Buyers of bonds are starting to look irrational in terms of return. Some European countries are at negative rates and look likely to go lower. Germany just sold 5 years at a negative rate while Nordic countries have been there for some time. In the US bond yields are dipping lower than the Fed forecasts which creates the need for an adjustment by one party or both.
When thinking about what rational investors would be buying a negative yield or in the case of the US one that the Fed is projecting to be overvalued in a few years time. What I don't see alot of talk about is the time frame and the type of investors. While it is true that holding the new German 5 year to term is going to give you a loss on your money, holding the Bund could be a great purchase if you are a Greek investor with money in the Euro that you want to protect in the event of a Grexit, or if you feel that market turmoil mixed with asset purchases by the ECB will take yields even more negative in the near term. You simply think that Deflation cannot be tamed. On the US side you can have expectations that the Fed will blink first, citing low inflation as the cause, or a renewed interest in US bonds will remain popular for investors wanting to get out of Euro denominated debt, selling it to the ECB and buying the equivalent in a currency more likely to strengthen to the Euro than fall.
No matter what the reason is (reality is a mixed bag with a prevailing bias that is moving yields lower) anyone looking to invest in the space should be aware that most of these investors are not looking to hold to term and the "irrational drop" in yields could easily become a rational spike as the conditions bond holders expect are met.
Going through the news this morning I see a lot of energy related talk. The FT report of OPEC looking to set up emergency meetings if oil continues to drop, the Iraq government running out of money and delaying salaries in the face of low oil and a fight with ISIS, protests in Venezuela, Norway looking to rebalance their economy, and so on. These are all ailments that have no doubt been exacerbated by the decline in oil over the past 8 months but the fact remains that the price of oil cannot be dictated by side effects alone, especially the supply side. Without cutting by Saudi Arabia any OPEC meeting will not produce any meaningful results that would affect the price of oil. Economic malaise as result of budget deficits usually propped up by oil revenues cannot be solved by cutting production in a meaningful manner. Without a concerted effort globally to limit supply of oil the price will not be adjustable by any one country (perhaps with the exception of Saudi Arabia but we know where they stand).
Because of this lack of power over oil prices, many countries will have to enact other measure that they can control to try to mitigate this change in price. Norway, looking to diversify its economy in the face of lower oil would have to look at non-oil companies lack of competitiveness in wages, hours worked, and price of goods. The government can help by weakening the currency or enacting reforms around trade and labor. Iraq may have to tap foreign governments for help in dealing with ISIS on a lower budget from oil revenue. Political turmoil in Venezuela was always a threat, but usually quelled by spending with oil revenue to keep the citizens happy.
When looking at oil prices, there is more to the story than the price itself, but also the side effects and most importantly companies and governments steps the address the issue. As more euro-skeptic parties and protests come to the center of these countries dependent on oil revenue more drastic reforms will be taken to rebalance the economy, with varying results.
With Australian dollar hitting new lows in the past week to the New Zealand dollar, it would be something to look at and question the continuing of the trend and what could cause the current direction to change. The Bank of Australia cut rates earlier this month to a record low while the Bank of New Zealand left rates unchanged. This caused the AUD to decline from about 1.07 to the current 1.035 to the NZD. While the move makes sense it is also something to note that the global economy is still shaky and the Fed is even starting to question whether a summer rate hike is imminent.
It would be important to note the type of data coming out of New Zealand being perceived as bad news, or even a lack of improvement in conditions ,could spark a rate cut of their own. Inflation has been on the decline in the country which could give more room to cut rates.
I am putting on a small speculative position longing the AUD to the NZD and will look to see improvements in the Australian economy which will alleviate the Central Bank's concern about the faltering economy. I will also look to see the Bank of New Zealand tackle weaker inflation by talking down the currency or even cutting rates.
More corporate bonds are nearing negative yields in Europe as the threat of QE is looming over the debt markets there. What makes this an interesting phenomenon, and why we didn't see such measures in the US is most likely due to the amount of debt outstanding in the US vs Europe. Many companies in the Eurozone get their financing from banks and do not go into the market to borrow as much as we see in the US. This lack of existing debt makes for a grab on assets for investors looking to gain higher yields than government bonds. US companies are taking advantage of this by borrowing in the Eurozone in the face of higher interest rate in the US. With the 50bln euro buyback looking to soak up a lot of the government debt outstanding, a renewed interest in corporates could last for years to come.
This lasting demand for European bonds will come from the fact that they are just that European. The yields on other bond are most likely to gain, especially in the US, as economic conditions start to improve. Real rates in the US could prove attractive for some time as rates increase but inflation remains tame. This shock will most likely cause some market panic in the stock markets and see a flight to safety into government bonds. But overall the yields in the US should stay higher on a real basis that that of the Eurozone.
Us oil companies have been cutting production in the face of lower prices, which has seen oil come some 35% off its lows seen last month. This is a significant measure that I spoke about in the "investing in real assets" series about energy. As production goes off-line and capital expenditures are cut, you will see more of a steepening of the oil futures curve. In the near term events like the renewed fighting in Libya could also provide support on spot prices while excess supply is depleted. This is a good time to start looking to add to oil positions for a longer term play. The last leg to wait for is redetermination that takes place twice a year, usually April and October, where creditors asses the value of the debtors secured assets. This could cause another wave in the drying up of lending to some smaller players and curb the growth, and even the replacement, of fracking wells.
Reading about the Australian government reviewing foreign purchases of agriland makes you think of the autarky goals of past regimes. While achieving a complete autarky is impossible the concept of being self-sufficient within your region does play into geopolitics of today. China securing farmland in Australia or other natural resources in Africa or the South China sea shows the same qualities of a government that wants to attain self-sufficiency, albeit now through economic means more than the military means of the past. The commodity super cycle may not be as strong as it once was, but cheaper prices in the commodity sector can provide opportunities for governments and corporations to start grabbing resources for future consumption and security.
On a broader scale what other countries are looking to stimulate their countries within and why? Could the grab for land, or limited partnerships with other countries be a means of avoiding the perils of the currency wars while stabilizing the economy at home? It is not an easy question to answer but looking through this lens into current global affairs could provide another side of the stories that we are scratching our heads over recently.
A rallying day for the equity markets and a down day for the dollar, oil was up big for another day as well. There seems to be a bit of decoupling going on that can leave investors scratching their heads. The dollar was thought to be rallying because of the sole strength of the US economy and the imminent rise in interest rates coming, despite other notions cutting rates or implementing QE. This had an effect on the dollar, about 2% off a 52 week high to a basket of currencies, which went against the bond market where yields are dropping.
What does this mean for the overall markets and where they might lead in the future? Much will depend on if the current theory that the US has reached terminal velocity and pulled away from the global economies woes or the bad news will pull the soaring US back to earth.
Bad news is creeping into the US economy through company earnings and manufacturing numbers as we have seen today. If this were to get worse we could see the lackluster growth of the global economy reach the US. On the other hand major trading partners are taking action to promote growth and pull out of their slumps. In this case the US could see continued prosperity and further gains in the equity markets. In terms of bonds the former scenario would be the most beneficial, with the possibility of delaying the FED's rate increases. I do not see a possible win for the dollar as the raising of rates will cause inflationary pressures (I will attempt to explain that theory in another posting) and a slowing economy will make the US look less attractive to other countries.