Fans of the HBO show Entourage may recognize this quote from Val Kilmer’s character in the episode “The Script and the Sherpa.”
“It's all so negative, man. I mean, the Man's most positive posi-tive is a nega-tive. It's a mega-nega-tive. Right?” When I was reading back through all of my market notes from last week for some reason I kept hearing Val Kilmer’s voice.
From interest rates to economic data points to global market returns; so far this year, it’s all so negative, man. But for the US Dollar, it’s all so positive.
Take a moment to consider what it means when a central bank goes negative. It means primarily three things.
First, it's an admission that all of the unprecedented monetary policy that we have seen since the Financial Crisis has done absolutely no good and they have no options left.
Second, it’s the newest trend to see who can burn their currency to the ground the fastest.
Third, it means that depositors in those economies are having to pay for the privilege of having their cash safeguarded in the banking system.
Back on January 29, the Bank of Japan surprised the world by going to negative interest rates. This decision was announced just 8 days after the BOJ Governor Kuroda said that the Bank had no such plans. I guess a lot can change in a week. The BOJ committed to using a three-tier system, which makes the negative rate much weaker than comparable moves by the ECB and other European central banks. It’s paying negative rates on any new bank reserves resulting from its asset purchases. However, the existing bank reserves, which amount to 50% of GDP, will continue to be paid interest at 0.1%.
In going from zero to negative, Japan joined a handful of other countries who have resorted to negative yields, including: the Eurozone, Switzerland, Denmark and Sweden.
Just this last week, the yield on 10-year Japanese Government Bonds (JGBs) went negative for the first time ever. “Ever,” as they say, is a very long time indeed.
60% of Japanese household assets are in bank deposits. This means a negative interest rate will have a negative wealth effect and it will reduce the purchasing power of Japanese consumers. Domestic demand will inevitably suffer and Japan’s contribution to global growth will likely fall even further.
So, the only thing that Japan has guaranteed by going negative is reinvigorated currency wars and a continued slowdown in global growth.
How do you think negative interest rates would play in the US? Can you imagine the run on banks if they started charging interest on checking and savings account balances?
If you think it’s far-fetched for negative rates to come to the US, think again!
In Yellen’s comments last week she said, “We had previously considered them and decided that they would not work well to foster accommodation back in 2010. In light of the experience of European countries and others that have gone to negative rates, we’re taking a look at them again because we would want to be prepared in the event that we needed to add accommodation."
But Yellen isn’t just talking about going negative. For the first time ever, the Fed is requiring that when banks do their round of stress tests this year, that they prepare for the possibility of negatively yielding Treasury rates.
But as the Fed is quick to point out, this scenario is purely hypothetical and not a forecast. That sounds about right.
Considering all the ways banks are stress tested since the Financial Crisis, does it make sense that the Fed would include a new measure in those tests for just for the fun of it? I don’t think so.
But frankly, we don’t need to know if the Fed is going to go negative to play out a few scenarios and make the proper adjustment in our portfolios.
For the better part of 2014 and 2015, I routinely discussed the US Divergence Trade. This theme existed because the Fed stopped QE and the rest of the world continued with and actually ramped up their own easing policies.
The market that benefited the most from this divergence trade was the US Dollar. The USD’s run since mid-2014 is well discussed but the recent 5% pullback from December’s peak has a lot of people questioning whether or not the run is over.
For those of you who like to be given fish, the answer is, it's not over, and in fact, the USD bull market could just be getting started. For those of you who like to be taught to fish, here’s my logic.
The rapid rise of the USD over the last 18 months occurred without the Fed raising rates, in fact the USD has been weaker since the December hike. Side note: while the USD index (DXY) that is traded actively has declined sharply, the broad trade-weighted USD index, which the Fed cares about, has not declined and remains at decade highs.
All the USD needed for its sustained run was for the Fed to hold pat and let the rest of the central banks burn their own currency. Let’s now map this same sequence of events over to what is occurring presently.
Right now, 2 of the 4 largest economies on earth have gone negative and both are actively committed to much more easing. The Fed essentially has 4 possible routes it can take from here.
1. It can raise rates one or more times.
2. It cannot raise rates and just stand pat.
3. It can begin to ease again.
4. It can join its global brethren and go negative.
Yes, going negative is a form of easing but for the sake of this conversation let’s view them as two separate actions.
The Fed raises rates the USD remains elevated or goes higher.
The Fed stays pat and doesn’t raise rates again and the rest of the world stays on its current course, the USD remains elevated or goes higher.
The Fed actually begins to ease again and more and more central banks ease or go negative, the USD remains elevated or goes higher.
The Fed comes to the conclusion if you can’t beat them, you join them. They go negative, and we find out if the US being negative weighs more heavily on the USD than other economies being negative gives the USD a boost. My two cents are that the USD remains elevated or goes higher.
It's rare to find trades that will work under a number of different central banking scenarios. When you do find them, it's best to enjoy them.
Bottom line: Everything I see right now points to a strong USD for the foreseeable future.
There are any number of ways you can get LONG the USD. The recent weakness and the market’s general uncertainty as to what the recent weakness means is a great opportunity to evaluate a potential trade in the Greenback.