The European Central Bank (ECB) finally caught the quantitative easing (QE) bug. I never would have guessed it. It is actually pretty amazing to imagine Germany, in all of its anti-inflation zeal, involved in a program that monetizes debt without sterilization. There’s even a bit of mutualization of debt – though not a lot, considering that the EU is supposed to be a union. The imperfections of the program aside, we’ve been though QE before. Obviously the US lead the way, Japan followed and now Europe joins. What can we expect from it and what impact will it have on marketplace lending markets?
The truth is we do not know the long-term impact of QE – it just hasn’t been long enough to judge. We do know that unlimited balance sheets buying potentially unlimited amounts of sovereign debt impact investor behavior. I think many investors are going to begin to look at fixed-income markets as hopeless and a waste of investment dollars, if they haven’t already. I don’t say this lightly, as someone who has spent his entire professional career as a fixed-income investor. I say it because it is simple math.
Last year, long-duration bonds had stellar returns. Investors either forgot or do not know that most bonds have a multiplier called ‘duration.’ If a 30yr Treasury falls in yield by 100 basis points, or 1%, an investor would get around a 20% return on their bond. Last year, 30-year interest rates fell from 3.92% to 2.75% in the US – leading to a very exciting return from a “low-yielding” security. As I write this piece today, 30-year US rates are 2.37%, and 30-year rates in Germany are 1.07%. How much more can these rates fall? The Fed is done (for now) buying US Treasuries, but the Bank of Japan (BOJ) and ECB are effectively going to be buying everything that exists in their markets for the foreseeable future. Rates can and will fall further, but at some point not far from here the central banks will be the only buyers – private investors, at some yield level not far from here, will correctly choose to move on.
I’d say that a US 30yr rate much below 1.75% would be a trigger point where there just isn’t enough upside left to justify the risk. So what will investors buy? The first beneficiary will the equity markets, especially equity markets in stronger economies like the US. Now, I’d point out (and will write a piece about) the fact that bonds and stocks have been positively correlated, meaning that if rates do start to move higher equities might in fact go down in price. What else will investors look at?
Alternative investments continue to gather new investors, whether that means hedge funds, private equity or marketplace lending. The ECB’s move will accelerate this as traditional fixed-income investors flee. The problem is, this causes other distortions. New investors in non-liquid markets tend to seek higher yielding and low quality assets. On one hand, central banks don’t mind this since it opens up credit markets to new players. On the other hand, these illiquid markets always end up mispricing risk when capital flows too freely, which leads to financial accidents.
What lessons can we learn from all this in marketplace lending? The money is going to continue to flow into our space. Where else can you earn high single-digit returns (unlevered) on less than 2-year duration assets? To add fuel to the fire, lower energy prices are about to push low consumer default rates even lower.
It all seems easy, doesn’t it? It won’t be. The ECB is the last bank to act. Rates are already low and markets are wary that the move is too little, too late. That said, the first order impact will be just as we wrote – a wall of money looking for a new home. We must remain vigilant, as the ECB would say, because once this money settles in, we will have to face the fact that trillions of dollars of central bank buying didn’t solve our problems.
At Blue Elephant, we see a downside to all of the easy money that will play out later this year. We are on record saying 2015 will be the year that puts the focus on the “fin” in “fintech.” Despite what I wrote here, we remain our up-in-quality investment book and continue to look for ways to diversify so that we can survive the bumps that are coming. Invest accordingly.