Economic pressures continue to mount, and bond markets appear to have priced in a high likelihood of further rate cuts. It’s even been suggested that yields could turn negative in the U.S. Jim Bianco of Bianco Research recently spoke to FS Insider and explained why he believes getting to negative rates would be courting disaster.
See Nothing But Problems Coming Down the Road, Says Jim Bianco for podcast audio.
China Backing Off Trade War?
U.S. tariffs spooked markets and the Chinese responded by devaluing their currency. The first rounds of tariffs were on industrial goods and products that consumers aren’t directly exposed to, while the current round of tariffs focuses on consumer products such as iPads and other technology. This scared markets and the yuan fell in price below the psychologically important level of seven, Bianco stated, as China deliberately weakened its currency to offset the increase in tariffs.
Then on Aug. 18, Trump announced a list of goods from China that won’t be subject to a 10% tariff until Dec. 15. This list is made up of “products where 75% or more of the 2018 U.S. imports of that product were from China,” according to an email sent from the U.S. Trade Representative Office.
In response to China devaluing its currency, the U.S. declared China a currency manipulator to involve the IMF and get the world community to help rein in the Chinese.
“Are the Chinese currency manipulators?” Bianco asked. “Yes,” he said,” they have been currency manipulators every single day since the Chinese government came into existence... This action, however, is being perceived by the marketplace as the Chinese stepping back from this trade war. They are not caving in—it's not over—but they had the opportunity to really ratchet this up big, and at least for now they decided not to.”
Fed Rate Cut Too Weak
The Federal Reserve should have lowered rates by 50 basis points at its last meeting, Bianco said. While some argue that interest rates are already too low from a historical perspective in the U.S., Bianco pointed out that world interest rates matter and should be considered. Everything is relative when it comes to interest rates, Bianco continued. Of $55 trillion worth of sovereign debt in the world—99 % of which is outside the U.S.—almost all of it yields less than the Fed funds rate.
There are only two interest rates that are higher than the fund's rate around the world; the U.S. 30-year bond, (recently traded as low as 2.12, the same as the funds rate) and the 30-year Italian, which is a very small issue yielding 2.45.
Should the Federal Funds rate be the highest interest rate on the planet? The answer the market is giving, Bianco stated, is obviously not. As a result, bond markets are demanding that the Fed address the Funds rate. This caused the yield curve to invert, Bianco explained.
“This is a sign that the market’s screaming the funds rate is too high because the rest of the world is much lower,” Bianco said. “They have to bring it down.”
Negative Debt Destruction
The cause of negative yields around the world is excess capital with no productive investment opportunities, Bianco stated. With loose monetary policy and quantitative easing inflating the money supply, we’re oversupplied with cash. On top of that, the world’s aging population is saving more and has less need of investment capital, he stated. Also, it is cheaper than ever to start a company. All of these forces are deflationary.
The only reason negative yields in Europe and Japan haven’t yet created more of a problem is that both economies can find positive rates in the U.S. and the U.K. This creates an outlet for capital, and is partially why the dollar is so strong right now.
This setup cannot produce a good outcome if negative rates spread, however. It’s harmful because the entire system is built on assumption of positive interest rates, Bianco stated.
We’re left without any benchmarks to measure markets in terms of negative rates, he added. The fractional reserve banking system and security settlement do not work in a negative rate environment. It only appears to work right now because nobody knows what to do.
“If we continue to see negative debt and if it shows up in the U.S. and in the U.K., it will do nothing short of destroy the financial system. It is that cancerous. … We created all this money, we don't know what to do with it, and it's creating havoc in the financial system,” Bianco said.