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.

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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.

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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.

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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.

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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 , 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 is described by a parameter . SABR is a dynamic model in which both and are represented by stochastic state variables whose time evolution is given by the following system of stochastic differential equations:

with the prescribed time zero (currently observed) values and . Here, and are two correlated Wiener processes with correlation coefficient :

The constant parameters satisfy the conditions . is a volatility-like parameter for the volatility. is the instantaneous correlation between the underlying and its volatility. thus controls the height of the ATM implied volatility level. The correlation controls the slope of the implied skew and controls its curvature.

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

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

for some positive shift . 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:

for and a free boundary condition for . 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.

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What I Like About Central Banks … NOT! Global Central Banks Pushing Interest Rates Lower Towards Negative Territory

The CFR Global Monetary Policy Tracker is updated through September 1. The Index of Global Easing(-)/Tightening(+) holds steady at -6.68, significant easing, as markets anticipate a further Fed rate cut this month.

Easing monetary policy are Brazil, Chile, Peru and Colombia in South America, the European Central Bank, Australia, China, Turkey, Poland and Finland. Tightening? Pakistan, Sweden, the UK and Canada.

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Almost 80% of negative yielding debt is held by global central banks.

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So, what I like about Central Banks?? Nothing, as they continue their nosedive into negative interest rate territory.

Or as Borat said, … NOT!

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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.

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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.

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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%.

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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.

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Shakin’ All Over! German Yield Curve Completely Negative Yield As Germany Issues €869M Zero-coupon Bonds At -0.11% (Tried To Sell €2B)

Things are getting crazy in Europe, particularly in Germany and Denmark,

As Brexit approaches, Germany is desperately trying to save their economy (or at least their banking system) by borrowing at negative rates for 30-years.

The German government sold 869 million euros of 30-year bonds with a negative yield, for the first time ever, adding to the world’s growing $15 trillion in existing negative yielding debt.

The bund, set to mature in 2050, has a zero coupon, meaning it pays no interest. Germany offered 2 billion euros worth of 30-year bunds, and investors were willing to buy less than half of it, with a yield of minus 0.11%.

Here are the German sovereign yield curve (blue) and the Danish sovereign curve (green).

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Of course, the US Treasury curve has the same “bucket” shape as Germany and Denmark (as well as numerous other nations).

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The US Treasury 10Y-3M curve slope is now -40 BPS.

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While not totally submerged, Sweden, France and the UK all have the bucket shape.

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Just so we understand, it’s not just Europe that is slowing. China is slowing too (and before the tariff war).

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Sovereign yield curves are Shakin’ all over.

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.

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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%.

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

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

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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!

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(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.

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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.