight, and would appreciate any insights you might have. Here are the dynamics that I am trying to get straight:
– The Fed pulls money out of the system through its reverse QE program. It does this primarily by not repurchasing bonds, MBS, etc. which causes the supply of bonds to rise, prices to fall, and rates to rise.
Yes, that’s half of the equation. It results in an increase in supply, which is especially painful in view of the massive increase in supply from the increasing budget deficit and the Treasury’s program to build a big cash kitty.
But as important, if not more important, it removes money from the accounts of dealers and banks, thereby weakening demand for the new paper.
– The Fed raises interest rates, which also causes yields to rise and prices to fall
On this I disagree. The market is raising interest rates because the supply of short term paper is ballooning and there’s less money around to absorb it. The Fed merely rubber stamps the rise in rates that result from tightening markets.
– The Treasury issues more bonds to pay for deficit spending and to replenish reserves, so the supply of bonds increases, yields rise, and prices fall
– The money to purchase this new supply of bonds (with safe high interest rates) drains money out of the stock markets and stock prices fall
Yes. Dealers and institutions who opt to buy Treasuries will need to liquidate something at the margin to pay for the Treasury purchases. Often that something is stocks.
– International funds flow out of the US as the foreign central banks (ECB and BOJ, et al) slow of reverse their versions of QE, making bond yields rise further and accelerating the fall of stock prices
My opinion has been that capital outflows have been politically driven. They started immediately after Trump was elected and the dollar began to reflect that after a massive short squeeze into the end of the year.
The US is no longer seen as the safe haven that it traditionally had been. The dollar should not have weakened given that the Fed had stopped printing and the BoJ and ECB were still printing. That money isn’t flowing to the US to the degree that it used to. But the dollar did weaken, because of the trend of repatriating euros in particular. Europeans sold US holdings for dollars and then sold them for euros for deposit back home.
In addition, despite ECB printing deposits in Europe just aren’t growing much. Negative interest rates (NIRP) incentivize depositors to extinguish them by paying down debt. NIRP is self-defeating. It helps to strengthen the Euro against the dollar. Ditto for Japan, which also has NIRP.
Assuming all of the above statements are true, then here are my questions:
But, they are not all true, so I would not make the assumption that they are.
– As “safe” bond yields rise, won’t investors leaving higher risk assets cause a higher demand for bonds and stabilize the yields at some balance point (say 3-4%) where the risk free rate is basically equal to the risk adjusted rate of stocks?
That is a possibility. Bonds are a different animal. With Government securities, you have a reasonable assurance of getting your money back at maturity. Not so with stocks of course. And I believe that stock investors will see a lot of pain when the 10 Year goes through 3%. The charts suggest that it is unlikely that the yield would stop there.
I prefer not to deal with hypotheticals. My focus is on identifying the current trend, and particularly major turning points. I want to be on the right side of a new trend as soon as possible before or after it starts. Then we’ll position accordingly as the data indicates.
But to address the what if scenario of bonds stabilizing at 3-4%, that would not change the fact that the Fed would probably still be pulling money out of the system. So the money to support enough bond buying at 3-4% would have to come from elsewhere. A bull market in bonds, or even a stable market in bonds, would be very bad news for the stock market.
– If the Fed drains dollars out of the system, won’t that cause a reduction of supply in dollars and force the dollar to strengthen?
Theoretically yes. But it’s not happening because Europeans and others are selling dollar denominated holdings, then selling the dollars for their home currencies so that they can deposit the money at home.
– If interest rates rise, won’t that hammer all the sovereign and private entities that have record levels of debt?
Sure. It’s a big problem.
– If the dollar strengthens, won’t that make dollar denominated debt very hard to pay (for emerging market economies in particular)?
The trend of the dollar is down until it isn’t. Again. I prefer not to deal in the hypothetical.
– if the dollar continues to strengthen won’t that hammer commodity prices (like oil, raw materials, and agricultural products)? Commodities are a major component of inflation. If commodity prices fall, then inflation should fall, right? And bond yields anticipate future inflation, correct? So if there is price deflation, rather than price inflation, then bond prices should also fall, right?
I would not insist that the dollar must strengthen. Theoretically it already should have, but there are clearly other trends at work that are driving the dollar lower. Rule number 2- The trend is your friend is the critical factor. Fight it at your own peril.
I know that you can’t take the time to reply to me privately. But if you need fodder for future articles, anything you could do to address some of these dynamics would be appreciated.
This was great stuff Bryan. While I could not agree with your underlying assumptions, I appreciate your thoughtfulness. They were great questions. Thank you!
I hope you, and all of my other readers have a wonderful weekend.