You don’t have to look too far to see that the whole world has been flipped on its head.
People are reportedly paying $40 for cheap throwaway (and allegedly useless) masks.
Polite folk are knocking the elderly out of their way in their desire to snatch as much toilet paper as they can get. Even the most sensible among us are buying tins of tuna by the dozen.
I hope they keep their receipts!
Gold — usually the go-to asset when things are looking grim — got smashed along with the rest of markets last week.
And interest rates — long the sole tool of central banks — reacted the opposite as intended, when a rate cut saw the market take a dive last week.
Only the day prior, US markets had enjoyed monster rallies in anticipation of a potential rate cut.
In an age where everything must be a record or ‘unprecedented’, major indices did not disappoint. The Dow had its biggest one-day points rally…ever.
However, the surprise rate cut — two weeks prior to the Fed’s next scheduled meeting (where a similar cut was predicted) — saw the market go into freefall.
There’s little doubt that the emergency cut shows the Fed is starting to panic. However, well before the coronavirus outbreak, interest rate cuts had already lost any impact.
Theories about interest rates flipped upside down
With rates already so low, and negative in some countries, theories about interest rates have also been flipped upside down.
That rates could even go negative was, up until the last few years, not even remotely in anyone’s head.
That someone would pay you interest when you borrow money just seems…well, unreal. As in both meanings of the word.
Surely getting paid to borrow would cause an infinite bubble. Who wouldn’t want a piece of that? Even ‘The Donald’ has been busy tweeting his enthusiasm.
Typically, the focus on interest rates is about the current (or cash) rate. That is, the rate you would expect to pay for any loan, from a mortgage to a personal loan.
But that represents just one part of the picture. Investors expect different rates of return for different periods.
The other part of the interest rate picture is long-term rates. In other words, the back end of the yield curve. That is, rates on long-term debt like 10- and 30-year bonds.
Under normal circumstances, the longer you lend money, the more interest you want to receive. This purely reflects opportunity cost — the longer you go without your money, the more potential profits you are giving up.
Yet, as I wrote here a couple of weeks ago, the yield curve in the US (then at least) was just about flat.
At that time, a 30-year US bond was generating a yield of 1.89%. That represented around just a 0.2% premium to the then US cash rate of 1.5–1.75%.
With the Fed’s latest 0.5% cut, that gap has expanded for the time being.
But markets look to the future. The real question is what the yield curve will do from here.
Coronavirus has spooked central banks
When the economy is humming along, the yield curve is normally positive. That’s because, as I mentioned above, investors are potentially forgoing more profits the longer they lend their money.
When the yield curve inverses, however — as it did at times last year — that will often show that a slowdown has begun, or is on the way.
Because central banks typically undertake a series of rate cuts to boost the economy in a slowdown or recession, investors expect to receive lower rates the further out they invest. That’s why the yield curve turns upside down.
What we are seeing now though, with this latest cut is something very different. Dare I say it, potentially ‘unprecedented’.
If the US yield curve does invert, what happens with rates already so low?
When the yield curve has inverted in the past, interest rates were nowhere near as low. Trading Economics calculates the average rate in the US for the last 50 years (from 1971–2020) at 5.6%.
As I say, right now, they’re 1–1.25%!
That’s getting mighty close to the lowest rate for that 50-year period — 0.5% in 2008 — at the peak of the GFC.
Clearly the coronavirus has spooked central banks. Add that to fears of a slowing economy, and it’s almost impossible to see what could possibly cause rates to rise…other than a return to inflation.
With the new cash rate of 1–1.25%, the back end of the yield curve only needs to invert by slightly more than that to cause something completely out of the ordinary.
That is, a positive rate at the front of the yield curve, and negative rates at the back end.
Think about that. Borrowing money long term and receiving interest, while lending money on the short term and…you guessed it, also receiving interest.
As I mentioned above, who wouldn’t want a piece of that?
Up until recently, this whole concept would have been unconceivable. Something that flies in the face of all conventional theories.
Normally, the machinations of the market would quickly price this anomaly out. But as I say, we are sure living here in crazy times!
The way the markets are, it’s no longer possible to think in absolutes. To rule something completely in or out. And that means keeping on your toes, and taking absolutely nothing for granted.
All the best,
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