Investors are hearing encouraging news. The trade dispute between the US and China seems to cool off. The risk of a chaotic Brexit is receding. The yield-curve is back to normal.
Nevertheless, the reaction of equities and bonds remains relatively modest. «The markets are still kind of in this no-man’s-land trying to figure out what’s going to happen next,’» says Jim Bianco.
According to the internationally renowned macro strategist, the lack of a powerful breakout could be a hint that the impact of trade may be overstated and that other factors are keeping the financial markets in check.
For example, trust in the repo market remains fragile, even though the Federal Reserve is intervening with ever bigger liquidity infusions. In addition to that, the likelihood of a recession in the US is significantly greater than most economists think, notes Bianco.
In this at-length interview with The Market, the President of Chicago based Bianco Research explains why he expects government bond yields to continue to decline over the next few months and what he thinks could pop the monster bubble in European sovereign debt.
Mr. Bianco, prospects of a partial trade agreement and a Brexit deal are generating support for financial markets. Is the worst in terms of uncertainty now behind us?
Many strategists keep talking about uncertainty as if there was never any uncertainty in the markets before and we just invented that word last year. For the moment, it looks like we have avoided a hard Brexit and that we’re heading towards phase one of a trade agreement between China and the US. So there may be a bit more clarity on the horizon. But despite these headlines, markets have yet to respond. The S&P 500 and the yield on ten-year treasuries are moving towards the higher end of their range. But so far, they haven’t broken out nor negated the news. So the markets are still kind of in this no-man’s-land trying to figure out what happens next.
Why do you think that is?
I suspect that people are overstating the impact that trade has on the financial markets. There is more that holds the markets back than just trade, although that’s what strategists have been telling us for a year and a half. The old saying on Wall Street is price drives news and so far, stock prices and bond yields have not yet broken out to confirm the recent good news. The longer a breakout takes, the more concerned we become that it might not materialize. Therefore, the coming days are going to be critical.
Taking this into account, next week’s FOMC meeting could play an important part. What is the Federal Reserve going to do?
I think they are going to cut interest rates for a third time and they will do it like they have done it all throughout this cycle: They will try to make noise that they want to stop cutting rates because they never really wanted to start cutting rates in the first place. We will see whether or not the market agrees with that. One of the problems the Fed has had is that they can’t really explain why they are cutting rates. The reason they are doing it is that the market is demanding it and they are afraid to fight the market. So if the market wants more rate cuts it will get more rate cuts.
What’s more, the yield curve has moved back into positive territory. How significant is this development?
The big thing that has pushed the yield curve positive has been the announcement that the Fed will be buying $60 billion worth of Treasury bills every month to solve liquidity problems in the repo market. They have created a new demand for the front end of the yield curve and the market is responding accordingly. There has been a discussion in Fed circles that even though they are increasing bank reserves we shouldn’t call it «Quantitative Easing» or «QE». Yet, the front end of the yield curve is acting exactly as if it was QE; exactly as if they were doing something that was going to be stimulating. So the market is behaving in kind and I’m not surprised that the yield curve is un-inverting.
The yield curve is perceived as a leading indicator for the economy. What does it mean for the outlook when the curve goes back to normal?
I think the curve will steepen out a lot more when all that buying kicks in. This is the way the curve typically un-inverts. In a massive way: very hard and very fast. I like to refer to it as a «wheelie» and when the yield curve is doing that wheelie it’s usually right into the teeth of the slowdown: It’s the moment when the market and the Fed realize that they’ve made a mistake, that the economy is much weaker than we thought, that there is a big problem and that more stimulus is required. That’s when you get that massive steepening of the yield curve. But maybe this one is different because we’ve got the Fed stepping in and just manipulating the curve steeper.
To calm tensions in the short-term funding markets the Fed is pushing more and more liquidity into the system. What do you think of this approach?
The repo market has been drugged into submission by the Fed. It has medicated the problem for now, but the problem has not gone away. This situation is becoming larger and more complicated. No one is sure how this is going to play out. If we knew how to fix this problem, it wouldn’t have happened in the first place. Temporary injections of money can help for a while. But the longer the Fed is doing this – I mean months or years – the more they risk another set of problems coming in. So sooner or later the markets must be taken off this drug. Relaxing burdensome regulations for banks would help, but this does not appear to be on regulators’ radars.
The Fed’s reputation is already at risk, especially with regard to President Trump’s vocal criticism of Chairman Jerome Powell. To what extent are the problems in the repo market undermining trust in the world’s most important Central Bank?
It’s really the New York Fed that runs these operations. And according to all the insiders, Jay Powell had a real strong hand in getting John Williams to the New York Fed from the San Francisco Fed when his predecessor Bill Dudley left. And then, Simon Potter, the architect of all the QE programs, was pushed out the door at the end of May. Sure, there are other competent people at the Fed, but it’s like: The guy who was running everything left and then we get these problems in the repo market. So it really does beg the question if there are too many academics at the Fed and if they have lost touch with the market.