US real yields tumble in an indication of prolonged Fed support

Investors pushed into riskier assets as market eyes long economic recovery

Colby Smith in New York

Jay Powell, Federal Reserve chairman, says he is ‘not even thinking about thinking about raising rates’ © AP

Real yields on US Treasuries fell to the lowest level since 2012 this week in a move that reflects a belief that a weak economy will need very loose monetary policy for a long time.

Real yields, which strip out expected consumer price-changes from the nominal yield on bonds, have plunged around the world as central banks have cut rates and unleashed monetary stimulus to limit the economic fallout from the coronavirus pandemic.

Investors attributed the latest leg down in the US to expectations that the Federal Reserve would be prodded to do more to shore up the economy, following signs that an economic rebound is stalling.

“Low real yields represent a barometer for liquidity being injected into the market,” said Jim Caron, a senior portfolio manager at Morgan Stanley Investment Management, who added that they prompt investors to search out other sources of income.

“It is no doubt supportive for financial assets and supportive for growth,” he said.

Line chart of Real 10-year Treasury yields, % showing Investors ready for more Fed support

The Fed’s decision to slash interest rates to zero in March and announce emergency measures has already helped spur a broad-based rebound across equity and fixed-income markets as investors put money into riskier assets.

That, in turn, has aided companies that need to raise money to see them through the pandemic, while boosting the wealth of equity owners.

The S&P 500 is now in positive territory for the year, while the tech-heavy Nasdaq Composite has hit record highs.

The slide in real yields has accelerated in recent weeks and comes despite little change in the nominal yield on the 10-year Treasury, which yielded 0.59 per cent on Wednesday.

The inflation-adjusted yield, however — derived by deducting the yield on 10-year Treasury Inflation Protected Securities (Tips) — fell as low as minus 0.92 per cent, a level last recorded in the aftermath of the eurozone debt crisis nearly eight years ago.

Such an extreme reading has been seen just once on an intraday basis in the past eight years, at the depth of the market turmoil in March this year.

In June, Jay Powell, Fed chairman, said he was “not even thinking about thinking about raising rates”. Other Fed officials have echoed his dovish stance ahead of the central bank’s next meeting at the end of July.

Scott DiMaggio, co-head of fixed income at AllianceBernstein, said the current level of real yields suggested investors believed the Fed would do more. “Central banks are doing everything they can to push down nominal yields in hopes that . . . they will pump up growth.”

Additional support was likely to be necessary, said Margaret Kerins, head of fixed income strategy at BMO Capital Markets, given that the recovery was set to be “long and protracted” with “no inflation fears”.

Fed policymakers have embraced the idea of allowing inflation to rise above their 2 per cent target in a bid to bolster economic activity. They have also debated so-called yield curve control, where the Fed caps rates, as well as more explicit forward guidance.

“The Fed is unapologetic about what they are doing,” said Mr Caron at Morgan Stanley Investment Management. “They are saying, ‘we need to do more’.”

A big fiscal deal

The EU’s leaders have agreed on a €750bn covid-19 recovery package

The union will borrow vast sums collectively for the first time

Like almost everything else at this week’s European Council, which concluded at 5.30am on July 21st after five days of deliberation, the question of whether it was the longest EU summit in history was hotly contested.

Some said it beat the record held by a mammoth discussion in Nice in 2000. Others thought it fell 25 minutes short.

Either way, it was a landmark event. Most of the eu’s 27 national leaders emerged into the Brussels dawn claiming to have agreed to something historic. To judge by the soaring euro and plunging spreads, investors concurred.

The deal has two elements: the regular eu budget, or multiannual financial framework (mff), worth nearly €1.1trn ($1.3tn) over seven years; and a one-off “Next Generation eu” (ngeu) fund of €750bn to help countries recover from the covid-19 recession (both figures in 2018 prices).

Rows over the second of these explain the summit’s length: at one point leaders spent over an hour arguing over whether to replace the word “decisively” with “exhaustively” in the communiqué. But in the end each returned home broadly satisfied.

The deal broke two historic taboos, says Silvia Merler, head of research at Algebris Policy Forum, the advisory branch of an asset-management firm.

First, Europe’s leaders agreed that the European Commission, acting on behalf of the member states, may incur debt at an unprecedented scale.

The NGEU will be funded by borrowing over six years, with bonds issued at maturities extending to 2058.

Second, €390bn of the €750bn will be distributed as grants, and hence will not add to governments’ debt loads—breaching what had been a red line over substantial intra-eu fiscal transfers. Both developments would have been unimaginable just six months ago.

Europe has marshalled a fiscal response to the covid crisis equal to or better than America’s.

The NGEU is worth some 4.7% of the eu’s annual GDP, albeit spread over several years, and comes on top of national governments’ stimulus efforts. The EU has plugged the budgetary hole left by the departure of Britain.

It has answered the European Central Bank’s pleas to balance its monetary activism with a comparable fiscal effort, and will provide investors with a steady stream of safe assets. It may have set a precedent for future crises to be met with collective debt, although that will be ferociously resisted, not least by the self-styled “frugal four”—Austria, Denmark, the Netherlands and Sweden—who were the biggest hurdle to striking a deal.

The recovery funds will initially be allocated to countries using criteria like unemployment and income per person. That will benefit the likes of Spain, and Italy, which says it is in line for €209bn in loans and grants.

The commission will evaluate governments’ investment plans on the basis of its annual “country-specific recommendations”, usually toothless reform checklists that Ursula von der Leyen, the commission’s president, says will now pack “more punch”.

Fully 30% of MFF and NGEU spending should be devoted to climate action, potentially creating a vast green stimulus.

But the commission will not have the only say over spending.

Rather like Germany during the euro crisis, the frugals do not trust the commission’s technocrats to police the reforms of southern states. Instead Mark Rutte, the Dutch prime minister, secured an “emergency brake”: any government can object to another’s spending plans, delaying and complicating disbursements.

That allows him to tell Dutch voters that they have not signed a blank cheque for feckless southerners. Some southern reformers even hope this rule may help their case (“Thanks Mark Rutte,” wrote a pro-market Spanish politician in El País).

But Lucas Guttenberg of the Jacques Delors Centre in Berlin fears the brake could entrench mistrust inside the eu if beneficiary governments believe others are objecting in bad faith.

The deal falls short of the “Hamiltonian moment” some had hoped for, referring to the us national government’s assumption of state debts in 1790. No one has proposed mutualising eu countries’ legacy debts; even the new common debt will not enjoy joint-and-several guarantees.

And the question of how to repay it is left for later.

Governments have long been unwilling to hand tax-raising powers to Brussels. Yet from 2028 money must be found to repay the new debt: if not from “own resources” (EU revenues, in the jargon) generated by new taxes, then from larger national contributions to the MFF.

A levy on plastic will take force in January, and the commission will later propose eu-wide taxes on digital firms and climate-unfriendly imports.

There are two areas of concern.

The first is the price demanded by the frugals. To preserve the recovery grants, cuts fell on so-called “future-oriented” areas like research, health care and climate adjustment.

These, critics grumble, are precisely the themes the frugals always said should take priority over farming and regional subsidies, which remain intact. And the frugals won big increases to the rebates they get on their eu budget payments (Austria’s more than doubled).

Such small-country triumphs do not fatally undercut the deal, but they cost money and will be bitterly contested at the next mff round.

A second set of worries centred on how to prevent handouts to countries that undermine the rule of law.

Wayward governments like Hungary and Poland are big winners from the MFF, and some had hoped that attaching rule-of-law conditions to disbursements might help bring them to heel.

In the end the leaders agreed on studiously ambiguous language, shaped by Angela Merkel’s team. It promises “a regime of conditionality to protect the budget” but postpones the decision on how to obtain it. “Lots of people will want this made more precise,” says Katarina Barley, a German social-democratic mep.

Many of Ms Barley’s colleagues in the European Parliament, which must sign off on the deal, also criticised the deal’s cuts to favoured programmes and their own exclusion from oversight of spending.

Yet although the parliament may extract tweaks to the deal, on past form it is unlikely to squash it. A budget must be in place from the start of next year. 

MEPS will not want to spark a crisis by blocking it.

Azerbaijan's Slow Drift Toward Turkey

This month’s flare-up may represent more than another clash between Armenians and Azerbaijanis.

By: Ekaterina Zolotova

On July 12, Armenian and Azerbaijani forces clashed in the Tovuz border region – far from the disputed region of Nagorno-Karabakh, where such clashes usually take place – and the sporadic violence has continued ever since. At first, the countries’ two larger neighbors with a geopolitical interest in the region, Russia and Turkey, did not interfere.

On July 23, however, Russian forces took part in pre-planned exercises with Armenian troops.

The Azerbaijani government promptly announced that it would host large joint air and ground exercises with Turkey. Armenia’s position against Turkey is fixed, a product of a century of bad blood, but Azerbaijan has traditionally attempted to balance between Russia and Turkey.

This month’s flare-up, however, may represent more than another scuffle between Armenians and Azerbaijanis. It may instead mark the beginning of a gradual realignment by Baku away from balancing and toward Ankara.

Turkey’s Ascent, Russia’s Descent

Turkey’s and Russia’s interests intersect in the Caucasus. For Russia, having allies in the South Caucasus guarantees a degree of stability in its border regions. Moreover, Azerbaijan provides Russia with strategic access to the Middle East.

Turkey, which is enmeshed in the gradual construction of a neo-Ottoman project to establish its dominance in the region, needs allies like culturally close Azerbaijan. Azerbaijan also has energy reserves, which are valuable for Turkey’s ambitions to become a regional gas center.

The Russian and Azerbaijani economies were bound together under the Soviet Union, and the two have maintained close economic, political and energy ties ever since. Their trade relationship is extensive, but Russia’s share of Azerbaijan’s total trade is diminishing: In the 1990s, Russia accounted for about 20-25 percent of Azerbaijan’s trade, but in the 2010s that share hovered around 8 percent.

Turkey’s share, on the other hand, has been growing: Total trade between the two amounted to $4.5 billion in 2019 (an increase of 33 percent from the previous year, and higher than the Russian-Azerbaijani figure of $3.02 billion, which was itself the highest in the past 10 years).

Azerbaijani President Ilham Aliyev has said he wants bilateral trade with Turkey to reach $15 billion a year and to increase energy exports to Turkey.

(click to enlarge)

Speaking of energy, Russia and Azerbaijan are increasingly looking like competitors in the oil and gas sector rather than partners. Baku’s attempt to enter the European Union’s energy market through Turkey, bypassing Russia, makes Moscow nervous.

Previously, Azerbaijan had used Russian pipeline networks to ship energy to Europe, which gave Russia control over the amount of Azerbaijani supplies in Europe.

The construction of pipelines through Turkey, however, is not subject to Russian influence.

Such projects, especially gas projects, have become important for Azerbaijan, which supplied 82 percent of its gas exports to Turkey in 2018.

These include the Baku-Tbilisi-Ceyhan oil pipeline, which transports Caspian oil to the Turkish port in Ceyhan, and the South Caucasian gas pipeline from Baku through Georgia to the border with Turkey, both of which were completed over a decade ago.

More recent endeavors include the Trans-Adriatic Pipeline, which will connect Greece, Albania and southern Italy, and the Trans-Anatolian Gas Pipeline, or TANAP, which was completed in 2018 and merged with the Trans-Adriatic Pipeline.

Russia has the TurkStream gas pipeline to Turkey (commissioned in January of this year), which targets the same market as TANAP, but Moscow has struggled to maintain its share of the market.

For example, in March 2019, Russia was the leader in gas exports to the Turkish market at 33 percent, but a year later, Azerbaijan had surpassed Russia with 23.5 percent. (In fact, Russia fell into fifth place, with 9.9 percent.)

(click to enlarge)

The other area in which Turkey is gaining ground on Russia is Nagorno-Karabakh. Russia traditionally acts as a mediator in the conflict, yet it continues to support Armenia, conduct exercises with its military, and supply Yerevan with weapons.

Indeed, ever since Vladimir Putin became president again, he seems to have largely ignored the resolution of Nagorno-Karabakh while intensifying military cooperation with Armenia through the Collective Security Treaty Organization. (The need for Armenia’s full cooperation in the then-budding Eurasian Economic Union no doubt played a part.)

Meanwhile, relations between Russia and Azerbaijan had cooled, thanks to a dispute over the Gabala radar station, Moscow's refusal to sell combat aircraft to Baku, and the ending of an agreement over the transit of Azerbaijani oil through Russian territory.

Turkey, on the other hand, broadly supports Azerbaijan, which it has pledged to back in the current conflict. Partly this is due to Ankara’s neo-Ottoman ambitions in the region that call for the imposition of “One people, two countries” there, and partly it’s due to historically tense relations with Armenia. (Turkey refuses to accede to Armenian demands to acknowledge the Armenian Genocide, and Armenia refuses to ratify the Treaty of Kars, which laid the groundwork for the modern borders of Armenia, Azerbaijan and Turkey.)

Turkey also partners with Georgia, which Ankara sees as a transit country and which relies heavily on energy supplies from Azerbaijan.

And then there are the economic factors at play. Since 2014, the Russian economy has been struggling with sanctions and with fluctuations in the price of oil, on which its health depends.

The Kremlin has tried to implement the necessary structural reform to stimulate the economy, but its efforts have largely failed, hence its renewed attention on reanimating the economy rather than on finishing expensive boondoggles with other countries.

The Turkish economy has its share of problems, but laying itself exclusively at the mercy of the oil markets isn’t one of them.

Russia is losing ground to Turkey in terms of investments as well. Azerbaijan has invested more than $17 billion in the Turkish economy, and Turkey has invested over $12 billion in the Azerbaijani economy. SOCAR, Baku’s state oil company, has new plans and projects that raise total investments in the Turkish economy to about $20 billion. Russia has invested only about $4.7 billion in Azerbaijan, while Azerbaijan has invested $1.2 billion in Russia.

Azerbaijan's Goals

Azerbaijan understands that larger and more powerful countries will always be interested in its affairs. But Baku has its own goals. It’s been independent for only a short time, and it has every intention of maintaining its sovereignty.

Like other former Soviet republics, Azerbaijan has a host of economic problems, not least of which is its own dependence on energy exports. It needs allies that will buy its goods and thus fund its government.

But it’s in no hurry to fully commit to any one ally. (Not that anyone has asked it to.) It benefits more from balancing both sides; it’s not part of Europe’s or Eurasia’s formal architecture, but it still needs Russian trade, just as it still needs European energy customers. Turkey is an important economic partner in that regard.

But any major move toward one side or the other heightens the risks of internal destabilization and losing all the economic benefits that come with balancing, not just for Azerbaijan but for the region as a whole, since it would necessarily pit Russia against Turkey.

It’s simply more profitable for Baku to rely on Russia and Turkey and turn into a logistic hub between Europe, the Middle East and Central Asia.

The country can thus afford some tactical adjustments in the short term that will keep its foreign policy essentially intact.

But it’s possible that will change as Russia loses ground to Turkey.

The Euro Crisis’s New Clothes

The European Union's new €750 billion recovery fund is intended to tackle crises such as collapsing manufacturing output in southern member states like Spain and Italy. But money cannot solve the problem of distorted relative goods prices within the eurozone.

Hans-Werner Sinn

sinn93_zubada_Getty images_euro

MUNICH – European Union leaders have reached agreement on a big €750 billion ($870 billion) recovery fund intended to help the EU member states hit hardest by COVID-19. But during the lengthy negotiations over the package, it became increasingly clear that Europe’s pandemic-induced economic crisis is an extension of the euro crisis that has been festering since the collapse of Lehman Brothers in 2008.

In essence, this is a competitiveness crisis brought about by the distortion of relative prices within the eurozone, which is a result of inflationary overpricing in Southern European countries. This overpricing, in turn, stemmed from the flood of capital that entered these economies after they joined the euro.

The collapse of the euro bubble following the 2008 financial crisis reversed the direction of private capital flows, leading to several rounds of intense capital flight from the Mediterranean region to Germany. This was reflected in a surge in the so-called TARGET balances that measure net payment orders and provide a sort of public overdraft credit within the eurozone. And now COVID-19 has triggered another phase of capital flight that eclipses all the others.

After the pandemic struck earlier this year, international lenders refused to roll over their outstanding loans to Southern European countries and demanded repayment, subsequently investing the money in the eurozone’s northern members, particularly Germany. Southern European investors also shifted their investments to Germany, and transferred corresponding amounts of money. These two streams of payment orders have forced the Bundesbank to tolerate open credit positions so far amounting to €1 trillion.

In March 2020, German TARGET claims increased by €114 billion – by far the biggest monthly rise since the euro’s introduction in 1999. Capital flight during two previous high points of the euro crisis, in September 2011 and March 2012, also caused Germany’s TARGET balance to spike, but by only €59 billion and €69 billion, respectively. Although capital markets cooled off slightly in April and May of this year, German TARGET claims increased again in June, this time by €84 billion. Between February and June, they rose by a total of €174 billion, to reach a record-high €995 billion.

Conversely, Italian and Spanish TARGET debts increased by €152 billion and €84 billion, respectively, during the same period. That implied debts of €537 billion and €462 billion, respectively, at the end of June – or €999 billion in total. Both this figure and the German claims number are so close to the €1 trillion threshold that one cannot help but wonder what secret forces in the background might have pulled the emergency brake.

Investors fled Spain and Italy because they no longer viewed these countries as safe bets. And the two countries’ central banks made their flight possible by providing extra liquidity via national printing presses.

Part of this liquidity came from the European Central Bank’s various asset-purchase schemes, including the Pandemic Emergency Purchase Program (PEPP) and the long-established Asset Purchase Program (APP), which the ECB has increased temporarily in response to the current crisis. Although these programs had envisaged symmetrical asset purchases by the ECB and all national central banks in the eurozone, these institutions bought a disproportionately large volume of Italian assets.

The additional liquidity also comes from a special Targeted Longer-Term Refinancing Operations (TLTROs) program worth more than €500 billion that the ECB made available to eurozone banks in mid-June. The -1% interest rate on the TLTROs was extremely favorable – so favorable, in fact, that many banks borrowed the money and immediately redeposited it with their own central banks at a rate of -0.5%. This provided them with an immediate arbitrage gain that amounted to an open subsidy by the Eurosystem.

But Spanish and Italian banks needed the TLTROs in large part to compensate for the capital outflows. Or perhaps they used them simply to pay off private foreign loans that had less favorable terms. In that case, the loans that the Spanish and Italian central banks provided via their national (electronic) printing presses would not only have enabled capital flight, but also served as a means of driving private capital away by offering better terms.

Be that as it may, the eurozone remains internally unbalanced. This also becomes apparent if one looks at manufacturing output in Southern Europe. Unlike domestic sectors, the region’s manufacturers must compete internationally, and therefore have suffered the most from high relative prices. Even before the coronavirus crisis, manufacturing output in Italy was 19% below its level in the autumn of 2007, just before the real economy reacted to the financial crisis; in Spain, it was 21% lower. The downward trend has continued during the pandemic, widening the output gaps to 35% and 34%, respectively.

The new EU recovery fund is meant to address this fiasco, but money cannot solve the problem of distorted relative goods prices within the eurozone. Fixing it requires an open or real devaluation. But no one wants to talk about that. Instead, the EU’s strategy seems to be based on hope and prayer.

Hans-Werner Sinn, Professor of Economics at the University of Munich, was President of the Ifo Institute for Economic Research and serves on the German economy ministry’s Advisory Council. He is the author, most recently, of The Euro Trap: On Bursting Bubbles, Budgets, and Beliefs.