The article below, “Bonds and Banks” by Alasdair Macleod, is rare in these hyperbolic times. It provides a reasoned basis for the position that financial assets are grossly overvalued and that a major correction (collapse) is coming.
Broken clocks are correct twice a day. Doomsayers holding to their views are bound to be right eventually, sometimes even within their own lifetimes. Mr. Macleod is neither and provides a reasoned analysis.
Debt, not surprisingly, is expected to be the trigger for the correction in one way or another.
The Debt Issue
The world is awash in debt. Governments in most developed countries have taken on funded and unfunded (social promises) debt that has no hope of being honored. The amounts are beyond levels that are comprehensible. The laws of mathematics rather than the laws of economics are now in control. All governments are insolvent and hopelessly so. All are engaged in a fraud best described as a Ponzi Scheme. All are now in that narrowing and more rapidly moving spiral known as the debt death spiral, described in several articles on this site.
Governments are not the only skater on thin ice. In an effort to disguise economic weakness, government encouraged and enabled other economic entities within their domain to do the same. Banks overleveraged knowing they have the blessing and backing of the printing press known as the central bank. Individuals were encouraged to borrow more as a result of lowered credit standards and interest rates. ZIRP (zero interest rate policy) drives interest rates near zero for quality credit borrowers. Corporations took advantage of this “free” money to alter their capital structure — adding debt while buying back common stock. This act boosts reported earnings per share, making the companies appear to be doing better as a result of financial gimmickry.
The result of this debt enticement is that virtually every economic entity is over-leveraged. Government, banks, consumers and some corporations are borrowed out. Much of this occurred since 2000 as the Fed became more involved in “managing the economy.” The attempt to encourage every decision-making entity to spend beyond what was prudent characterized their “management efforts.” Those who took advantage of this false largess felt richer for the last twenty years. Now they are going to feel poorer.
Those whose jobs were destroyed by this misguided policy and whose lives were forever altered have already felt the pain. Those who believed they were doing well are the ones who are about to be hurt. They will feel poorer as they are forced to spend less than their income in order to service the excess debt they took on. Investors who believe they are geniuses because they stayed in the stock market are likely to get a very rude awakening.
Jim Rogers has a particularly pessimistic view, believing that the can that has been kicked for so long has run out of road:
I would suspect when we have this correction, it’s going to cause central banks to panic. There’s going to come a time when there is not much the central banks can do when they have lost all credibility. When governments have lost all credibility. They will print and spend and borrow, but there comes a time when people are just going to say We don’t want to play this game anymore. And at that point, the world has serious, serious problems because there’s nothing to rescue us.
Undoubtedly when the market epiphany occurs, the Fed will intervene on a scale never before seen or imagined. That will solve nothing! Central banks and governments have perpetrated this fraud.They will make one last, desperate attempt to prevent the inevitable correction. In doing so, they will be unable to save the market and may put the very foundations of society at risk.
The debt bubble is now so large that the slightest prick will burst it. Many look to Greece as the catalyst. A more reasonable, although not more comforting position, is that we will not see the precipitating factor coming. It is likely to be something small and off the radar (think Thai baht). In retrospect we will understand and rationalize causality.
Mr. Macleod in his article focuses on a narrow aspect of the problem — banks. It is narrow but not unimportant. A focus on interest rate derivatives, estimated at over 500 Trillion dollars (the size of world economies is only 75 Trillion) could produce a scarier narrative. So too could the focus on bankrupt governments heading for default and civil unrest. Instead, Macleod concentrates on a (relatively) smaller and more understandable problem — the banks. He lays out the transmission mechanism that is likely to produce the negative outcome. (The emboldening was not in the original article.)
An article by GoldMoney’s Head of Research, Alasdair Macleod
This year has seen some big losses develop in the bond markets, though prices have stabilised in recent days. The chart above is of the yield on the lowest investment risk in ten year maturities. Most other 10-year bonds have seen even sharper rises in yield (i.e. greater price falls). This matters because the banking system is heavily invested in sovereign bonds, not only in the short end of the market where it traditionally invests its liquidity, but also in longer maturities between five and ten years. Furthermore, central banks have become exposed to the same risk through their bond purchases with implications for currency stability, but that is a separate issue.
The primary reason for today’s excessive duration mismatch between short-term deposits and bonds of longer maturities is zero interest rates. Banks simply cannot make reasonable returns by buying shorter maturities, and they are encouraged by banking regulations to pick up a little more yield by buying longer-dated government bonds instead of lending money to customers who are categorised as riskier. The result is banks have suffered substantial losses in recent months, most of which have been in the current quarter.
The table below summarises the losses seen in the larger sovereign bond markets at the worst point last week, and it is noticeable how badly Eurozone government bonds were hit.
This is a separate but related issue from Greece, which is worrying enough in its own right, because the write-offs at the ECB from a Greek default will exceed the ECB’s shareholders’ capital.
It is worth bearing in mind that Eurozone banks are closely tied in with their national governments, and are expected to take the lead in funding them. Furthermore, Basel Committee regulations make this easier by treating sovereign bonds as preferred investments. So imagine the losses faced by the average Italian or Spanish bank, when their national bonds fell by these amounts in the space of six weeks, particularly when their bond holdings exceed their tangible shareholders’ funds by a multiple factor. Even German banks were badly hit, not to mention the French and Eurozone banks in other countries not listed in the table. Unless the current recovery in bond prices holds by the end of this month, these banks could be forced to record systemically destabilising losses at the quarter end.
This is not all. The general assumption has been that in the absence of price inflation central banks are in control of bond markets, so these losses were not meant to happen. Instead it is becoming apparent they have become trapped by their own monetary policies, with no remedial action that will not destabilise markets. Furthermore, as I pointed out recently, with inflation being under-recorded in official statistics bond prices were and still are far too high, so further falls can be expected.
The markets are telling us that the bond bubble may be in the early stages of imploding. We can take the general media silence on this issue as evidence that investors were caught unaware, but central banks should be alert to the dangers. Recent talk about normalising interest rates has been inspired by a need to control valuation excesses, which should now be replaced by attempts to prop up bond prices; so talk of the Fed raising interest rates should now fade. And while Chairman Yellen in yesterday’s FOMC* statement could not admit this, she effectively confirmed it by sitting firmly on the fence.
History tells us two related facts. Central banks are always defeated by markets in the end, and central bankers have a touching faith that next time they will retain control over markets. But if we accept the lessons of history, we must dismiss complacency over systemic risk to the financial system. We can go even further, and begin to expect that of all the risks that will eventually trigger a widely expected financial crisis, it will be an old-fashioned bear market in bonds.
*Federal Open Market Committee
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