Capital Markets Update

By Louis S. Barnes                                 June 5, 2015

Last week I thought the rise in long-term rates was overdone and had a chance to reverse. Oops. The jump in rates has continued, and with it deepening confusion. In just six weeks, the 10-year T-note has moved from 1.90% to 2.40% today, mortgages from 3.75% close to 4.25%.

News media today are desperate to find valid business models to replace newspapers and think-TV. Thus a mass move to competitive nano-second shouting, trying to match the attention span of the phone-addicted. How to convey emphasis, or events over time if every headline is hysterical, and the copy below twitter-bitted?

Today’s payroll report added little to damage already in place by Wednesday. A nice gain in jobs, heavy with poor ones (57,000 in “liesure and hospitality), and a minor up-tick in wages — 0.3% in May after 0.1% in April, year-over-year 2.6%. A couple more reports as adequate as this, and the Fed will lift off.

But that’s not the story. That’s just twitter-flicker. Go back, way back, to summer 2013, when Perfesser Bernanke announced the pending end to QE3. The Taper tantrum took the 10-year from the same lows as this past winter to 3.00%, and mortgages just short of 5.00%. From which rates slid in an elegant straight line to last winter’s lows. The twin puzzles throughout that slide: why, and how far down?

The first part turned out to be easy. There were plenty of bond buyers to fill in behind the Fed, and economic data in the US stayed soggy-ambiguous and deteriorated overseas. That simple calculus changed last fall, and I think we are all struggling to keep the change in mind now. Last fall the Fed began its hold-us-back chanting: liftoff and normalize… liftoff and normalize. Meanwhile every other central bank embarked on deeper versions of QE. That central bank mismatch has no precedent.

The immediate result of the mismatch was a massive global devaluation versus the dollar, pushing down US rates, and the advent of ECB QE encouraged wild over-buying of euro-denominated bonds. The whole affair was assisted by the collapse in oil which began last October, turning risk of inflation into risk of deflation. That pattern continued into February, assisted by lousy global economic data.

The end of the 16-month drop in global rates coincided with this reversal: US data was so bad that markets began to assume the Fed would hold off and then move slowly. An aggressive Fed was the reason for the strong dollar, which stopped rising. The fantastic devaluation has produced better numbers in Europe, buoyed the euro and eliminated nearby risk of deflation. The German 10-year in six weeks has gone from a panicked yield of 0.05% to an equally panicked 1.00% (intraday), today 0.85%.

Everybody drop your phones and ask the long-term question. Has anything changed since last year? In these real economies? I suppose the US economy is closer to full employment, whatever that means. Maybe employers will pay up, maybe not. Europe’s gain has been the US’ loss, zero sum. Oil will stay down. China and Germany are still deadly predators, generating deflation for all the others and completely indifferent.

I am a fan of the Fed, and this and the prior Chair, but it is having an awful time. Its forecasting models have not worked. Its six-month insistence on liftoff and normalizing toward a 4% overnight cost of money in a couple of years, in retrospect has been ridiculous and counter-productive. Vice Chair Stanley Fischer this week replaced “liftoff” with “crawling,” in an embarrassing reversal of his previously threatening stance.

The Fed’s difficulty does not signal incompetence; it marks the unprecedented situation afflicting world trading, currencies, and credit.

It looks to me as though a rate decline that should have stopped last fall sometime instead overshot, and we’re now back where we were.

Everyone has remarked on the rise in volatility, many blaming “illiquidity” caused by new regulation. Keep it simple: volatility is rising because the world is dependent on un-coordinated but hyper-active central banks, and markets are always illiquid when too many people try to get through a closing door at the same time.