Sunday, February 7, 2016

Why Are Spreads Widening?

Once I rose above the noise and confusion
Just to get a glimpse beyond the illusion

Why are bank credit spreads blowing out? Unlike 2008, when the causes of widening spreads were a mile wide and easy to see (i.e., mortgage-related derivatives), this time around I'm having trouble pinpointing the cause.

One theory surrounds plummeting oil prices and the strain this places on junk-rated oil and gas operators (and their leveraged bank creditors). While certainly contributing to domestic bank woes, this theory does not satisfactorily explain the global nature of the credit spread wides.

Instead, I'm pondering a theory surrounding the growing implementation and impact of negative interest rates (NIRP), a central bank policy that once again caught limelight recently when the Bank of Japan suddenly went negative.

Essentially, NIRP imposes a tax on creditors and depositors. Depositors must pay banks for the privilege of placing their funds with the institution. All else equal, this will motivate depositors to deposit less or, worse yet, pull their deposits. No big deal perhaps when banks were simply money storage facilities. But today, banks are leveraged investment machines that pyramid deposits 10:1 or more. Can you say 'bank run?'

John Succo adds that NIRP also imposes costs on carry traders. In 'normal' times reducing interests from, say, 1% to zero, traders would borrow the low interest rate currency and sell it to finance investments in other countries. Selling the low interest rate currency causes it to weaken while pushing higher the currencies of countries receiving carry trade investments.

In a NIRP world, however, borrowers must pay a fee to hold proceeds on deposit, thereby reducing incentive to put on carry trades. Moreover, NIRP currencies are less likely to devalue when carry traders don't/can't sell them. Policymakers hoping that NIRP will cause currencies to devalue in beggar-thy-neighbor fashion are likely to have their hopes dashed.

As the world awakens to these NIRP realities, perhaps that is why bank credit spreads are blowing out.

Perhaps that is also why gold is on the move.

position in SPX, gold

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