Act (Un)Naturally! ECB’s Draghi Warns of Bubble Risk (Including Real Estate) in the Euro Zone (17 European Nations Have Negative 2-year Sovereign Yields)

Slowing European economic growth coupled with massive, unnatural Central Bank policies has led to a massive bubble in stocks and real estate. All the ECB did was “act (un)naturally.”

WASHINGTON (Reuters) – There are “mild signs” of overvaluation in the euro zone financial and property markets, creating a risk for stability at a time when the economy is slowing, the European Central Bank’s President Mario Draghi said on Friday.

“The financial stability environment remains challenging, as the global economic outlook has deteriorated,” Draghi told fellow policymakers on the International Monetary and Financial Committee in Washington.

“There are mild signs of overstretched valuations in the euro area in some riskier segments of the financial markets, as well as in real estate markets, with marked differences across regions.”

The ECB has acted unnaturally since the financial crisis of 2007-2009 by dropping their main refinancing rate to 0% and rapidly expanding their balance sheet.

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In addition, the ECB’s M3 money growth continues to grow.

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And 17 European nations now have negative 2-year sovereign yields.

The heartland of Euro (meaning Germany, France and Austria) oppose more QE (asset purchases by the ECB) while peripheral counties (Spain, Italy and Greece) want to keep on expanding the ECB’s balance sheet.

Of course, none of this Central Bank interference is natural and sets the stage for a bubble burst.

ECB’s Draghi is a regular “buckaroo.”

Draghis.

How Negative Rates Broke Black-Scholes, Pillar of Modern Finance (How About SABR?)

I suggest that students at George Mason University ask their finance professors how negative interest rate impact their use of the famous Black-Scholes model.

(Bloomberg) — Negative interest rates have quite literally broken one of the pillars of modern finance.

As economists and central bankers weigh the pros and cons of sub-zero rates and their impact on the world, traders have been contending with a rather more mundane, but fundamental issue: How to price risk on trillions of dollars of financial instruments like interest-rate swaps when their complex mathematical models simply don’t work with negative numbers.

Out are certain variations of the Black-Scholes model, the framework that allowed derivatives to flourish in the past four decades. In are a hodgepodge of approximations and workarounds, including one dating to the 19th century.

Granted, the current state of affairs is more a nuisance than a serious problem. And it’s one that has been largely confined to Europe and Japan.

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But with sub-zero interest rates becoming a long-term economic feature and the number of negative-yielding bonds reaching $15 trillion, it’s an issue more and more traders, particularly in the U.S., are trying to wrap their heads around.

“I was quite surprised that I’ve started getting questions from U.S. clients wondering, ‘What’s the impact of negative rates? What are the mathematics?’” said Sphia Salim, a London-based rate strategist at Bank of America.

The issues are most apparent in the market for interest-rate swaps. (This market allows professional investors to lock in interest rates and lets speculators bet on whether rates on bonds or loans will rise or fall.) That’s because the Black 76 model, the main tool to price options for interest-rate derivatives, and its variants are so-called log-normal forward models.

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For those who aren’t math nerds, it can essentially be boiled down to this: the formula breaks because it requires users to calculate a logarithm, and a logarithm of a negative number is undefined, or meaningless.

One option has been to dust off a framework that was first proposed nearly 120 years ago. Known as the Bachelier model, it’s named after the French mathematician Louis Bachelier, who laid out his approach in his 1900 thesis “Theory of Speculation.” The model is best known for solving the math behind a theory from physics known as Brownian motion (some five years before Albert Einstein did the same in his revolutionary work on thermodynamics), and applying it to finance, according to a 2016 paper by Ian Thomson.

All is not lost. There is the SABR Model that is a stochastic volatility model.

The SABR model describes a single forward $F$ , such as a LIBOR forward rate, a forward swap rate, or a forward stock price. This is one of the standards in market used by market participants to quote volatilities. The volatility of the forward $F$ is described by a parameter $\sigma$ . SABR is a dynamic model in which both $F$ and $\sigma$ are represented by stochastic state variables whose time evolution is given by the following system of stochastic differential equations:

dF_{t}=\sigma _{t}\left(F_{t}\right)^{\beta }\,dW_{t},

d\sigma _{t}=\alpha \sigma _{t}^{{}}\,dZ_{t},

with the prescribed time zero (currently observed) values $F_{0}$ and $\sigma _{0}$ . Here, $W_{t}$ and $Z_{t}$ are two correlated Wiener processes with correlation coefficient $-1<\rho <1$ :

dW_{t}\,dZ_{t}=\rho \,dt

The constant parameters $\beta ,\;\alpha$ satisfy the conditions $0\leq \beta \leq 1,\;\alpha \geq 0$ . $\alpha$ is a volatility-like parameter for the volatility. $\rho$ is the instantaneous correlation between the underlying and its volatility. $\alpha$ thus controls the height of the ATM implied volatility level. The correlation $\rho$ controls the slope of the implied skew and $\alpha$ controls its curvature.

The above dynamics is a stochastic version of the CEV model with the skewness parameter $\beta$ : in fact, it reduces to the CEV model if $\alpha =0$ The parameter $\alpha$ is often referred to as the volvol, and its meaning is that of the lognormal volatility of the volatility parameter $\alpha$ .

A SABR model extension for Negative interest rates that has gained popularity in recent years is the shifted SABR model, where the shifted forward rate is assumed to follow a SABR process

dF_{t}=\sigma _{t}(F_{t}+s)^{\beta }\,dW_{t},

d\sigma _{t}=\alpha \sigma _{t}\,dZ_{t},

for some positive shift $s$ . Since shifts are included in a market quotes, and there is an intuitive soft boundary for how negative rates can become, shifted SABR has become market best practice to accommodate negative rates.

The SABR model can also be modified to cover Negative interest rates by:

dF_{t}=\sigma _{t}|F_{t}|^{\beta }\,dW_{t},

d\sigma _{t}=\alpha \sigma _{t}\,dZ_{t},

for $0\leq \beta \leq 1/2$ and a free boundary condition for $F=0$ . Its exact solution for the zero correlation as well as an efficient approximation for a general case are available.^[2]

An obvious drawback of this approach is the a priori assumption of potential highly negative interest rates via the free boundary.

negative_density

U.K. Bank Credit Rallies as Johnson Strikes Brexit Deal With EU (UK CoCo Prices Jump, But Not Deutsche Bank’s 6% CoCo)

While the UK Parliament has to sign off on the Brexit agreement, bank credit rallies after Boris Johnson reached an agreement with the EU.

U.K. lenders’ riskiest notes jumped, leading a credit rally, after Prime Minister Boris Johnson reached a Brexit agreement with the European Union.

Barclays Plc’s 1.25 billion pound ($1.6 billion) 5.875% CoCo reversed earlier losses and hit 99.5 pence on the pound, the highest since May 2018, according to data compiled by Bloomberg.

barccoco

Nationwide Building Society’s 600 million-pound perpetual bond, sold last month, hit a record. Oddly, NBS’s perpetual bond started rising on October 10th, well before PM Boris Johnson announced his Brexit agreement.

A contingent convertible bond (CoCo), also known as an enhanced capital note (ECN) is a fixed-income instrument that is convertible into equity if a pre-specified trigger event occurs.

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A famous CoCo bond is the Deutsche Bank 6% Perpetual.

db6descrp

While issued at par (100), the G-spread on the Deutsche’s 6% CoCo bond is … 11%.

Odd, that DB’s CoCo bond remained relatively calm after the Brexit deal was announced.

Is that UK PM Boris Johnson or Martin Kernsten, the Nipple King from Parks and Recreation?

Its always sunny in the UK!

Draghi Goes Big! Draghi Faced Unprecedented ECB Revolt as Core Europe Resisted QE (France, Germany Versus Spain, Italy, Greece)

This reminds me of the Mel Brooks skit “The people are revolting.”

It this case, it is France and Germany resisting more QE while “the people” (Spain, Italy and Greece) are revolting and pushing for more QE.

(Bloomberg) — European Central Bank governors representing the core of the euro-area economy resisted President Mario Draghi’s ultimately successful bid to restart quantitative easing, according to officials with knowledge of the matter.

The unprecedented revolt took place during a fractious meeting where Bank of France Governor Francois Villeroy de Galhau joined more traditional hawks including his Dutch colleague Klaas Knot and Bundesbank President Jens Weidmann in pressing against an immediate resumption of bond purchases, the people said. They spoke on condition of anonymity, because such discussions are confidential.

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Those three governors alone represent roughly half of the euro region as measured by economic output and population. Other dissenters included, but weren’t limited, to their colleagues from Austria and Estonia, as well as members on the ECB’s Executive Board including Sabine Lautenschlaeger and the markets chief, Benoit Coeure, the officials said.

Mario Draghi says the ECB will maintain a “highly accommodative stance of monetary policy.”

Such disagreement over a major monetary policy measure has never been seen during Draghi’s eight-year tenure. It casts a shadow over the resolve underpinning his parting stimulus shot before Christine Lagarde succeeds him, and also over his account of the proceedings. The extent of the rift might open the door to critics of the institution to question the legitimacy of its decisions.

Despite the disagreement, Draghi presented the decision to relaunch QE as having enough support to move forward. There was no vote on the matter, in line with typical ECB practice. Such a ballot would be a rare occurrence, but if one had taken place, under the Governing Council’s system of rotation to streamline decision-making, the French and Estonian governors would have been unable to cast a vote this month.

“There was more diversity of views on APP. But then, in the end, a consensus was so broad there was no need to take a vote. So the decision in the end showed a very broad consensus. As I said, there was no need to take a vote. There was such a clear majority.”
– Mario Draghi, Sept. 12 press conference in Frankfurt

One key argument wielded by policy makers opposed to Draghi’s resumption of QE was that it would be better to save it to use as a contingency in an emergency, such as an abrupt outcome to Brexit if the U.K. leaves the European Union without a transition deal, the officials said.

Spokesmen and spokeswomen for the Austrian, Dutch, Estonian, French and German central banks declined to comment on the ECB discussions. An ECB spokesman also declined to comment.

QE has previously proved contentious. Draghi encountered significant opposition in 2015, when he pushed the Governing Council to start bond purchases, against the wishes of his German, Dutch, Estonian and Austrian colleagues.

Draghi’s decision to press ahead without such key support risks leaving Lagarde with a headache when she starts in November. She will need to decide whether to persist in a policy that has divided her Governing Council, risking further acrimony. The alternative would be to dial back the ECB’s current stimulus commitments, an approach that could provoke a market backlash.

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That’s what she said.

Seriously, how much extra QE does Spain, Italy and Greece want?

ebcohno

Is it because their banking systems are still in the doldrums? Here is a sample of an Italian, Spanish and Greek bank.

The Reasonabilists? Negative-yielding Debt Exceeds $17 TRILLION With Japan And France Leading In Negative-yield Issuance (Danish 10-year Fixed Mortgage Rates At -0.5%!)

It has been over 100 years since The Federal Reserve System was created by Congress in December 1913 and then signed into law by President Woodrow Wilson. Since its creation, the purchasing power of the US dollar for consumers has gone from $3.32 in December 1913 to $0.13 today.

fedresyikes

Virtually even nation has a central bank and together they have helped push down sovereign yields into negative territory in the amount of > $17 TRILLION.

The global stock of negative-yielding debt is now in excess of $17 trillion as rising market volatility lends extra force to this year’s unprecedented bond rally.

negyielddevbt

Thirty percent of all investment-grade securities now bear sub-zero yields, meaning that investors who acquire the debt and hold it to maturity are guaranteed to make a loss. Yet buyers are still piling in, seeking to benefit from further increases in bond prices and favorable cross-currency hedging rates—or at least to avoid greater losses elsewhere.

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France is the leader in Europe at $2.3 trillion in negative-yielding sovereign debt. France’s 10-year sovereign debt bears a coupon of 0.50% at €109.004 and a yield of -0.408%.

france10y

Japan, of course, is the global leader in negative-yielding debt at $7.3 TRILLION.

Mortgage rates can be negative as well. Just ask the Danish bank Jyske Bank. Jyske is offering a 10-year fixed-rate mortgage (FRM) at … -0.5%. Finland’s Nordea Bank is offering a 20-year FRM in Denmark at … 0%.

But wait! Who on earth would buy negative interest rate mortgage bonds? PIMCO, that’s who!

But are negative mortgage rates reasonable? Or is Zorp the Surveyor approaching?

Zorp the surveyor.

Zorp

Beyond The Sea! Boston Fed’s Rosengren’s Plea To Not Cut Rates While Europe Slows (17 European Nations Have Negative 2Y Yields, 13 European Nations Have Negative 10Y Yields)

What a difference 10+ years make in financial markets.

Here is the US Treasury yield curve at the height of the housing bubble (2005) compared to today. Back on July 1, 2005, the yield curve was upward sloping whereas today the curve is inverted at tenors of 5 years or less, then upward sloping.

difference

At the ten year maturity, both Canada and the US are below 2% in terms of yield (Venezuela is at a whopping 55%!). Chile, in USD, is just about 2%.

america10

Beyond the sea (Atlantic), there are 13 nations will negative 10-year sovereign yields. Plus the European Financial Stability Facility is at -0.357%.

euro10

At the two-year maturity, Europe has 17 nations with negative yields. And tanking.

17euro

The Boston Fed’s Rosengren is arguing against further rate cuts from an effective Fed Funds rate of 2.1250% while the European Central Bank (ECB) target rate is … -0.40%. That is quite a spread!

fxarb

(Bloomberg) — Federal Reserve Bank of Boston President Eric Rosengren continued to push back against further interest-rate cuts by the central bank, arguing he’s not convinced that slowing trade and global growth will significantly dent the U.S. economy.

Meantime, President Donald Trump urged the Fed to cut by a full percentage point to aid U.S. and global growth while complaining the “dollar is so strong that it is sadly hurting other parts of the world”

The German government is getting ready to act to shore up Europe’s largest economy, preparing fiscal stimulus measures that could be triggered by a deep recession, according to two people with direct knowledge of the matter.

Rosengren’s point is that the US economy is still growing with low unemployment while Europe is grinding to a halt. Germany is at 0.40% YoY, Italy is at 0% YoY and France is at 1.30%. The US is at 2.3% YoY. This is, in part, Rosengren’s point.

While the US economy is humming along at 2.3% YoY growth, Treasury is considering issuing 50- and 100-year bonds. Both will have huge duration and convexity risk.

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So, economic slowdowns beyond the (Atlantic) sea may spill over to the US.

President Trump needs a Dream Lover to enact his rate cuts. Otherwise, markets will be splishy-splashy.