How helicopter money ensures planets do not diverge
"Are equities and bonds on the same planet?" This is what a colleague of mine from a US investment house asked in a research note last week. Indeed, it is a rather good question. While we saw last week the S&P 500 closing for the first time above the 2,000 level, we also saw the US 10-year Treasury yield briefly flirting with 2.30%, a low not experienced since mid-2013.
Even though European equities are not at historical record highs, we are still close to five-year peaks, while German 10-year bund yields have been below 1% for three weeks now, even nose-diving briefly under 0.9%. Moreover, if you want the German government to accept your money for two years, you need to pay an interest of 0.03% a year, almost as much as the rate charged by the Swiss government. Although not negative yet, even Italian and Spanish government 2-year bond yields are now close to zero. At the same time, their equity markets have outperformed overall European equities since the beginning of the year.
If we take a traditional view, clearly something is wrong here. Rallying equity markets usually herald a positive view on the economy, while falling government bond yields usually warn of turmoil yet to come. Unfortunately, this does not necessarily apply in the post-financial crisis environment. It would be preposterous to say "this time is different", which is a recipe for financial disaster. However, since we hit bottom in the US equity market roughly four and a half years ago, we have experienced a very high positive correlation among asset prices which are usually uncorrelated or move in opposite directions.
That government bond and equity prices are moving in sync (meaning that interest rates move in the opposite direction of equity prices) can be explained by schizophrenic or compartmentalized market participants - hence the "other planet" metaphor. However, in my view, there is a much simpler and more down-to-earth reason: the massive build-up of liquidity by central banks, especially the US Federal Reserve. As of July 2014, the combined balance sheet of the Fed, the European Central Bank (ECB), the Bank of Japan (BoJ), the Bank of England (BoE) and the Swiss National Bank (SNB) stood at 11 trillion US dollars - that is a massive two and a half times the amount (roughly 4.5 trillion US dollars) back in July 2008.
Obviously now, with tapering in full swing, the Fed exiting quantitative easing 3 by October and the BoE more and more likely to hike interest rates before the end of the year, many market participants have started to worry whether the money binge is over. If so, then we might go back to some more "normal" asset behavior. However, there are reasons to question whether the major central banks will take their feet off the gas pedal so easily.
The ECB has been hinting it might expand its balance sheet again if "low-flationary" pressures continue. Remember that this central bank has actually seen a shrinking of its balance sheet by over one trillion euros during the last two years - one possible explanation why price pressures are so low in the Eurozone. Moreover, in my view, given the shaky condition of the Japanese economy, no one should be surprised if Abenomics' monetary expansion continues beyond its acknowledged target.
Finally, for those who doubt that monetary policy could become even more extreme than what we have seen in the last couple of years, I recommend reading an article in the latest Foreign Affairs by Mark Blyth and Eric Lonergan titled "Print Less but Transfer More - Why Central Banks Should Give Money Directly to the People". Their science fiction defense of the famous helicopter money, first mentioned by economist Milton Friedman and later suggested by former Fed chief Ben Bernanke, would, if really implemented, help ensure that government bonds and equities stay on the same planet.