(By Ed Pawelec) "It was an accident!"
If you have kids, you have heard this 1,000 times.
Who could have possibly guessed that a child climbing onto a stack of chairs with a gallon of milk in her hand to reach the cookies in the top cabinet would lead to a lot of spilled milk, a broken chair, and a screaming toddler? And of course no cookies.
This is the nature of unintended consequences: a seemingly good idea that may not have been fully thought through ends up in disaster... or at least spilled milk.
US bond holders received a gift last week as a result of some unintended consequences, and it is likely to be one that keeps on giving.
Can you see the yield on the US 10-year note falling to 1% from the current 1.48%?
If it does, ETFs like
TLT (iShares Barclays 20 Year Treasury Bond Fund) and IEF (iShares Barclays 7-10 Year Treasury Bond Fund) have some room to run.
I Meant To Do That
Last week Mario Monti, president of the European Central Bank (ECB), cut interest rates on the continent by 25 basis points. This lowered the bank's key lending rate to .75% from 1% and, more importantly, the rate it pays on deposits from .25% to zero.
This easing measure was supposed to spur European lenders into putting their money to work in the economy instead of having it lay around the ECB collecting .25%. But that has not happened, and there were a number of consequences, some intended, some unintended.
The first intended consequence, lower interest rates across the Eurozone, worked. Since Mr. Monti cut the rates on July 5, interest rates have plunged. The 10 year notes of both Spain and Italy have retreated from the "unsustainable" levels above 7% and 6% respectively. It also helped short term rates. Yesterday, the Italians paid 2.69% to borrow for the next 12 months compared to 3.97% last month in a €7.5 billion auction. Good job!
The second intended consequence was to weaken the Euro so that, in time, it would make European goods more competitive, spur exports, and reinvigorate the economy. Since last week's action, the euro has weakened just shy of 3% against the dollar and more than 3% against the yen. Time will tell if it leads to a stronger Eurozone economy, but I would hazard that it will not. And that is because of the unintended consequences...
Oops!
The first
unintended consequence was that some rates were pushed into negative territory. As I mentioned last week, the Danish central bank set its 2-year deposit rate at -.2%, but investors have pushed German and Swiss rates on 2 year paper below 0. Even France is selling 3 and 6 month debt at a credit.
Think of it this way: confidence in any economic growth in Europe has been so eroded by endless easing that investors are willing to lend money to Europe's "strongest" countries just to get most of it back in two years. I guess their mattresses are full.
It also caused JP Morgan, Goldman Sachs, and Blackrock to immediately close their European money market funds. They have been followed by Royal Bank of Scotland, BNY Mellon, and Northern Trust. This presents a real problem for both banks and investors.
Money market funds are designed to preserve capital and, in the US, are designed to have at least $1 in assets, very short term high quality debt, for $1 in deposits. Unfortunately, if you take in a dollar in deposit and it costs $1.02 to buy an appropriate security, that balance gets upset quickly.
For the banks, it may cause depositors to flee. For smaller investors, like anyone who has a brokerage account, it means that the fraction of a percent that you were earning on your uninvested capital was a good deal if brokers start asking you to pay to keep cash in your account. I am not even mentioning pension funds and insurance companies that rely on the short term liquidity of money market funds to pay beneficiaries. That is a totally different story.
The second unintended consequence was how and why the euro weakened. Investors sold euros to buy dollars and used those dollars to buy US and Japanese debt. This was evidenced in the Japanese 10 year falling to a 9 year low and yesterday's 10 year US note auction.
There was so much demand for US debt yesterday that the investors accepted a yield of 1.46% at auction when they could have bought the same security on the open market and received 1.51% for the next 10 years! This is not typical. Usually treasuries at auction fetch the same or slightly higher rates (lower prices) than the same security in the open market.
With overnight deposits at the ECB (the ones that earn 0%) plunging from €809 billion on Wednesday to €325 billion on Thursday, it's not hard to guess where some of that money went. And that flow is likely to continue making TLT and IEF appealing in the near term.
Taking It To The Bank
In the chart below, TLT broke through horizontal resistance in late May and found support in that area during the month of June. That is the white line around 124. It is now moving back toward its early June high and is potentially forming a "cup and handle" formation, which is often a bullish continuation pattern. After a stock has a big pop above resistance, it consolidates above that level before moving higher.
As you can see, the "cup" is mostly formed. The "handle" should form over the next week or so, meaning that TLT will trade sideways to slightly lower. It is likely to find support on its rising 20 day moving average, and from there it can break toward new all-time highs. I have not included a chart of IEF because it is nearly identical.
If the Fed was intending to further lower interest rates with another round of QE, it is too late. Mr. Monti has taken care of that, and there is a chance to further profit from the unintended consequences of his actions.