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AAM Viewpoints - The Great Battle Ahead: Negative Interest Rates and Historic Debt Issuance


Prepare for the Unstoppable Force and the Immovable Object to battle it out over the next few years.  While the equity markets continue to befuddle fundamentalists as to their strength considering the historically poor economic and earning metrics, the credit markets are providing some interesting components to the potential recovery’s shape.  There are many areas that deserve a little more scrutiny and historical context; however, we will focus primarily on the negative interest rate debate and supply appetite. 

The first is the trajectory of the negative interest rates projection and the disparity between the Federal Reserve and the markets.  From an aggregate standpoint, the amount of negative interest rate yielding debt has declined dramatically from the peak.  In August 2019, we hit the all-time peak of just over $17 trillion in negative yielding debt.  This collapsed in the wake of the response to the COVID 19 economic shut down hit a recent low of $7.6 trillion, primarily based on the credit concerns.  It currently stands at $11.7 trillion as the risk off crowd plowed back into some of the safe assets and some prices recovered.  The bulk of this index is from Japan and European sovereign issuers with some being in the corporate and agency debt issues.  

Aside from the recent anemic growth rates, the Central Banks of Japan, European Central Bank, and the Central Bank of Switzerland are all at zero percent policy rates or negative.  Recently, the Fed Fund futures is being priced in as negative from the market perspective.  Though the Federal Reserve is adamant about not wanting or thinking about it publicly, the markets have become more voracious with their expectation.  Currently, the market is pricing in a negative rate by the September 2020 meeting. 

However, this has quite a bit to do with Banks and their hedging of their portfolio with the market, which led to a further positive feedback loop that caused the probability to sneak into the negative territory.  Considering the heightened negative territory we are in along with the labor market, corporate earnings, and economic contraction, there has been very little depth to this market as well as every credit market.  In the Fed Fund futures contracts that trade on the Chicago Board of Trade, volume since February is running thirteen times greater than the previous two years.  Considering the low level of the Fed funds, any increase in this magnitude makes the measure to negative an almost forgone assumption since the absorption of so many one-way trades skews the results.  Therefore, just like the shape of the Treasury curve and the synthetic adjustment from the Federal Reserve’s historic purchases, one must also take the conclusion of higher probability of negative rates with a more scrutinous eye of an Olympic interpretive dance while ice skating judge.  So, while we must now consider this a possibility, what is the projected duration of said event.

The amount of debt issuance and increasing budget deficit that is being funded works contrary to the potential negative rates lasting for any length of time.  Consider the raw issuance of debt in the last few months in many credit markets…hint it also points to a different conclusion that the economists are coming to about the functioning of the credit markets and why the Federal Reserve deserves a high five rather than a slap.  We will focus on the US debt market as it is nearly twice as large as the second largest region of debt, the European Union.  The US comprised 39.4% of the global debt market at the end of 2019 while the European Union comprised 20.5% (SIFMA). 

  • With the budget deficit hitting an all time high of $738 billion, issuance for longer dated maturities has started to ramp up.Some estimates of a $4 trillion deficit will be funded with greater issuance, and not all being in the short Treasury Bill which are barely positive in yields.
  • Estimates for the second quarter of 2020 total issuance is estimated to be around $3 trillion, which is nearly a five-fold increase of the heaviest quarterly issuance that occurred in 2008.
  • They have now extended some of the maturities with the 10-year yielding 0.64% and the 30-year standing at a 1.32%.A recent reintroduction of the 20-year Treasury note received decent interest and believe this tenor will have a large weight of the new issuance.
  • As a byproduct, the average size of the investment grade corporate bond has inflated dramatically despite the fear in the markets.Through April, we have issued almost 70% of what was issued in each of the last two years.However, the size of the issuance has almost doubled to average just 1.2 billion in total float for each issue.
  • According to Citigroup, if the issuance should continue through the end of the year in the Investment Grade Corporate universe, the gross supply could be over $2 trillion.Consider the entire size of the corporate investment grade universe as measured by the Bloomberg Barclays Investment grade index (fixed rate) stands at $6.19 trillion currently.

If anyone remembers the supply demand component of their economic classes in college, at some point when normalcy (relative term) returns, market rates become susceptible to increased pressure.  Some of the credits will compress toward where the Treasury markets are, while others who are trading within historical norms may see increased pricing pressure.  We see this as an opportunity for those with more appetite for risk, that certain debt trading at historical wide spreads may offer at least the best buffer from rates increasing. 

As we wait to see who the victor is, the sequencing appears to be the most important.  While negative rates may be an issue in the immediacy, longer term the increased issuance and duration of the debt will be the ultimate victor.  A clogged drain ultimately opens.  The fact that this amount of debt that is finding receptive interest with increased size and swollen uncertainty, should be a positive sign about the potential for a faster recovery in the markets than what was seen during the Credit Seizures in the 2008. 

 

CRN: 2020-0511-8293 R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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