Here in North America, it is easy to focus on the potential for higher rates in the coming months. However, for most of Europe, the world is still bat shit crazy. Rates that were already negative, continue to go even more negative. What had been an experiment with rates slightly below the zero bound has become a full on policy tool with Central Banks extending short rates well into negative territory.
The 2 year bond, which is a good proxy of anticipated Central Bank rates, has plunged deeply below zero for Germany, Sweden and Switzerland (and most other Western European nations as well).
This coming week we find out how much lower Mario Draghi wants to push the ECB. Will it be another 15 or 20 basis points cut? Or even more? And how much more QE will he promise? The market is hopeful Super Mario will have once again over promised and yet still over deliver. Expectations are high, but when his back has been up against the wall before, Mario has come through.
I am not sure what he will do, but I know the market has become all too comfortable with negative rates. When Mario first set negative interest rates there was a whole lot of chatter about the lower bound. Analysts spoke about why rates would only go as low as negative 5 or 10 basis points. Yet here we are with the 2 year yielding negative 42 basis points in most of the EU.
If we can trade at negative 40, 60 or even 100 basis points – what’s stopping minus 200 or 300 basis points? Or even lower? The taboo has been broken. There is no stopping even more outrageously negative rates.
The ironic consequence of negative European rates is the feedback loop is causing even more deflation, which results in even more negative rates. As Europe lowers rates, it causes the Euro currency to fall, which strengthens the US dollar. This causes commodities to decline, which only makes deflation all the worse. The fact the Chinese have a soft peg to the US dollar exacerbates this phenomenon.
I find it amusing that there is so little talk about competitive devaluation. Central Banks have been careful to justify these cuts into negative territory as economically justified, but let’s be honest – we have long past that point.
Our global financial system was not designed for negative rates, yet here we are with one of the largest economic union blocks trading with a minus sign in front of most government yields.
And instead of considering the consequences of this preposterous development, the ECB and other European Central Banks are simply diving deeper into the negative rate abyss.
Negative rates across so much of Europe is a sign the global financial system is badly broken. I do not see how this will not eventually result in negative rates across the other zero bound nations. How long will Japan be able to withstand this pressure? So far the BoJ’s crazy balance sheet expansion has been enough to keep the Yen weak, but interest rate differentials eventually matter.
Have a look at the US/German 5 year interest rate differential versus the level of the Euro currency:
Although initially the widening of the spread between the US/German rate did not result in a fall in the Euro, eventually it kicked in.
As Europe consistently hammers away with negative rates, it will ratchet up the pressure on other currencies. They will either have to follow Europe with negative rates, or suffer painful currency appreciation.
So far the US is steadfastly putting on a brave face against the backdrop of this competitive currency devaluation technique. The Chinese who have a soft peg with the US dollar are desperately trying to hold on in the face of this onslaught. But there is no way they will be able to continue down this road much longer. The Chinese will be the first to blink. Then it will be interesting to see if the Japanese are forced to join the dark side of negative rates to maintain their competitiveness. And then when the shit really hits the fan, even the US will be forced to reverse course and consider negative rates.
Don’t get me wrong and mistakenly think I am assigning blame on the Europeans for this development. All countries are to blame. And even if they weren’t – who cares? The only thing that matters is how it will resolve itself.
As traders the important thing to understand is the move into deeply negative rates has opened a Pandora’s box. There will be way more consequences than most market pundits are considering. We will look back at this development and wonder why we didn’t make a bigger deal of it. It isn’t right, and nothing good will come of it…
Have a look at short Swiss Francs
Earlier this year the Swiss National Bank abandoned their peg to the Euro. The ensuing chaos was legendary, and it ruined many hedge funds’ year. But more importantly, it unleashed a deflationary wave on the Swiss economy. The SNB responded with aggressive rate moves deep into negative territory.
The yield curve all the way out to 10 years have moved to negative yields:
Stop and think about the absurdity of this level. The Swiss government is getting paid to issue bonds! An investor is paying 35 basis points for 10 years to the Swiss government for the privilege of taking their Francs.
But these negative rates have an effect. Have a look at the EUR/CHF cross rate:
The CHF is slowly getting weaker. And when you think about the pickup versus the US dollar (US two year yielding positive 1% and CHF two year yielding negative 1%), you won’t be surprised to learn the CHF has actually recouped all of its post peg strength:
Right now the market is leaning hard against the Euro. Tons of hedgies are short, and there is a lot of expectations built into this Thursday’s ECB meeting. But even though sentiment is poor, the Euro has not broken to new lows:
Maybe it will break, I don’t know. But it might make much more sense to throw the bricks into the wettest paper bag instead. The rate differential against Swiss Franc is even more advantageous, and the market is already confirming the breakout.
Think about shorting the Swiss Franc instead…
Thanks for reading,