Up and Down Wall Street
Negative Interest Rates Turn the World Upside Down
Markets swoon and the euro and yen jump despite efforts of European and Japanese central bankers.
By Randall W. Forsyth
With few exceptions, investors—both pros and those playing along at home—are feeling about as sullen and defeated as Cam Newton after being manhandled by the Broncos’ defense. Since the beginning of the year and especially in the past two weeks, they’ve received a similar battering.
Their frame of mind might best be summed up by a quip passed along by Bill Blain, a droll chap who once toiled as a journalist before coming to his senses and going over to the Dark Side of finance (at least that’s the opinion of certain presidential hopefuls). “This crisis is worse than a divorce,” a client of his at Mint Partners in London relates. “I’ve lost 50% of my net worth, but I’ve still got my husband.”
Presumably most are faring a bit better than that, which would be much to the consternation of politicos wont to brand anyone from the environs of Wall Street as evil or worse. The two fellows whose visages grace the cover of this week’s magazine—Bernie Sanders, the self-described socialist senator from Vermont, and Donald Trump, the bombastic billionaire leading the GOP presidential race—also don’t inspire a lot of love from those who earn their living in the actual vicinity of lower Manhattan or its geographical extensions.
Add that to the tally of woes besetting markets. Then there’s the wild card of a possible independent bid by Michael Bloomberg, who at least has the experience of governing after 12 years as mayor of the Big Apple.
The possibility of three candidates—one who originally hailed from Brooklyn, the other two superrich Manhattanites—vying for the presidency, conjures up the specter of none garnering a majority in the Electoral College.
That the next president could be chosen by the House of Representatives (as per the 12th Amendment to the U.S. Constitution) can elicit but one response. As Bernie would say, Oy vey.
Another, equally remote scenario also gave markets the willies last week: that the Federal Reserve could potentially push its key interest-rate targets below zero, as its central-bank counterparts in Europe and Japan already have. Not that anybody imagined it was on the agenda of the U.S. central bank, which, after all had just embarked on raising short-term interest rates in December and marching to a different drummer than virtually all other central banks, which are in rate-cutting mode.
But Janet Yellen, the Fed chair, still was asked about the possibility of negative interest rates by congressional inquisitors last week, even though negative rates remain the longest of long shots.
NIRP—negative interest-rate policy—was supposed to be a high-proof tonic for what has been ailing deflationary economies and drooping financial markets. Since prescribed by the European Central Bank, the Swiss National Bank, Sweden’s Riksbank, and the Danish central bank, it appears to have provided a modicum of stimulus on the Continent.
But the announcement of NIRP in Japan has had perverse effects. The BOJ governor, Haruhiko Kuroda, claimed last week that it was working as intended, bringing down Japanese government-bond yields, with the benchmark 10-year yield dipping below zero. However, NIRP backfired in its intended impact on the yen, which soared instead of declined, and on Japanese stocks, which plunged.
Clearly, the fault can’t all be placed at the doorstep of the BOJ, especially when much of the markets’ maelstrom centered on European banks. Still, the unintended consequence of NIRP has been to squeeze banks’ net-interest margins, or NIM—just as the risks of credit losses are on the increase.
Jeff deGraaf, the chief strategist and head of Renaissance Macro Research, points out that corporate credit has weakened ahead of, and more acutely than, the Standard & Poor’s 500 index. That’s reflected in the sharp rise in the cost of insuring investment-grade bonds in the credit-default swap market since last spring—signaling trouble ahead of stocks’ swoon last summer and their latest tumble.
Credit concerns, of course, are tied in with the collapse in crude oil and other commodities, which puts many borrowers in peril. And deGraaf further observes that a “bail in” of a Portuguese bank late last year (in which creditors of a formerly good bank overnight were transferred to a bad bank, costing bondholders about 80% of their investment) further raised concerns on the Continent.
Last week, those concerns extended even to Deutsche Bank (ticker: DB), whose co-CEO was moved to issue a statement that it was “rock solid” and could make all its debt payments.
That such a declaration was necessary was reflected in the market’s assessment of Germany’s biggest bank; its shares traded for about a third of their stated book value, while its CoCo bonds—contingent convertible securities—slumped sharply. (CoCos are hybrid debt securities that convert to equity under adverse circumstances. Thus, they have the limited upside of bonds and the unlimited risk of stocks, the worst of both worlds, all for a bit more yield.)
For its part, Standard & Poor’s last week lowered its ratings on Deutsche’s Tier 1 securities (those closest to equity, like the CoCos) to single-B-plus from double-B-minus, and on its perpetual Tier 2 obligations to double-B-minus from double-B, owing to concerns over the bank’s earnings. Notwithstanding these below-investment-grade marks, Deutsche announced a buyback of its senior (not CoCo) bonds, which trade at sizable discounts. Discharging those obligations at less than face value accrues to the income statement; they’re paid for out of liquid assets on the balance sheet, however.
RIGHTLY OR WRONGLY, the credit concerns spread around the globe, including to U.S. banks with relatively less exposure to deteriorating credits and with stronger capital positions than their counterparts overseas. Part of that reflected the sad truth that, in a bad market, investors sell what they can, not what they want to. As noted in this column last week, sovereign wealth funds (those repositories of the wealth of various nations, especially oil producers) were large holders of financial stocks.
Historically, lower interest rates have given big boosts to banks; a lower cost of funds widens their net-interest margins, while cheaper borrowing rates spur loan demand. Not this time, deGraaf observes. But NIRP means lower NIM, for all of you acronym fans. Banks must pay a fee to park reserves at the central bank under most of the negative-rate schemes in place.
Thus, banks face rising credit losses, along with squeezed lending margins, an example of the best-laid plans of central bankers gone awry. There are other unintended consequences, as well.
Though it’s not admitted in polite company, negative interest rates are also a way to lower a currency’s exchange rate. But this also has backfired. The yen and the euro have rallied strongly, especially since the BOJ’s move to NIRP.
Why would a currency guaranteed to have a negative return rise in value? You’ll read that investors flock to the euro and yen as havens in times of market turbulence (even though the dollar arguably is the safest shelter in a storm).
What’s also happening is the unwinding of so-called carry trades, in which speculators borrow low-cost currencies that are expected to decline (such as the euro and the yen) to fund higher-return investments.
When the specs have to sell out (voluntarily or in response to a margin call), they must buy back the yen or euros to repay the loans.
Negative rates have produced a world turned upside down. And the direction for risk assets hasn’t been higher as a result. No wonder markets are in a sour mood.
THE U.S. STOCK MARKET wound up the week on a happier note, certainly more so than did Tokyo, where the Nikkei shed 11%, a plunge that might be characterized as “huge” by a certain presidential hopeful.
On Friday, the Dow Jones industrials and the S&P 500 each added 2%, and the Nasdaq Composite advanced by 1.7%. The gains trimmed their respective losses for the week to 1.4%, 0.8%, and 0.6%.
The turnaround actually started on Thursday, with yet another report that the Organization of Petroleum Exporting Countries would try to get together on output cuts. That pulled crude prices out of their tailspin, and stocks with them, just as the S&P 500 touched a critical level on the charts. In any case, nearby U.S. crude rallied 12% on Friday, but still ended down 4.7% on the week, at just under $30 a barrel.
It’s an old trader’s adage that markets never bottom on a Friday. Bounces tend to happen at the end of a down week as bearish bets get closed out before the weekend. And RenMac’s deGraaf observes that Friday’s market action had the earmarks of short-covering.
The incentive to even out positions would be doubly strong ahead of a three-day weekend for Presidents Day in the U.S., as well as the reopening of China’s markets on Monday; they had been shuttered for a week for Lunar New Year’s celebrations. Bulls hope that Shanghai doesn’t ape last week’s gyrations, as trading resumes in the Year of the Monkey.
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