What’s behind the Pope’s statement on derivatives?

On the latest edition of Market Week in Review, Chief Investment Strategist Erik Ristuben and Sam Templeton, manager, global communications, discussed the rise in the 10-year U.S. Treasury yield, the impact of geopolitical issues on markets, and the Vatican’s recent statement on derivatives.

10-year U.S. Treasury yield reaches milestone

The yield on the 10-year U.S. Treasury note surged to 3.1% on May 17, Ristuben said, breaking through the 3% barrier—and subsequently holding above it—for the first time this year. Over the past year and a half, yields have moved up fairly significantly, from the market cycle low of roughly 1.4%, Ristuben said—largely due to anticipated higher rates of inflation. Does this mean yields could climb even further, perhaps into the 4 or 5% range?

“At Russell Investments, we don’t think so,” he stated—“because there are feedback loops in place that will likely limit how high yields can go.” For example, Ristuben said, in conjunction with the drop in Treasury prices, the U.S. dollar strengthened roughly 1% the week of May 14, per the U.S. Dollar Index. “A stronger dollar typically means a slower growth rate and weaker corporate earnings—in other words, not great news for equities,” he explained. As proof, Ristuben noted that the S&P 500® Index sold off roughly 0.5% on May 15 as the 10-year Treasury yield rose above 3%. “It’s very important to note that this sell-off came in the face of what’s been spectacular—and I mean spectacular—first quarter earnings,” Ristuben said, emphasizing that in his opinion, negative feedback loops like this will prevent the yield on the 10-year Treasury note from getting too high.

U.S.-China trade talks continue

Turning his focus to geopolitical events, Ristuben said that in general, these types of issues affect markets on a transitory basis. Zooming in on the ongoing trade talks between the U.S. and China in particular, he stated that in his opinion, the discussions appear to be more about negotiations. “There’s been no strong sign yet to indicate the talks will lead to a trade war,” he said.

Ristuben pointed out that over the past decade, there’s been a slew of geopolitical events, most of which have not ultimately affected financial markets. “Initially, these issues can cause jitters in the marketplace, and command the attention of investors—but in the long run, they tend to not have a lasting impact,” he said.

Pope rails against credit default swaps

In a statement released May 17, the Vatican issued a scathing rebuke on derivatives, focusing on credit default swaps in particular. “Pope Francis referred to them as ticking time bombs,” Ristuben noted—“and that’s led many to wonder if another global financial crisis could be in the works.”

In Ristuben’s opinion, this is unlikely to be the case. He explained that the credit default swap market is dramatically smaller today than it was 10 years ago—chiefly because U.S. banks are currently very well capitalized. “Since the Great Recession, the U.S. Federal Reserve has pumped trillions of dollars into the banking system—so while you could try, potentially, to use credit default swaps to get people concerned about bank insolvency, I don’t think it would work,” he said.

Ultimately, in Ristuben’s opinion, the pope has a point about the role that credit default swaps played during the global financial crisis—but Ristuben believes that the crisis was mainly caused by an undercapitalized banking system. “I don’t see such a system existing in the U.S. this time around—maybe in the future, but not right now,” he concluded.

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