We continue to expect the Federal Reserve to be ready to raise rates in September. Consistent with that timeline, the Fed would need to continue to see the kind of positive economic data we have seen over the last few weeks. That the bond market is a bit ahead of them is not a surprise. Remember, the Fed is actually a follower; they do not lead.
As always, there are storm clouds. Puerto Rico is a seriously bad situation and potentially as big a problem to the U.S. as Greece is to Europe. Both debt crises reflect access to central bank-engineered cheap borrowed money coupled with limited ability of the borrower to exercise structural discipline. The municipal bond market will most likely have to take a haircut. Puerto Rican bonds are tax free in all U.S. jurisdictions, which means that they are owned everywhere.
The link to Greece is relevant in a few aspects. First, markets want to know “Is this Lehman?”, with cascading counterparty risks that will cause contagion? We anticipate the answer should be “no”, given that there should be no surprises. Frankly, both situations have been well telegraphed for some time.
A second issue around Greece is whether other countries follow suit. We do not know the answer there, but the question is really whether Portugal or Spain says “me too”. Going forward, they will likely have higher borrowing costs. But there is another victim here too, and that is Europe itself. Simply recall the history of an endlessly combatant continent, grabbing each other’s land. Then the idea was “let’s unify” under the European Union, and then a common currency was extended to a segment of that group. There was the dream of unity, peace, and prosperity. Also, there was a desire for a suppression of nationalism and the ascendance of the rule of law. So going forward, they were supposed to argue about trade quotas and budgets, not inflict violence on each other. But now as negotiations devolve, there have been fighting words exchanged.
Further to this point, for most Europeans, the decision was always about “which side” they wanted to be on: with the West or aligned with Russia. That Greece is now cozying up to Putin is not a positive indicator. Would this outcome declare the dream of Europe to be a failure? That’s the question in play. Joining the likes of fellow defaulters Zimbabwe, Sudan, and Somalia, we could have a failed state in Europe, meaning that the link between prosperity and the EU is severed. While Greece was a member of the EU early on, maybe they should not have been let into the Euro (a smaller club). Iceland and Ireland maybe did better jobs of climbing back from recession. While they have also done better, the ultimate outcomes in Spain and Portugal remain to be seen.
Third, there is likely a lot more pain in store for Greece as well as Europe. Exiting the Euro will have real socioeconomic consequences and could lead to more social unrest. But it’s more than pensions slashed and unemployment soaring. Add in Greece’s proximity to the migration dilemma from Africa and the Middle East and this could be a nightmare. Specific to the default, Greece just does not have the money; it’s a financial problem. But it’s a political problem too, because the crisis has profound implications for democracy, the original rallying point that drew Greece into the EU more than three decades ago, when their junta was overthrown. Alexis Tsipras, the prime minister, now argues that far from securing Greek democracy, the EU has actually become its enemy, by trampling on the will of the people.
In the end, this is also a clash of mandates and shared sacrifice for larger goals. It puts the Greece’s ideas of ditching austerity against the voters and taxpayers of other countries who want to see their loans repaid and do not think an unreformed Greece should benefit from their money. We have the immovable object up against the irresistible force.
The next question is whether China is a bigger problem than Greece. Growth in China is slowing to its lowest rate in decades, and that has important implications for global trade and finance, as well as investor confidence. Greece is 2% of Europe’s GDP; China is 15% of the world’s. We think this is a potential cause of concern for global markets.
If we pull these threads together, the result is that anxiety has increased and markets are slaves to sentiment and human behavior. Basically nobody is constructive on the bond market. Arguably, few have championed the bond market’s virtues in quite some time. But to make it more interesting right now, the Fed’s own members have, of course, indicated that short-term rates are going to nudge higher.
In response, we have noticed the dealer community becoming more risk averse. When any market participants look to sell bonds, the dealers do not seem to be stepping up to support the sellers. Why would they want to buy your paper? Instead, pull up the drawbridge and hide inside the moat! Plain old risk aversion-driven illiquidity is the norm of the day. It seems like vanished from the scene are many of the participants, the shock absorbers, those market players that smoothed out market actions, by stepping in and holding positions.
A companion of heightened illiquidity is intensified volatility, an exacerbation of price actions. Limited volume can cause large price moves. These price moves are just based on flows, and not necessarily due to new economic data that has altered the outlook.
In the face of this illiquidity and volatility, we see two other major issues. First, central banks globally are still in a process of providing further monetary accommodation. While the U.S. central bank looks to be an outlier to this process, markets, especially bond markets, have been driven by central bank actions for several years now. When most central banks globally are still providing accommodation, it’s a bit of a stretch to think that the U.S. can operate outside of the influence from the rest of the world.
But we see the second problem as more fundamental. Inflation, growth, and employment are all pointing towards levels of economic prosperity that are simply below historical patterns, much less what is desired. While we do not think this should not stop the Fed from exiting its past seven years of extraordinary accommodation, the global storm clouds we have discussed could knock the Fed off its track if economic data weakens or the dollar strengthens. Even the head of the International Monetary Fund recently urged the Fed to hold off raising interest rates until 2016.
Altogether, we think this leaves us in a market that is likely to remain volatile. In this environment, we believe it’s prudent to avoid seeking yield simply through extended credit quality or duration exposure – holding low quality or longer-dated bonds “out on the yield curve”, respectively. In our opinion, those types of securities are the most likely to be susceptible should the storm clouds turn into a downpour. Here at Roosevelt, we continue to focus on our risk-conscious approach to generating consistent income regardless of the interest rate environment or potential market volatility.
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