If there was a fix, we weren’t in on it,” said Richard Melito, father to the boxer nicknamed “The Bull.”
Although not quite the same as a boxing match, we can be assured that the fight in the bond markets is fixed too. And in a simpler way. No right hook or uppercut needed; with just a computer keystroke, the fix is in.
The central banks make money out of thin air and make sure that rates are fixed – this time at zero and possibly heading lower. Call it magic, a band aid, a necessary evil, emergency relief, new monetary policy, whatever you wish. In the end, those are the rates and there is not one thing that any money manager can do about it. Not one thing!
The Fed’s balance sheet is at $7.0 trillion and mark my words, it’s going higher. But they are not alone. According to Yardeni Research, the European Central Bank is up to $7.6 trillion in assets with the Bank of Japan at $6.4 trillion and the People’s Bank of China at $5.30 trillion. If you add all of them up, it totals $26.3 trillion. That is larger than the total Gross Domestic Product of the biggest economy on the planet, which is the United States. Just think, if we increase rates by one percent on that $7.0 trillion of debt, the U.S. will have to pay $70 billion in interest, and remember that total U.S. Treasury debt is over $26 trillion, so that cost balloons to $260 billion. The same holds true for the rest of the central banks. So, I ask, where is the incentive for central banks to increase interest rates?
The bottom line is that the Fed, and their brethren central banks, now are in total control of the fixed income markets. Some investors have an escape, although a riskier one: high yield or equities. However, there are investors, namely many municipalities, that are prohibited by law from investing in assets other than investment grade short-term fixed income. So, their funds are now earning peanuts or nothing.
Although the COVID-19 pandemic was the catalyst that caused the assets of the central banks to increase by over 45%, the whole central bank intervention and manipulation began after the “Great Recession” in 2008. This has not only affected the fixed income markets, but also the equity markets. Just look at the return of the S&P500. Forget the focus on the economy: the S&P 500 has increased almost in lockstep with the central bank’s increase in assets and is reflective of the use of the money that has been created. One of the collateral damages of major central banks controlling and dominating the fixed-income markets is the equity markets, as determined by their flood of assets and our current interest rate environment.
It is not just the amount of money they have amassed or created with the wave of a wand, but their newfound intentions of what to do with the assets. The Fed is not just buying Treasuries and US Government Agency debt, but also corporate bonds (bonds of companies), municipal bonds (bonds issued by cities and counties), bond ETFs (like mutual funds but priced throughout the day) and high yield bonds. Not only have purchases of these markets lowered return profiles, but what is to stop them from purchasing stocks or who knows what tomorrow? There does not appear to be a limit as to what they could do if the Fed Chairman, Jerome Powell, waves his wand and makes it so.
For the professional money manager, or for an individual, all one can do is follow along and try to anticipate their next move. Investors cannot afford to be in cash or short-term investments waiting for market corrections. Earning zero may be an option, but it is a very costly one. However, increasing risk to earn income may also be a very costly option. Borrowers may be living in a state of Nirvana, but investors must live in angst every day.
It is our opinion that a lot of the rise of the stock market has been caused by traditional bond money going into equities as they try to replace yields with dividends and appreciation plays. When you can no longer get any meaningful yield, you are literally forced to try something else. However, a 10% drop in stocks is not uncommon and it certainly would be a very hard pill to swallow for fixed income investors that were used to consistent cash flow and little volatility.
A huge spike in volatility is not out of the question, and we may see it in the near future, which is never a good thing for any of our markets. We are facing our elections, the issues with China, the continuing problems stemming from the coronavirus pandemic and then the protesting and rioting that has taken place in some cities in the United States. More unpleasant surprises may be ahead in each of these areas, so being prepared would be very wise.
Yes, the “fix” is in, and in our opinion, it is here to stay. These are very uncertain times, in a wide variety of areas, and while cash may be useful as a safety net, it also gets you nothing, or almost nothing – thanks to the central banks – while it sits there in your bank or securities account. This is the most difficult time in memory to preserve capital now, as more risks have to be constantly taken to get any kind of return. Caution! Continuing reflection on the risks you are undertaking is certainly advisable in our present circumstances. Be wise, don’t jump before you look. That precipice has become very, very steep.
Xavier Urpi, Chief Investment Officer