Jun 1, 2015

Emphasis on the Negative: Market Bubble, or the New Normal?

In a recent story reported by the Telegraph, Jeremy Warner asserts that the global negative rate environment might be putting the world on course for the biggest mass default in history. In this video blog, resident trading strategist and FX Expert Udi Sela, VP, Client Solutions Group, at Numerix asserts that while the low rate environment may not lead to a catastrophic default, inflation is certainly on the horizon. He elaborates on the impact negative rates are having across the European government bond market, and explains from his perspective what the global financial markets might come to expect in the coming months. Lastly, Udi addresses where investors are going in the quest for yield, and when we might see market normalization.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video transcript:

Jim Jockle (Host): Hi welcome to Numerix Video Blog, your expert source for derivatives trends and topics. I’m your host Jim Jockle. As we continue to follow the issues and impact of the global negative rate environment, an interesting article recently appearing in The Telegraph and has brought to light some interesting questions, and some fairly startling facts. Here to discuss this is Udi Sela, resident trading strategist and FX Expert for Numerix. Welcome Udi, how are you?

Udi Sela (Guest): Very well, thank you, Jim.

Jockle: Thank you for joining us. In this story, Jeremy Warner of The Telegraph states that negative interest rates have put the world on course for biggest mass default in history. And while this is a huge assertion, I want to just start with you Udi, and do you agree or disagree with the reporting from Jeremy Warner here.

Sela: Actually, in terms of the biggest default, I personally don’t see that. What may happen is inflation. Because basically what is happening is that the central banks, I mean the large ones, if it is the US, the Federal Reserve, or the Japanese central Bank (BOJ) or Chinese or the European Central Bank, are flooding the market with cash.

So eventually, in order to try and sustain demand and of course enable lower funding, central banks have embarked on various quantitative easing programs. So eventually I think this money will hit and will create inflation. And if you like, Jim, what we’ve been seeing in the last 2 weeks is actually a reversal, in the respect that the yields are coming back from the extremely low levels. If we saw the Bund (the German 10 year government bond) yield zero, it is now trading at something like 75 basis points, still very low of course. And even the Swiss 10 year note is trading above zero. The one thing you will see is people being afraid of the liquidity trap being unable to liquidate long bonds positions and therefore people are now exiting the trade ahead of being “trapped”.

Jockle: So that brings up a question, right. We’ve seen the sharp decline in the Bund, and obviously what’s going on in Switzerland, are we more poised for continuous shocks like this, as liquidity concerns continue to plague the market?

Sela: I think that’s a great question. In my opinion, yes, I think that the volatility will rise even further and again the thing is given the latest regulation, what is happening is that bond market makers do not want to hold large bond positions. So it’s very difficult to get deal prices, in this case bids, or enabling people to sell bonds for large amounts. So this is creating a lot of nervousness in the market, which of course means higher volatility, yes.

Jockle: So, that brings the question, with the negative rate environment, where are investors going for yield?

Sela: So I personally think, well, we’re seeing a couple of things. First of all, we are starting to see a recovery in commodity prices, for instance copper or of course oil; in crude oil we see that in WTI, we see that in brent prices. I think that smart money will go into inflation linked bonds.

In addition we see an interest in credit structures and interestingly, with US economic recovery, and unemployment is coming lower in the US, still it is not followed by salary increases. As a result the inflationary pressures are not that high yet. People are moving away from bonds, from US bonds and as a result, the dollar is weakened a bit from the low levels; let’s say 1.04 against the Euro, trading now at 1.12.  

Jockle: Where is the end in sight here? Is it a pull back on quantitative easing, at what point do we potentially see some sort of normalization?

Sela: People now are talking 2018, even 2019, when previously speaking with 2016. And to some extent people even are talking about a new order of the low rates. So the new normal could be instead rates of 2%, instead of 4%, which seems to make sense to me because if you look at the overall growth of the economy, we move down from levels of like 4-5%, and the new normal seems to be like around 2-3%, depends on how emerging the economy is, I mean in which country.

So, perhaps the new normal, we should forget about the past and the new normal is rates which are much lower. And if you even look at works of economists that have won the noble prize for, so if the problem of the 70’s was inflation and then stagflation, it seems now that the problem is really this environment with weaker demands and weaker growth.

Jockle: So for final thoughts, what are you watching? Any particular indicators? Is it oil, is it looking at a geo-political landscape with the current UK elections? What’s keeping you up in the night?

Sela: I look mostly at the 10 year yields and I look at commodities, and I try to look at credit spreads to see how distressed the market is. But if I always want to see where the market is going, the first thing I would do is look at the 10 year US and 10 year Germany. Russia is starting to recover in terms of the volatility is much lower, the Ruble, and the 10 year yields went down to 11 of 10 from like 15, they cut the rates. So these are things that I tend to look at.

Jockle: Well Udi, thank you so much for shedding light on this topic and we look forward to discussing this with you again, especially as we come up into some of the summer markers that we should keep an eye on. On the Numerix Video Blog, it’s our goal to examine the topics that you want to talk about, so please keep the conversation going on LinkedIn or on Twitter @nxanalytics. Thank you so much for joining and thank you so much Udi for your insight.

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