In the story of Faust, the protagonist makes a pact with the devil, exchanging his soul for unlimited knowledge and worldly pleasures. The deal only lasts for 24 years but Faust agrees to the terms; trading his soul for immediate gratification. During the ensuing 24 years Faust squanders his new abilities and indulges in frivolous endeavors. When the term is up he is carried off by the devil.
The markets’ current relationship with stimulus could be called Faustian: The allure of free money now and low rates is intoxicating, but much like Faust’s deal there are inevitable consequences, even if they are years away. The markets continue to rally on every new stimulus announcement; albeit less with each subsequent round.
While many market participants have questioned the impact of the stimulus, it is becoming harder to argue that there is no relationship between asset prices and stimulus levels.
This week saw continued and additional stimulus from the European Central Bank, the Bank of England (BOE), and the Japanese Ministry of Finance (MOF). Mario Draghi and the ECB were expected to announce ABS purchases, but few if any had expected the ECB to cut rates as well. The ECB’s across the board reduction of 10 basis points dropped the rate on the main refinancing operation to 0.05%, on the marginal lending facility to 0.30%, and on the depository facility to negative 0.20%. The aggressive move was driven by the ongoing deflationary pressures and the weakening economic picture that is beginning to affect even Germany. The stimulative measures from the BOE and MOF were largely a continuation of existing measures.
On the U.S. front there has been continued debate around the timeline tied to the Federal Open Market Committee’s first-rate hike. However, the data this week continued to paint a mixed picture culminating with the disappointing nonfarm payroll figure on Friday. The Bureau of Labor Statistics reported that in August only 142,000 new jobs were added, down from July’s revised 212,000 with a modest drop in the unemployment rate from 6.2% to 6.1%. This payroll figure was well below estimates and was the lowest monthly jobs print for 2014.
The data point that was likely the most important for the FOMC was the hourly earnings figure, which came in at 2.1% on a year-on-year basis. The troubling element of the report -- and one that I have highlighted in the past -- is the continued drop in the labor force participation rate, which fell to 62.8%. In fact, in August the number of people not in the labor force increased at a rate that was almost two times that of people who found employment.
Global sovereign rates were mixed this week as the tier one countries largely saw rates move higher while those in the periphery had rates fall. German Bunds sold off, hitting .97% before rallying to .92% on Friday to finish the week 4 basis points higher in yield. The best performers of the week were Spanish, Portuguese, and Italian debt; Spain was the best of the best with rates falling by 21 basis points. The spread between Bunds and Treasuries finished the week at 150 basis points.
U.S. rates rose by as much as 13 basis points as longer-dated securities were the worst performers of the week. We saw 30-year Treasuries back up through the 3.20% level, retracing last week’s entire rally. Investors used the selloff his week as an opportunity to deploy the cash balances that had been building over the last 4 to 5 weeks. Credit spreads on the week were flat in the U.S., and 3 to 5 basis points tighter in both Europe and Asia.
The curve finished on Friday with most relationships steeper, tied to the selloff. The spread between 2-year and 10-year Treasuries increased by 7 basis points, finishing the week at 192 basis points. The belly of the curve saw the most steeping as shorter-dated assets outperformed by 7-plus basis points.
Given the new round of stimulus in Europe and with more expected, I continue to believe that we could see additional flattening. However, we are likely to see some steepening in the short term as the market calibrates to the recent lows.
It’s becoming clearer that the market has in fact made a deal with the devil in the form of stimulus. As the global economy continues to struggle, the world’s central bankers seem intent on solving the various issues with cheap money. I believe that we are dealing with more structural issues rather than cyclical ones and that the current mechanisms of global stimulus are missing the target.
Much like Faust’s deal, the market’s current arrangement with the various monetary authorities will end; however, unlike Faust we just don’t know when.
Sean Fallon, CFA, is Senior Vice President of Stephens Inc. He joined Stephens in July 2012 to head the Municipal Taxable efforts and to trade CMBS, Agency CMBS, and ABS. He has 19 years of experience managing and trading fixed income assets.