The rise of tourism in financial markets

Summary

• How has the blowout number in non-farm payrolls impacted the narrative?

• Christine Lagarde — The beginning of the end to central bank independence?

• Negative yielding debt — The rise of financial market tourism.

• Geopolitical roundup — Update on Iran, South Korea, Japan, and China.

There was plenty of content for the market to digest throughout the week, none of which materially shifted the market narrative. The biggest development was the blowout non-farm payrolls data in the US, which came in well above expectations. Equities were lower and yields rose after the release, highlighting that we are now squarely in the camp that good news regarding the US economy is bad news for both equities and bonds (yes you won't read that in a finance textbook). As a reminder to what we owe our good fortune to, equities have been supported by the renewed commitment of central banks to provide accommodative policy in the wake of an ever-deepening manufacturing recession. Meanwhile, bonds have rallied on recession concerns as well as falling long-term inflation expectations, causing policymakers to worry that long-term expectations may be de-anchoring. This accommodative backdrop has resulted in the spectacular year to date rally in everything (look at the blue bars in the figure at the end of Market update #14 — Depth Charge) but it’s likely this performance doesn’t last. The biggest risks going into the tail end of 2019 will be that i) the global slowdown continues despite central bank easing and ii) that central banks fail to meet market expectations of rate cuts. Remember that this is a fine line given that in order for central banks to deliver on accommodative policy, the incoming data needs to be weak enough to merit a rate cut, but good enough to fend off the bears in the market. The knee jerk reaction we saw in markets to the jobs data on Friday highlights just how fine this line truly is. In Market update #13 — Hating on the Fed is as American as apple pie I explained how “stretched” positions were in bonds and that there was a real risk of a snap back higher in yields. Well, Friday we got a taste of what that would look like, with the 2-year yield jumping 12 bps over the day, posting the second largest one day move of the year. Now although the payrolls print was strong, it wasn’t strong enough to take a July rate cut off the table but it certainly reduced the probability of the Fed moving 50 bps at the next meeting. The chart below is from the CME Fed Watch Tool and shows the probability of a 25 bps rate cut (Green line) and the probability of a 50 bps rate cute (orange line).

The important thing to note going forward is that, if Powell intends to keep rates unchanged in July he will need to start to communicate that to the market this week in order to avoid a sloppy correction. We will likely get a taste of this later this week when Powell testifies in front of House of Financial Services on Wednesday. I’ve read plenty of commentaries this week saying that the Fed should have never allowed the markets to price in as many cuts as they have… the fact of the matter is, the horse has left the barn and now it’s up to Powell to fix this mess if plans to keep rates unchanged or deliver the rate cut. Either way, the cost of disappointing the market grossly outweighs the cost of surprising it. Christine Lagarde, the chairwoman of the IMF (International Monetary Fund), is set to take the reigns of the ECB from Mario Draghi — continuing the trend of increasing political influence over central banks. It’s impossible to count the number of times President Trump has barraged Fed Chair Powell with comments about how little he understands about economics. Although the extent to which Trump has attacked Powell is unprecedented, it’s not uncommon for Presidents to argue with central bank governors and, it’s actually probably healthy to have some political banter. One could definitely argue that President Trump has had some influence over the Fed's interest rate decisions, with the most controversial one being in December, where the Fed raised rates in an effort to show that neither the President nor the stock market dictated policy ... only to reverse course a few weeks later. It's difficult to tie the change in tone from the Fed to the threats that Trump would fire Powell given that financial conditions tightened significantly in the last quarter of 2018. For these reasons, I think it's more informative to go outside the US for evidence of an erosion of central bank independence. I think the most blatant violation of central bank independence comes from Turkey where just this week Erdogan, president of Turkey, fired the CBT governor for refusing to resign after not lowering rates. This strikes a surprisingly similar tone to the resignation of Urjit Patel, the Indian central bank governor, who stepped down in 2018 for "personal reasons" after raising rates to keep inflation subdued. In both these cases, there was a dramatic reaction in FX (both the Lira and the Rupee moved 3 percent the day of the announcement) and, more importantly, central bank credibility was damaged, leaving markets to just deal with it. Now a more subtle shift in central bank independence has been the one the ECB has taken with the nomination of Christine Lagarde. Lagarde is viewed as more of a politician than a central banker, which may actually be what Europe needs given that the political landscape in Europe is as fraught as ever. Should the European economy fall into a recession, Lagarde may very well be the person who helps build consensus on policy and helps manage the tense relations with Italy. Although Lagarde is not formally an economist, it does not mean that she cannot do the job (after all she has an entire governing council to help navigate the intricacies of monetary policy). If anything, it shows the increasing importance for political considerations when conducting monetary policy. In terms of policy views, Lagarde is almost certain to carry on with Draghi’s legacy which will likely entail some form of quantitative easing later this year. Hopefully, she doesn’t get glitter bombed. The push for central banks to provide accommodative policy has resulted in a record amount of negative yielding debt (above US$13 trillion), fostering an even greater search for yield in a market without any. I mention negative yielding debt a lot in my emails and I want to make sure that everyone understands what I mean by this, if you don’t then it’s likely that you frankly also don’t fully understand why assets like corporate bonds and equities have performed so well. Now bear with me here because I know that this is not completely intuitive. The chart below shows the amount of government debt outstanding relative to the amount of government debt outstanding that has a negative yield (note that this number is less than US$ 13 trillion because it does not include corporate debt). 

The main takeaway from this chart is that the majority of the world's risk free bonds have a negative yield. If I wanted to park my money in government bonds, the majority of the bonds out there would guarantee me a loss. Now picture this, I work at a pension fund and I know that I have a population that is getting old and will be retiring in the next few years (let’s call them the baby boomers). Over the past 2 years, I’ve been playing it safe with my fund's money, investing it in government bonds which have been gaining just above 1 percent. All of a sudden I get hit with this giant wave of central bank accommodation which has slammed all of the yields on government bonds to nearly zero if not below zero (that’s what happened this year). I know these baby boomers are going to be knocking on my door asking for their pensions in a few years and, I don’t have enough to cover them. What's more, all the risk-free bonds that I was investing now have negative yields and if I invest in them I’m guaranteeing a loss. I’m basically screwed unless I change my risk tolerance and go searching for that return. When the stock of negative yielding debt increases it pushes investors further down the quality ladder in an effort to meet their required rate of return. In this case, my pension fund would likely end up being invested in riskier assets than I would be comfortable owning. This may seem wrong but what is the alternative? Well, I lock in a loss on a government bond and then cross my fingers that you die before my pension fund runs out of money. If you don’t (which you probably won’t because everyone lives longer nowadays) I tell you that I can’t pay your pension anymore and that you’re basically SOL (shit out of luck). Ok, let’s bring this full circle. In the beginning, I talked about how if you don’t understand negative yielding debt than you clearly don’t understand why equities and corporate bonds have done so well over the past few years. The main thing here is that the demand for these riskier assets has increased because institutional investors like pension funds are getting involved in them in order to meet their pension obligations. Whenever I talk about negative yielding debt I want you to think about tourism. Picture all of these pension funds as tourists in financial markets, dipping their toes in whatever market yields a high enough return. In the geopolitical space, tensions with Iran have continued to escalate with Iran announcing that it had breached the Uranium enrichment ceiling set out by the Nuclear deal in 2015. Iran also threatened to restart a deactivated reactor that would produce 20 percent enriched Uranium (when the agreed-upon deal was 3.6 percent) indicating a clear move away from the deal. Interestingly enough, it appears that the US isn’t the only country Iran has a bone to pick with. Last week the UK seized a tanker of Iranian oil heading to Syria and, in fear of a response from Iran, British Petroleum (BP) is keeping one of their vessels sheltered in the Persian Gulf. The reaction in the market was muted with oil prices only a touch higher. Interestingly, the relative cost of downside protection on oil options is more expensive than the cost of upside protection as per the chart below. The lack of concern regarding the upside risk to oil despite all the conflicts with Iran could be a function of other players (the fracking wells) going back online as oil prices drift higher, essentially creating a ceiling on oil prices. Regardless, if history is any guide, when risk reversals are this stretched we generally see oil prices break higher.

On the trade front there appeared to be little to no material developments between the US and China however, tensions are mounting in other parts of the world. Shinzo Abe, prime minister of Japan, announced that he has tightened controls on exports to South Korea as a result of a court ruling in South Korea regarding labor dispute from 1965 (Article here). The details themselves obviously matter for chip manufacturers like Samsung (who allegedly only have 3-months worth of inventory on hand) but this conflict serves to highlight a broader theme of politics inserting itself into markets in an effort to cause economic distress on another country. It seems like President Trump has set precedent for the rest of the world in this regard. Meanwhile, in China equities took a beating to start the week on news that China was going to launch a Nasdaq style technology board. What made sentiment sour was the fear that there wouldn’t be enough liquidity to support the new market. A more general concern was that this new exchange would just fuel more speculation and bubbles -- a concern that is probably well founded. As things stand now, 25 companies will start trading on this technology board on July 22nd. Tiago Figueiredo