Jim Bianco, President of Bianco Research, cautions against evermore unconventional monetary policy interventions. He fears that the global slowdown is going to get worse and he spots opportunities in long-term bonds and gold.
The global economy is on the brink: Europe is headed for recession, Japan as well and China’s growth rate is the slowest in almost thirty years. Only the economy in the United States seems to hold up. But for how long?
«We live in a global world and if Japan and Europe are struggling and the world has a problem it’s going to come to the US eventually», says Jim Bianco.
According to the internationally renowned macro strategist, the biggest threat to the US economy is the inverted yield curve. «This is the market’s way of saying the Federal Funds Rate is too high and must come down», Mr. Bianco is convinced.
Against this backdrop, the founder and President of Chicago based Bianco Research argues that the Federal Reserve should cut its target rate by 50 basis points at the next FOMC meeting. He also cautious against introducing negative interest rates in the United States during the next recession because in his view that would cripple the global financial system.
In this at-length interview with The Market, the profound financial market observer explains where he spots opportunities for investors in today’s challenging economic environment.
Mr. Bianco, the summer is basically over and we are heading into the final stretch of the year. What’s ahead for the financial markets in the coming months?
There are two issues at play: First, the trade and currency wars where the situation reminds me somewhat of «This Is Spinal Tap». It’s a cult satire movie from the eighties about a rock band and they coined the phrase «up to eleven» because that’s how high their amplifier went. So the expression «turning it up to eleven» refers to the act of taking something to an extreme. I’m saying this because I think Trump is “going to eleven” on trade: He’s going to turn it up so high that there is going to have to be a deal. That’s the way he wants to do this. He will just make it intolerable so everybody has to sit down and cut a deal.
What’s the other issue?
The inverted yield curve. The three-month/ten-year curve has been inverted since May and this is the market’s way of saying the Federal Funds Rate is too high and must come down. It is interesting how hard everyone is standing on their head to dismiss the yield curve and tell me why it’s different this time. This is not surprising, as it tends to happen every time the curve inverts until the recession hits. It might be different this time, but I still think that the yield curve is telling us that the Federal Reserve has to cut rates and it has to cut them aggressively.
Why is the inverted yield curve such a problem?
An inverted curve damages the economy. Accumulate enough damage and the economy sinks into recession. So, the curve does not predict a recession, it causes it. What is not known is how much damage the economy can withstand. Currently, the three-month/ten-year curve is at -49 basis points. It hit -52 Sunday night and it’s getting close to the 2007 extreme of -60, which is the most inverted reading of the last two decades.
You were interviewed by the White House in May for one of the open positions on the Board of Fed Governors. What should the Fed do at the next FOMC meeting on September 18?
The late economist Rudi Dornbusch coined the phrase that the Fed murders the economy by holding policy too tight for too long. Well, take careful note because that seems to be what the Fed might be doing yet again. The market is screaming to cut rates aggressively and the Fed is fighting it. So the question is how much it takes to un-invert the yield curve. At -49 basis points, that means a 25 basis point rate cut at the FOMC meeting next month is not going to un-invert the curve. You are going to need to cut 50 basis points or something along those lines.
At 2 to 2.25%, the Federal Funds Target Rate is already quite low. Shouldn't the Fed be more careful than usual with its ammunition?
The “running out of bullets” argument is dangerous: either Fed cuts work or they do not. If cutting rates do not stimulate now, they will definitely not work if you save them until things get worse. Holding them back does nothing. So go hard now, cut hard now. If it works, great. If it does not work, saving the bullets for a rainy day would not have made a difference anyhow.
Then again, at the Jackson Hole conference last week Fed Chair Powell reinforced his view that the US economy is in good shape. Where do you see trouble brewing?
You don’t see it in the economic data but you will find it when you look at interest rates in the developed world. Today, the highest interest rates in the developed world are the 30-year Italy government bond and the Fed Funds Rate at around 2.1%. The Fed Fund Rates has never been that big of an outlier before. So the market is saying: We live in a global world, relative interest rates matter and the Fed Funds Rate is out of line with everything else.
Why do relative interest rates matter?
There was a paper delivered on Saturday in Jackson Hole about the effects that globalization has on monetary policy. It pretty much said the same thing: The reality is that we live in a global world. So you have Draghi at the ECB being at -40 basis points and Kuroda at the Bank of Japan being at -10 basis points. They’re dragging their rates to negative which is forcing the rates in the US down as well. The global economy is going to be perceived as weak and on top of that, you have the whole trade situation. That’s why the bond market is going to continue to send messages that there are problems and I think the stock market is going to continue to churn sideways to lower until there is some kind of resolution.
How serious is this threat to the global recession?
All those low global rates are signaling a big problem in the world. I think Europe is in a recession. Italy has negative GDP and Germany had three of the last four quarters either zero or negative GDP. Industrial production numbers out of Germany are terrible, and Japan is very close to being in recession, too. At the same time, economic data in China is at thirty years lows. That’s what's holding interest rates in Europe down all the way to negative and is forcing the rates in the US down as well. We live in a global world and if Japan and Europe are struggling and the world has a problem it’s going to come to the US eventually, too. That’s why the market is telling us the Fed has to cut rates.
So why isn’t there a greater sense of urgency at the Fed? At the last FOMC meeting, Powell characterized the first rate since 2008 as a «mid-cycle adjustment,» not «the beginning of a lengthy cutting cycle.»
The problem is that nobody knows what mid-cycle adjustment means. As we speak, the market is pricing in four more rate cuts in the next year. That means a total of five rate cuts, including the July 31 rate cut. So the market is pricing in something that the consensus of economists is nowhere near. If you look at a recent Bloomberg survey, only seven of sixty economists had the Fed cutting rates five times. The other 53 had the Fed cutting less than five times. What’s unusual about this cycle is that the market is an outlier right now. Again: it comes back to the fact, that consensus economists are looking at US domestic economic data and they don’t see trouble whereas the market is looking at global data and it sees trouble.
But there’s also the well-known line that the market predicted nine of the last five recessions.
Economists can only wish they were this good! They have predicted none of the recessions in the last 50 years. What economists usually do is that they give you a 30% chance of recession. That means a 70% chance that there isn’t one. And then, when the recession hits, they stay at 30% because they think it’s going to end soon. The old joke about stock salesmen used to be that they never see a bear market and when there actually is one, they’re screaming it’s over. That’s kind of what economists do in terms of predicting a recession: they never ever predict one.
So what’s going to happen next?
This story has played out many times in the past during similar economic turning points: The market is ahead of the Fed and economists and is calling for rate cuts. The next month or two will prove critically important in determining which opinion prevails.
Should the Fed follow other Central Banks and introduce negative interest rates in the United States if a recession can’t be averted?
I believe that negative interest rates are extremely toxic for the financial system. Economists and the Fed make the mistake that they look at negative rates from the lens of borrowers, and when you are a borrower of money lower is better, zero is better, negative is better. That linear relationship holds up all the way through and I agree with that.
What’s the problem with negative rates then?
The problem is that they’re not looking at it from the perspective of the financial system. Where are borrowers going to get the money from? They are going to get it from the financial system and that’s where the lender is. The financial system has been built on the idea of positive interest rates. So negative interest rates in the US would become a big problem for the financial system. The banking system cannot function properly with negative interest rates and neither can the pension system. Also, all the valuation measures that we’ve invented - whether it’s the Fed model, the capital asset pricing model or even the Black-Scholes options model - don’t work with negative interest rates. That’s because when these models were developed no one had thought of the possibility that we would see zero or even negative interest rates.
Are negative interest rates already damaging the financial system?
I see it happening in Europe. There are cracks appearing in the financial system. The German banks are screaming and yelling about it to the ECB. The only thing that might be holding them together is that they have the option of positive interest rates in the US, in the UK and some other countries. Today, 94% of all interest earned income in the developed world comes from U.S. debt. That’s also the reason why UBS and Credit Suisse can survive despite what’s going on with deeply negative interest rates in Switzerland. They are global banks with a big footprint in the US where they get positive rates. Once they lose that option, they’re in big trouble as well, like all the other banks. So if the US sinks into economic weakness and decides to go negative it will really cripple the banking system.
What’s your take on the Dollar against this backdrop?
I’m only a mild Dollar bull at this point. Last Friday, there was some speculation about a direct intervention in the Dollar exchange rate by the Treasury for the first time in over twenty years. I think that would be a giant mistake. I suspect that as long as the rates in the US are going to stay up and the Fed is going to be slow in cutting them there will be underlying support for the Dollar. I don’t see it really weakening much. So the path of least resistance will probably continue to be sideways to up in the Dollar.
What should investors do with their money in this market environment?
Investors should be recognizing that with the economic slowdown there will be a further rally in bonds and that would probably mean deeper negative yields in Europe. Keep in mind, going to negative interest rates in Europe has led to some eye-popping total returns: The total return on 15+ year government bonds in Switzerland is 30% this year versus 16% on the S&P 500. In the US, the thirty-year treasury bond is reporting a 20% total return.
These government bonds trade almost like the FAANG stocks. Isn’t that a reason for caution?
I think rates will continue to go lower as a perception of economic weakness and more Fed cuts to come. So you are going to have good total returns in safe assets and risk assets are going to struggle. But once we get a sense that there is a bottom in the global economy, or some kind of resolution in trade, or the Fed decides to get aggressive and starts talking about a 50 basis point rate cut, then you can maybe review the option of moving back to more risk assets. But right now, risk assets are going to be problematic and safe assets like long term government bonds will provide you a great capital return.
Do you think the yield on ten-year US treasuries will take out the all-time low of July 2016?
Yes. Right now, we’re at about ten basis points away. So it’s not a hard call at this point to say that the ten-year yield will take out the 2016 low. The thirty-year yield already has.
Where else do you spot opportunities?
Gold has a nearly perfect correlation to the amount of negative debt in the world. So if rates continue to move lower and negative debt continues to grow, that will be a positive factor for gold and gold will continue to catch a bid. For 5000 years, the problem with gold was that it yields nothing. Today, gold is the high yielding alternative in a world with negative interest rates. As long as we don’t see a bottom in the global economy, no immediate resolution to trade, and the Fed doesn't get aggressive, I could see the gold price hitting $1700 or $1800 in the fourth quarter and maybe even making a run at the all-time high of $1900 before the end of the year.