Are we approaching the end of free money?

Dear PGM Capital Blog readers,

On Thursday, October 6, ECB president Mario Draghi said to build a Taper consensus as QE Decision nears and had pointed out that it is considering ways to scale down its support to the European bond markets as follows:

  • Slowing QE by 10 billion euros a month when the current QE program ends in March 2017.
  • Make the start of the tapering program dependable on economic outlook of the Euro zone.

The European Central Bank, quantitative easing program, has started on 9 March 2015 is due to run until March 2017.

ECB chairman Mr. Mario Draghi, has repeatedly said that the QE program will run until the end of March 2017 or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim.

He also said:

Ultimately, the decision will be driven by the outlook for inflation.

Below chart shows the ECB asset purchasing program, since it start in March 2015, up to September 2016.

The report caught the market somewhat off guard, and in response, Eurozone government yields have risen across curves and countries.

Based on the news, the benchmark for the Euro-zone bond, the German 10-year note, seems to have left the days of negative yields behind it, and is currently hovering around 0.05% testing levels barely seen since Brexit earlier this year.

Below chart shows a map of bond yield shows that beside, Norway, across the board Europe and the EU based on the ECB asset purchasing program, they currently living in a world of negative interest rates.

Map of government bond yields

Later in 2017, the ECB could think about tapering, and try to wind down the program in March 2018, but these are hypothetical exit strategies, not something the ECB will likely implement for a while.

What might be easily forgotten, perhaps blurred by the super-easing of the Draghi era, is that this is in fact not the first time the ECB has been contemplating tightening.

What is different this time around, is that in the US, the Federal Reserve has already moved to hike interest rates once, and is widely expected to hike once more at its coming December meeting.

If this happen, it will be for the first time since the global financial crisis, of 2008, that two of the world’s most significant central banks — the US Federal Reserve and the European Central Bank — could be tightening their monetary policies at the same time, in what might be the beginning of the end of a remarkable long-stretched run of virtually free money and financing.

The big question now is whether the policies have in fact fixed the underlying problems, or merely masked them by propping up their economies and not allowing malinvestments and markets to correct with a flood of easy money and exaggerated financial valuations.

Now that the tide is about to withdraw, how will everything look?

The turmoil and volatility we have seen in the financial markets lately, can be interpreted as a sign that they are concerned and are fearing the consequences of FED rate hikes.

Rising Interest Rates Are Bad News For Bondholders
The market price of an individual bond will fluctuate in the opposite direction of interest rates, which means that, when interest rates — which recently hovered at their lowest levels in 40 years — rises, the prices of bonds you own now will generally drop as yields and interest rates go up.

For example, if you purchase a U$10,000 bond at par value (or face value) with a coupon (yield) of 4%, your annual income is $400. If interest rates rise and a newly issued bond with an identical rating pays 4.5%, the market value of your bond declines to US$8,889.

The fact that bond prices and yields move in opposite directions is often confusing to new investors.

Bond prices and yields are like a seesaw: when bond yields go up, prices go down, and when bond yields go down, prices go up, below illustrative chart shows this relationship.

In other words, a move in the 10-year Treasury yield from 2.2% to 2.6% indicates negative market conditions, while a move from 2.6% to 2.2% indicates positive market performance.

The above means that, if higher interest rates are on the horizon, it may be time to sell some of your bond holdings (if you have any) and rotate the money into other investments – like dividend-paying or high-growth stocks.

However, the short-term pain might be favorable for bond investors, which may have to endure short-term price losses in order to enjoy higher coupons in the long run, especially if the alternative is to only kick the can further down the road by allowing the bubble in government debt to inflate further, which could very well end with a much more painful forced correction at a later point in time.

Last but not least, before following any investing advice, always consider your investment horizon, risk tolerance and financial situation and be aware that markets can remain longer irrational than that you can remain solvent.

Until next week.

Yours sincerely,

Suriname Times foto

Eric Panneflek

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