Larry Berman on QE unwinding and volatility
This week, global fixed-income markets will get hit with a few blows to the head and one wicked upper cut.
U.S. supply totals $193B on Monday and Tuesday with the Fed expected to hike rates 25 bps on Wednesday. Supply in the long end of the curve will be particularly interesting to watch for who the buyers will be. Increasingly, the Street will need to take down more paper as QE unwinds. This takes liquidity out of the market and adds a notable degree of volatility to the bond market. Our first chart this week looks at the volatility index of US 10 year yields (yes, there is a VIX for everything!)
The European Central Bank (ECB) is expected to detail their plan for halting their bond buying program on Thursday, which should see the weaker European countries spreads continue to widen. Who is going to buy Italian debt besides Italian banks that really can’t afford to hold it given their still fragile balance sheet? We heard overnight that the new Italian government has no interest in leaving the common currency. While that may be true in theory, the only way they can spend the money they want to on infrastructure, lowering taxes, adding a universal basic income, is to borrow hundreds of billions more. The only real buyer of Italian debt in recent years has been the ECB. At the end of April, the ECB held 341 billion euros worth of Italian sovereign debt with an average remaining maturity of almost eight years. This figure could rise by roughly 3.5 billion euros a month, based on ECB purchases totaling 30 billion euros per month. This compares to Italy’s gross government debt of 2.26 trillion euros at the end of last year. As a percentage of GDP, this is 132 per cent, the second highest in the euro zone after Greece.
In the U.S. and Canada, we have said for years that we do not have to worry about bond yields rising too much and we really don’t. But an uptick in inflation expectations should pressure 10-year and longer Treasuries higher and that should stress equities at some point soon. Yields are not rising because the economy is strong, yields are rising because of the double whammy of supply: QE unwind and massive government spending. It matters how the curve steepens or flattens and what is the root cause.
There is little reason to be bullish on stocks with big leverage, U.S. corporate balance sheet leverage has not been this bad in decades. Many companies who have been leveraging up to buy back shares will face some margin pressures along with rising wage pressures as the pool of qualified workers diminishes. Late in the business cycle is always a time for caution in portfolios. It will be particularly challenging this time around given pressure on bond yields. The typical balanced portfolio may not given investors the sleep-at-night portfolio they are expecting.
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