Now that the effects of 3-D and IMAX have worn off, I shared what is becoming a tradition: An interview with Rick Santelli. In the past, Rick has asked me for some of my predictions for the coming year. As a market participant who holds the power of market forces in high esteem and disdains models as all-knowing, it is difficult to find narrow based foreseen outcomes. Last December, Rick and I discussed the Swiss National Bank making some move prior to the January 22 ECB meeting. The SNB did make a move on January 15 but I was certainly not prescient enough to call for a 40 percent overnight move in the EUR/CHF cross. (Though I did warn blog readers that the SNB’s failure to levitate the EUR/CHF cross off the 1.20 floor with massive amounts of euro buying was a cause for concern, so readers of NOTES were not caught short Swiss Francs and certain readers were long the Swiss cross.)
This year’s interview did not include any predictions but I did comment today that a flattening of the yield curves in 2016 may lead to all hell breaking loose. WHAT DID I MEAN BY THIS? Grab a glass of scotch or Chuckie B., or some medicinal California and think about what I am going to say. (And, to paraphrase Danny Devito in the War of the Roses, when a person who charges $5,000 an hour offers free advice you might want to listen [humor intended].) In July 2012–the 24th to be exact–the U.S. 2/10 curve was flattening when it appeared that Europe was in a deep crisis. The two-year yields on EU sovereign debt were rapidly rising as the market feared about the viability of the EU and the EURO currency.
The European 2/10 curves were also flattening and when ECB President Mario Draghi issued his famous, NO TABOOS AND WE WILL DO WHATEVER IT TAKES to preserve the EU and the euro, the two-year yields began dropping and the 2/10 curves reversed course and began to steepen. The July 24 low was 117.25 positive slope. This was also the low made in January 2015 when the ECB and the SNB were busy revealing their plans about the EUR/CHF peg and the ECB‘s new QE policy (again, 117.25). As the year comes to an end, the flattening of the U.S. 2/10 curve continues and today we made an intraday low of 119.80. Now I will warn again that because of the lack of liquidity the last few weeks of the year prices can be easily manipulated and/or distorted.
BUT IF THE MARKETS RESUME FLATTENING IN RESPONSE TO GLOBAL ECONOMIC WEAKNESS AMID CHINESE SLOWING OR SOME GEO-POLITICAL EVENT ALL HELL WILL BREAK LOOSE. WHY? Last time the yield curves dramatically flattened in 2007 or 2012 in Europe the central banks, like John Mayall, HAD ROOM TO MOVE. When the U.S. curve inverted in early 2007, the FED FUNDS rate was at 5.25% so the FED could swiftly cut rates in response to an incipient crisis. In Europe,the yields on the two-year notes of the so-called PIIGS were more than 7.0% and thus a dramatic drop in rates could be a positive signal to the markets.
WITH INTEREST RATES AT ZERO IN ALL THE DEVELOPED ECONOMIES WHAT WILL THE KEY POLICY MAKERS DO? A FLATTENING CURVE AT THIS JUNCTURE WOULD PUSH THE FED INTO NEW TERRITORY AND PUT FEAR INTO THE MARKETS. Thus, “ALL HELL WILL BREAK LOOSE” is an inference that the flattening of the curve at the zero bound will signal that the central banks have lost “control.” Will it be on the first close below 117.25? Most probably not but it is certainly an area for investors and traders to be very aware of. That was my point and it needed explanation beyond the alloted time of the Santelli spot. I await any questions or responses.