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The amount of negative yielding debt stood at USD 14.2 trillion last Friday. A high was put in mid-December 2020 around USD 18.3 trillion. During the extreme shock month of March 2020, this metric fluctuated between USD 14.9 and USD 7.7 trillion. The history of this metric is short-lived and stood near zero before mid-2014. Its ascent kick-started over Q3 2014 as Draghi announced back then that the ECB would take the QE path in order to save the monetary union construct. The ECB lowered its depo rate facility rate from 0.00% end of May 2014 towards -0.40% by March 2016.
The adoption by the ECB of such an aggressive Negative Interest Rate Policy (NIRP) has been possibly the signal of choice over the past decade and the first signal we elaborate on in this edition. NIRP impacted across asset classes. The signal has been reverberating till today. This signal pushed the number of negative yielding debt in high gear towards USD 12 trillion by mid-2016. Between 2015 and today, investors learned to live with, on average, USD 10 trillion of negative yielding debt. I’ve taken this longer introduction in order to stress the difference between signal and noise within financial markets.
When googling ‘Signal versus Noise’ we get the following result: “Signal and noise are two terms used in electrical engineering and communications. Signal is a time or space varying quantity carrying some information, and noise is an unwanted effect on signal which reduces the visibility of that information. Signal to noise (S/N) ratio is a widely used parameter to measure the quality of signals. The higher the S/N ratio the better the signal in quality.” Interesting.
We are living and working in fairly low signal-to-noise times with poor signal qualities and high noise content! Noise is an unwanted effect on signals. Noise can randomly fluctuate the value of signals, and it disturbs the process of revealing the information sent through a signal. We can state that most (but not all!) central bank press conferences catalogue under noise.
Market participants should weigh each central bank meeting in that respect: signal or noise. Information content of a signal is an important parameter, and it is called the ‘entropy’. The higher the entropy the higher an investor’s vigilance, attentiveness should be in a correct interpretation of medium- and long-term impact.
The ECB signal to adopt NIRP was high on entropy. The FED’s signal not to go beyond zero-interest-rate policy as well. Last week’s piece on ‘ECB anxiety, FED confidence and EM suspiciousness’ was of interest as most of current FED and EM central bank decisions fall more or less under the noise label. I attached anxiety to the ECB as potentially a new signal that is in the making. An ECB signal that would take us out of NIRP and into Zero Interest Rate Policy (ZIRP) over the next 3 years. The ECB is aware that the negative effects of NIRP outweigh the benefits for the public at large. Effectively, NIRP is feeding and pushing inequality to a higher, worse level. The ECB starts to provide market participants with arguments that might lead to such a policy reversal.
A second key signal ensued on the back of the tragic pandemic over the past year and a half. Monetary policy conduct moved closer towards ambitions reflected in fiscal policy. These common ambitions range from achieving maximum, inclusive employment conditions to macro-prudential measures that safeguard the health of real estate’s overactive involvement in greening public funding channels, thus preventing the negative externalities of climate change. The signal translates into the containment of these costs by capping nominal rates implicitly or explicitly. The combined power of developed markets (DMs) central bank asset purchase programs limits any undue upside pressure to nominal rates but more importantly depresses the level of real rates as well pushing these into deeply negative territory.
The sheer size and length of these QE episodes has led to a dominant position by central banks. Central banks have become the marginal rate setters both at the short and the long end of yield curves. The markets have all but accepted that condition. Increasing inflation expectations get translated more often into lower real rates than higher nominal readings. Essentially, central banks clear the system by ‘destroying capital’ on the back of the public at large. Central bank policies across DMs impose a tax on savings, letting inflation run above target whilst controlling nominal rates well below nominal economic growth rates. That brings us back to our end statement relating to inequality in the above bullet point.
On regular occasions, as over the past week, one witnesses attempts by sell-side influencers to tilt bond investors into panic mode. The story goes that, as market makers in US Treasuries were questioned on the level of 10-year US Treasure rates end of 2021, they arrived at 1.70%. That number becomes the object of short-term noise. The 10-year forward rate to December 31 sits at 1.44%…
At times, noise can deviate markets a long way from what the signal tells us. The moment an investor is unmoved by the noise and has the skill to remain correctly positioned based on the signal’s information, he holds a winning ticket.
The European Green deal unveiled by the European Commission consists of an ambitious package of measures that center around cutting greenhouse gas emissions (GHG), invest in research and innovation and preserve Europe’s natural environment. The Green Deal includes reaching a European Climate Law that enshrines the 2050 climate-neutrality objective, a European Climate Pact that has to engage citizens and all parts of society in climate action and a 2030 Climate Target Plan in order to reduce GHG emissions by 55% compared to 1990 levels by the end of the decade.
By taking a 1990 basis, the plan lacks ambition but has signal quality. It might even become the signal of choice over this decade. This third signal becomes visible through the term premium that governments and corporates are required to pay in order to fund themselves. As investors climb the ESG learning curve, their list of minimum requirements in order to invest in bond- (for governments and corporates alike) and/or corporate equity instruments, will become more stringent. It will separate the ‘good’ issuers from the ‘bad’ issuers. Balance sheet cliff risks do not deserve enough attention today. Corporate bond markets should take stock because credit risk premiums might fall victim to divergence pressures to the detriment of ESG laggards. Investment managers that can build on strong and proven processes are better prepared and equipped to allocate capital than asset managers that want to take shortcuts. Over the first half of November, we welcome the UN Climate Change Conference of the Parties (COP 26) in Glasgow. The intensity or entropy of the signal is what’s at stake.