“Things fall apart, its scientific.” Wild Wild Life Talking Heads/David Byrne
The negative rate world is difficult to grasp because participant behavior can be illogical when compared to positive rate cycles. We have compared this to Bizzaro World where Superman is bad and peeps say good-bye when they meet. No one has done more to explore this strange new world and incite our thinking about it like FTAlphaville. Their post today is no exception and we encourage a read.
It all starts with the concept of the “risk free” rate. As central banks get deeper into quantitative activity (because of the “zero bound myth) the basket of “riskier-less” assets expands and is coveted. The ability to quickly exit (the market liquidity myth) promulgates an environment of risk curve experimentation similar to recreational drug use. Agency paper is a QE gateway drug. But we digress..
A few simple rules apply. If its risk free, then it yields nothing (or less). (The game the past few years has been to move questionable securities to default yields then “demand” they be made risk free–more on that later) As Cental bank QE moves out the maturity curve and the product curve, and as participants act accordingly behind them, the returns will/must -over time- decline accordingly, or the policy fails. IOER creates a floor that may be ABOVE the equilibrium rate, we argue that is the case now by at least 10bp. Thus, we advocate dropping the floor and abandoning the purchasing of any security beyond the maturity of the CB forecast. This would allow the term structure to (hopefully) explode wider and point to a future time where we leave Bizzaro World. The relative increase in the term rate would represent both the increase in Fed traction to inflation and the future return to the system. Hence. our post from the weekend that, to the extent B/Es gel around the 2% Fed target the system also STAYS in Bizarro World. Form a cost/ benefit standpoint over a short time frame this-to a command control central banker – is called STABILITY.
The negative rate world would force participants to adjust behavior and risk profile simultaneously. There have been numerous reports of the “Death of the Bond Vigilantes” as referenced to the 80’s high real rate world. But in a negative world, the Bond Vigilante is the bond HOLDER. (ironic that some of the loudest “Death stories” come from PIMCO) By demanding both a high return AND suffocating borrower ability to default, they circumvent the cleansing process. According to David Schawel (the go to guy for all things mortgage), there are 750B in Fan Fred 5.5-6% loans just sitting there. Rather than crawl through the existing refi network, we should automatically make them all 3-3.5%. The bonds would decline rapidly in what amounts to a transfer of wealth from bond holders to citizens who happen to be funding the defunct agency anyway. Not all wealth transfers are created equal and the Fed is a primary holder mitigating a proportion of the fallout.
Its a Wild Wild Life in Bizzaro World, I’d like to get out of it before the science part kicks in.