The Methadone Market

Highlights

• The Methadone Market. Methadone replacement treatments for heroin addiction are controversial; equally controversial are global monetary policy makers' replacement treatments for the financial markets' and economy's addiction to credit. The "cure" to the credit crisis has simply been more credit—this time provided through massive expansion of central bank balance sheets to offset the contraction in private money credit. The addiction is not cured but rather supplanted by a hopefully more manageable and less destructive opiate. The BoJ now becomes the world's leading provider of liquidity and the market reaction to its historic April 4th announcement illustrates much of how the "Methadone Market" now functions.
• Front running Global Monetary Policy. The best performing bond market the day Japan announced ¥60-70 trillion in market intervention? France. Why it was illustrates much of how financial markets operate in a world of "unconventional" monetary policy: anticipate what central banks will purchase (and in the case of France its follow on impacts) and purchase it for them.
• Think all that money printing is inflationary? Think again. Investors' knee-jerk reaction to such policies of massive money printing is to correctly fear for the inflationary consequences. The trouble is getting the timing right. Policy makers the world over are fighting the specter of deflation with policies designed to create inflation. While this is the intent, the result in the real economy is frustrated by both demand and supply problems in the banking system. The excess liquidity creates inflation—but in asset prices, not yet in the real economy. Money creation is the necessary condition for inflation, but is not sufficient. Private market expansion of credit usage is still required for inflation. The US appears the first to show expansion as critically the housing "echo-bubble" leads to both supply and demand for credit expanding. But the rest of the developed world remains in contraction contributing to disinflation globally.

So What Do I Do with My Money?™

Sell your inflation hedges. TIPS in fixed income, commodities and commodity related exposures and gold all ran up in price in anticipation of a tsunami of inflation that is still far out at sea. While eventually it may hit shore, that outlook is pushed off at least a year and likely more. Inflation figures (at least those that policy makers use) are now falling. We see stable inflation in the near term, and the lack of increases undermines the case for inflation hedges, while their high prices make them vulnerable to a break as we saw recently in gold. The best inflation hedge remains staying exposed to risky assets—stocks in equities and credit in fixed income—that will continue to inflate under ample and now-expanding global liquidity.

The Methadone Market

Methadone replacement treatments for heroin addiction are controversial; equally controversial are global monetary policy makers replacement treatments for the financial markets' and economy's addiction to credit. The "cure" to the credit crisis has simply been more credit—this time provided through massive expansion of central bank balance sheets to offset the contraction in private money credit. The addiction is not cured but rather supplanted by a hopefully more manageable and less destructive opiate. The Bank of Japan (BoJ) now becomes the world's leading provider of liquidity and the market reaction to its historic April 4th announcement illustrates much of how the "Methadone Market" now functions.

The best performing bond market the day Japan announced ¥60-70 trillion in market intervention? France. Why it was illustrates much of how financial markets operate in a world of "unconventional" monetary policy: anticipate what central banks will purchase (and in the case of France, its follow-on impacts) and purchase it for them. Figure 1 below highlights the market reaction the day of the BoJ announcement on April 4th. French 10-year government bond yields dropped by 12 basis points—larger than any other bond market—meaning their bond prices went up the most the day of the announcement. Recall that the BoJ announced it would purchase ¥60-70 trillion of Japanese financial assets per year over the next 2 years, the bulk of which— ¥50 trillion would go to the purchase of Japanese Government Bonds (JGBs). JGB yields had already been falling in anticipation of such an announcement and at the 10-year maturity had declined from a yield of 0.80% to 0.50%. Such paltry yields make the US 10-year yield of 1.70% look like a veritable bargain.

And that is precisely the point. Low Japanese yields and the prospect for even lower yields resulting from the BoJ purchases would lead Japanese investors to buy other global bonds in the pursuit of higher income. Here we see how monetary policy made "strictly" for domestic purposes hardly has strictly domestic consequences. The Fed has been ignoring this reality since the onset of its foray into "unconventional" monetary policy making. And so the BoJ and other global central banks have to follow suit. The Fed's goals are simple: restore the health of the labor market and its means even simpler: restore the health of the housing market through making owning houses more accessible through cheap credit. A crisis brought about by too much credit finds its salvation in even more cheap credit.

The BoJ has its own rationale—though if it wants to avoid raising the ire of the G20 or more importantly of China it must refrain from admitting it at least publically. The Fed's monetary policy led—however unintentionally—to an increase in the yen vs. the dollar of around 20%, undermining the export competitiveness of the Japanese economy. The delayed response in Japan—necessitated by politics and catalyzed by the transition and election of a new leader, Shinzo Abe, last year seeks redress—through the return of the yen to its lower value by massive yen printing. "Fine and good, just don't admit this publicly" is the global reaction—because that's how the Fed has been doing it: rationalize your currency debasement policies through domestic intentions. If the currency implications result in a decline that is not your intent, well, that's OK.

Except it's not OK to financial markets. It's highly distortive. The liquidity provided locally moves globally. And that brings us back to our April 4th BoJ announcement effect. Why do French government bonds go up the most that day? Because that has been what Japanese investors have been buying most. They buy French bonds because they offer higher yields than JGBs but not the risk of Italy or Spain. German bonds? Might as well just stay at home for those paltry yields. So, armed with such knowledge we see the "Methadone Market" in action: the BoJ buys ¥50 trillion in JGBs, the JGB yields go even lower forcing even more Japanese to buy even more French bonds. So I'll buy those bonds first to profit from this central bank announcement. So much for fundamentals in a world of massive central bank asset purchases.

Similarly, we find examples recently in Europe. On April 23rd this year, economic data from the eurozone showed declining manufacturing sentiment across the continent—a leading indicator of economic performance. Yet the stock market finished up 3%—the best single day in over 3 years—based on expectations of ECB policy action that was subsequently delivered on in the form of a 25 basis point cut. This led to—as per the "methadone market" mechanism—rising stock prices.

We've gone from "Don't fight the Fed" to "follow the Fed" (the period of QE1 and QE2) to "Front-run the Fed." Front-running by your broker means they trade for themselves ahead of your order. This will get your broker fired or put in jail. But front running monetary policy makers is encouraged. The combination of transparency and credibility co-opts private market balance sheets into doing the Fed's (or ECB's or BoJ's) purposes leading to less central bank balance sheet being required to accomplish the intended effect.

Mario Draghi perfected this technique in his market intervention last year. The now famous line "We will do whatever it takes to support the eurozone and believe me it will be enough" worked to ease Spanish and Italian funding conditions without ever spending a euro. How? A central banks balance sheet is unlimited so when credibly threatened to be used (the second "believe me" part is the threat) is larger than any private sector balance sheet.

No Way Out

The trouble with such Financially Repressive policies is that they are easy to get into but hard to get out of. We described the dilemma facing the Fed last month in our monthly, titled "No Way Out," that running such policies in reverse doesn't work. You can co-opt the private sector to join you in purchasing assets but can you ever tell them you are going to sell? For Europe, such constraints mean that if the required "conditionality" (the pursuit of structural reforms) that the ECB established as the condition for receiving such unlimited support ever is broken, could they ever withdraw it? Such an announcement would immediately cause the country in question to lose market access and move immediately into "default." Unconventional monetary policy only works in one direction and the financial market understanding of that facet in the short run contributes to the behavior of the "Methadone Market."

The Inflation Impact

Think all that money printing is inflationary? Think again. Investor's knee-jerk reaction to such policies of massive money printing is to correctly fear for the inflationary consequences. The trouble is getting the timing right. Policy makers the world over are fighting the specter of deflation with policies designed to create inflation. While this is the intent, the result in the real economy is frustrated by both demand and supply problems in the banking system. The excess liquidity creates inflation—but in asset prices—not yet in the real economy. Money creation is the necessary condition for inflation, but is not sufficient. Private market expansion of credit usage is still required for inflation. The US appears the first to show expansion as critically the housing "echo-bubble" leads to both supply and demand for credit expanding. But the rest of the developed world remains in contraction, contributing to disinflation globally.

For the US, we watch the amount of private sector credit creation for leading indicators of the conditions both necessary and sufficient to create inflation. Figure 2 highlights household and business sector credit growth rates. Credit usage has stabilized since the collapse during the crisis and now shows signs of slowly healing. Not just stability but expanding use of credit will be required before the risk of inflation returns. In the meantime, inflation likely remains benign supporting the Fed's ability to remain highly accommodative and postponing fears of any imminent large increase in interest rates. Our year-ahead forecast for the 10-year US Treasury was 2.25%. And though a 4th year in a row of concerns about economic slowdown coupled with the surprisingly large BoJ intervention may lead us to end up lower than that level, rates should stay in the range of 1.75% to 2.25%.

So What Do I Do With My Money?

The lack of near-term inflationary pressure means underperformance of inflation hedges —Treasury Inflation Protected Securities (TIPS)—in fixed income but also commodities and gold. Selling the dollar also looks more risky than any time in the past four years as the Fed remains the most likely candidate to ease off of accommodation first while Europe and Asia need to ramp up their pace of money creation.

*As of 04/30/2013, Securitized Assets: ABS (MTD 0.40, YTD 0.45, YTM 0.88, Overweight), CMBS (MTD 0.89, YTD 1.02, YTM 1.62, Overweight), Non Agency RMBS (Overweight). ** Emerging Market: Hard Currency (MTD 2.92, YTD 0.59, YTM 4.51, Neutral), Local Currency (MTD 2.11, YTD 3.45, YTM 5.27, Neutral), Corporate (MTD 1.43, YTD 2.14, YTM 4.63, Neutral).

Note: ^† Yield to worst. ^‡ Yield to Maturity. ¹ We continue to view TIPS favorably as an alternative to nominal Treasury exposure in a portfolio. Inflation protected position represents outright positioning. The respective indexes are listed at the back of this report.

The sector performance and yields listed are represented by, respectively: Barclays US High Yield Index, S&P Leveraged Loan Index, Barclays US Securitized Ex-MBS Index, Barclays US Mortgage Backed Securities Index, Barclays US Corporate Investment Grade Index, Barclays Global Aggregate ex-USD Index, JP Morgan EMBI Global Diversified Index, Barclays US Inflation Protected Securities Index and Barclays US Treasury Index. The reference indices are represented by the Barclays US Aggregate and the Barclays Municipal Bond Index.

Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities ("high yield" or "junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging/developing markets or smaller capital markets. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

The opinions expressed are those of BlackRock® as of May 7, 2013, and may change as subsequent conditions vary. Information and opinions are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable. The information contained in this report is not necessarily all-inclusive and is not guaranteed as to accuracy. Past performance does not guarantee future results. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Reliance upon information in this report is at the sole discretion of the reader.

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