The Future of The ECB (w/ Raoul Pal & James Aitken)
RAOUL PAL: The ECB, so we've already seen obviously Australia and New Zealand now QE. ECB, that's the big unknown because there seems to be this is where we start to move into the world of juxtaposition between politics, fiscal, monetary. Talk me through what you're thinking about that and then I want to come back to bond yields again, as we said. JAMES AITKEN: Sure, sure. Raoul, the ECB, if we thought July 2012 was whatever it takes, this is whatever it takes hued, and to think that Madame Lagarde with one loose sentence undid nine years of Draghi when she said, unforgivably, my job is to not control spreads. That was quite courageous over, she realized within five minutes how foolish that was. Ever since, the ECB has been in repair mode. If we thought the summer of 2012 was whatever it takes, one would imagine, Raoul, that to avoid fragmentation risk, which is the great terror of European policymakers as we know, to avoid fragmentation risk, the ECB is going to have to be the buyer of first resort of all its sovereign bonds and Italy, in particular. There's a bit of a discussion around that I'm sure you've seen, and your subscribers would have seen, a lot of headlines and again, last night, all the duction the Germans did against euro bonds and joint and several liability and all this stuff, okay, that's unfortunate. You would have thought there's be a little bit of more political solidarity right now across and within Economic and Monetary Union. It's not happening, but you know what, I don't think it matters because the ECB has an open-ended balance sheet here. I think they're going to need a lot of it, so they are buying and buying and buying. Their priority is to prevent a fragmentation premium in Italy in particular, for obvious reasons. I suspect they're going to be on the hook as the sovereign buyer of first resort for a long time to come because there is no alternative. I would recommend we all keep a very keen eye on BTPs obviously. I am somewhat concerned to say the least, that despite extraordinary and persistent ECB buying, Raoul, these BTP spreads keep leaking. That's not a great sign, not a great sign at all. The ECB, I assume, is a constant presence in all those sovereign curves for a long time to come. I shouldn't overlook the fact that they've given tremendous regulatory relief to Eurozone banks. To be clear, that does not mean a catalyst for any sustainable rewriting of European banks, but it does mean that they are free from balance sheet restrictions and via the ECB is financing facilities, they are getting enormously cheap funding at a cost of minus 75 to put into eligible collateral of all sorts, which creates a positive carry trade for European banks. Again, that doesn't mean you own them, but the idea would be that that positive carry trade enables the best European banks to muddle through. The final point, as much this also applies in the United States, the regulatory relief that we've seen in the United States, such as at long last, a one-year raincheck or relief on the leverage ratio, it's not as some people have said to allow primary dealers in the United States to go hog wild on Treasury repo or anything like that, it's to ensure that there's enough balance sheet capacity to lend to the real economy, which is obviously the critical thing here. It's about the real economy and ensuring that there's ample credit flow into households and small businesses and that's critical in the US as much as it is in Europe. RAOUL PAL: I just want to get back to the Treasury market right now, just because it's been interesting to me that you imagined that the Fed wants to have yields as low as possible, it's a bit sticky still that the market hasn't woken up to the game or there's something else going on. Why is that? Why have bonds been stagnant for the time being? Why is the whole curve not trading at zero? JAMES AITKEN: There's a lot of bonds to be sold, Raoul. That's the short answer. RAOUL PAL: Who's selling them, the sovereigns? JAMES AITKEN: Well, there's some of that and we can see it in the Fed's custody data. There's definitely been some liquidation of Treasury securities by-- it's called the North Asian reserve managers. That's no surprise that the holdings would go down. When I say there's a lot of bonds to be sold, I should have been more precise. There's a lot of bonds to be issued, a colossal amount of bonds to be issued more than anyone can perhaps tally up yet, because we've got the CARES act that went through Congress the other day, and that's going to require a lot of issuance. Now, they're talking about oh, well, the cost of borrowing's free, let's tag on another 2 trillion of infrastructure or whatever. There's no barrier to issuance. I think quite a few people, Raoul, are starting to or trying to tally up the amounts of treasuries that will need to be issued or even bunds or BTPs or gilts or Australian government bonds to finance this bridge that all these governments are trying to provide through COVID-19. I wonder if that is in the back of investors' minds in terms of, you know what, now we're going through an economic emergency, perhaps an economic catastrophe. All in all, if the world's going into a sudden stop, Treasury yields ought to be perhaps a lot lower given the disinflationary undertow. However, when I imagine the future supply, perhaps that ensures that yields don't fall too much yet. Now, of course, the flip side of that is that for macro financial reasons, it would be a disaster as we work our way through or perhaps we've arrived at this very tenuous equilibrium, if we dare call it that in financial markets where realized and implied volatility is coming down a bit in equities, which is no bad thing. Somewhat similar in the better parts of the credit markets, giving everyone a time to take a deep breath and reflect on what their right exposures ought to be. The worst thing that could happen in this mini-timeout here is that long term nominal and real bond yields start to go up a lot. RAOUL PAL: Yeah, I'm worried about the real bond yields. JAMES AITKEN: Exactly right. The good news for the Fed and by golly, that's taken a lot of buying is that they have arrested what was a very nasty selloff in TIPS, or should I say yields backing up a lot. These days, Raoul, even positive 10-year TIPS yields in the United States would probably be orthogonal to any hopes of a rapid rebound out of this mess. RAOUL PAL: How can you possibly-- look, I don't know how big the deflation number's going to be in CPI and core CPI which lags it. I have no idea how big it is. Is it 5%, 10%? I don't know, but it's going to be monstrous, even if it's 3%. The problem is with bond yields that close to zero, you only get a tightening of financial conditions. JAMES AITKEN: Temporarily, you would think so. At the highest level, that's not a bad way of thinking about it. Then I also have to calibrate this extraordinary support that the Fed and other central banks are providing and then I need to calibrate it another step further, because I think we're all aware that this is going to be a very, very difficult couple of quarters, if we're lucky. This current quarter, every piece of data is going to look a little bit like the Great Depression, and I very much doubt anybody incorporated that in a vamoose, except Renaissance Technologies. Anyway, that's another conversation. We all know it's going to be hideous. If we're lucky, we get one quarter of data that feels like the Great Depression. Then if we dare to imagine the third quarter, we get some serious crappy, tentative recovery, although it won't actually be a recovery for a lot of people, it'll feel like a really bad recession that comes after the Great Depression. Now, the reason I flagged that is because there's no doubt we have this extraordinary disinflationary undertone to the current quarter, but as realized and implied volatility comes down, markets will start or data start looking through and saying to themselves, okay, near term disinflationary risks are given versus, dare I say, medium term inflationary risks as we attempt to restart the world in a heterogeneous fashion with bottlenecks everywhere. What's the unemployment rate? We'll probably be ending up quite high for the foreseeable future. We may have an extraordinary situation in the third quarter, I don't know yet. This is just a theory or thesis. We may have an external situation in the third quarter where the unemployment rate remains high, and firms are having to bid back for labor to get people into the labor force again to help them expand capacity and deal with the global economy spluttering back into life. I hear what you're saying. I don't doubt that we're going to get some extraordinarily bizarre CPI prints through the middle of this. I'm trying to imagine the second half of this year when the world starts to come back online. Temporary disinflation, a given. Structural reflation or more inflationary, I think that's what we need to keep our eye on. Again, it comes back to the Fed, what's their trade off? Well, they told us going into this ironically, they were going to consider the yield curve control and revising their inflation target and everything else. By the way, what they're doing now looks awfully like yield curve control without actually targeting a particular rate, because they're in the market every day. They are going to be so cautious dialing back any of this liquidity provision as we move through the rest of '20 and into 2021. They are only might be that the inflation that they've long desired might arrive in a meaningful way later this year, but they will remain on hold. That's, indeed, the answer to your question about between inflation and real yields and everything else. RAOUL PAL: Going back a bit to the comments about the issuance of bonds. We know there's probably more to come from fiscal stimulus around the world, probably quite a lot. Particularly when you go into let's say, Q3, things have dragged on a bit, the economy's not there. We expect to start to see stuff and certainly around the election, we're going to start to hear a lot of noise. Now, I presume the central bank will be the buyer of every bond issued, and we start moving to the MMT style environment where basically, the government balance sheet as they're trying to repair everybody's balance sheet, the households, the small businesses to everybody else, the central bank has to step behind it. That's globally, the same central bank did everywhere to try and allow governments to run massive deficits to do this. How is your thinking of that evolving? JAMES AITKEN: The implicit in your question is central banks everywhere, which to me means competition for global savings. If we assume that any central bank anywhere is not going to be a backstop buyer of all those bonds to be issued, we assume that one or more private sector actors will find them decent value and consider the case of the United States. Yields are still positive, a bit. They're certainly not zero, but there are no incentives for example, for the fully hedged Japanese investor to buy any treasuries account prices, level and structured credit, they're just odd. Unless, unless you get the dollar down a lot, so in yen terms, to use Japan as a proxy for global power savings, the only way you entice private capital back into the Treasury curve in a meaningful way that would enable the Fed for example, to step back, I think is via a very substantial dollar depreciation, which we'll talk about later on. RAOUL PAL: Just the other thing is why not the US pension system, which is massively underweight treasuries and has a need for it because of the aging population? JAMES AITKEN: Well, that's what I thought. One of the most extraordinary things of the past month is that you look at holdings of Treasury securities and holdings of STRIPS have actually declined in March. Now, if I read the data correctly, it was $15 billion. Who cares, but obviously, the STRIP treasuries have been very, very popular so US pension funds, in particular are managing their long term liabilities. I'm like, why on earth would US pension funds, assuming they're the biggest holders of these STRIP treasuries, why on earth would they be net sellers? What other exposures do they have that they got called away from, because I think there's much redemption risk? The broad answer to your question is, yes, of course, at a price, the US pension system will be a buyer, but then I need to calibrate that for capacity in terms of the amount of bonds to be sold. Of course, there are banks as well who would be happy to own Treasury securities in their HQA buffers, so of course there are buyers of Treasury securities around, but I still come out to myself and say, I very much doubt that the Fed's going to be backing away much from support in the Treasury market because they cannot afford to have any sustained rise in nominal, and especially real yields. I think they're stuck that there's this broader question about competition for global capital. Australian superannuation funds, are they going to be buying huge amounts of Ozzy government bonds? Well, I guess so. How about Japanese investors? What's the cost of hedging your FX risk into Ozzy and stuff? Then you go around the world and you're saying who's been the keenest buyer of Treasury securities or certainly one of the biggest constituencies of Treasury ownership over the past several years? Unsurprisingly, it's the sovereign wealth guys or more accurately, the reserve guys. If for reasons of downstream liquidity to their own financial systems, they're no longer a net buyer, they're the net seller. You keep coming back to the Fed, I'm afraid they're the only game in town. We have a lot of unfinished business in government bond markets. I would be surprised if central banks have stepped back much, if at all, by the end of this summer. You may have seen yesterday the Reserve Bank of Australia articulated that they were intending to step back a tiny bit from the rate of bond purchases they've been conducting while still targeting three years of yields of 25 basis points. Perhaps it was another misunderstanding by markets, but even the merest hint that the Reserve Bank of Australia was stepping back from their current run rate of bond purchases, sure, a pretty nasty selloff in Australian government bonds and the 10-year in particular. I think, Raoul, that's not a bad metaphor into thinking about how difficult it will be for the Fed to step back and to finish this point, how impossible it is for the ECB to step back.