Interest rate and US$ surge mark start of the Great Reckoning

Right direction Nov16

The bond market vigilantes are back.  And they clearly don’t like what they are seeing.  That is the clear message from the charts above, showing movements in 10 year government bond interest rates for the major economies, plus their exchange rate against the US$ and the value of the US$ Index:

  As I warned in the Financial Times in August, You’ve seen the Great Unwinding; get ready for the Great Reckoning
  The financial world has completely changed since the Brexit vote in June, and then Donald Trump’s election
  The Brexit vote saw rates begin to surge and the US$ to rise; these moves have accelerated since Trump’s win
  Since the Brexit vote, US rates have risen by more than a half from 1.4% to 2.3%
  UK rates have trebled from 0.5% to 1.5%
  Chinese rates have risen by more than a tenth from 2.6% to 2.9%; Japanese rates have risen from -0.3% to zero
  German rates have risen from -0.2% to a positive 0.3%; Italian rates have doubled from 1% to 2%

At the same time, the value of the US$ has been surging against all these currencies, as the black line in each chart confirms.  And the value of the US$ Index against the world’s major currencies has risen by 8% to $101.

These are quite extraordinary moves, and it is most unlikely they will be quickly reversed.  They mark the start of the Great Reckoning for the failure of the stimulus packages introduced on an ever-larger scale over the past 15 years.

Now investors are going to find out the hard way that return on capital is not the same as return of capital, due to the return of the bond market vigilantes.  As James Carville, an adviser to President Bill Clinton once warned:

I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.

The key issue is that the demographic dividend of the BabyBoomer-led SuperCycle is now creating a demand deficit.  The 50% rise in global life expectancy since 1950, combined with the 50% decline in fertility rates, means that we have effectively traded 10 years of increased life expectancy for economic growth.  That’s not a bad trade, and I have yet to meet anyone who would volunteer to die early, in order to allow growth to return.

The problem is that in recent years, policymakers have chosen to ignore these demographic realities.  They have instead assumed they can always create growth via stimulus programmes based on ever-increasing amounts of debt.

Today, we therefore now face the problem of high debt ($199tn according to McKinsey. and 3x global GDP, last year), and no growth.  So as I warned in January (“World faces wave of epic debt defaults” – central bank veteran), investors are now beginning to realise all this debt can never be repaid.

These developments also highlight how central banks are now starting to lose control of interest rates.  Instead, markets are beginning to rediscover their real role of price discovery based on supply/demand fundamentals.  They are no longer being overwhelmed by central bank liquidity:

   The interest rate rises will have major impact on individuals and companies, as prices realign with fundamentals
   A rising dollar is also deflationary for the global economy, as it further reduces growth levels outside the USA
   In addition, it is bad news for anyone who borrowed in dollars, thinking they would benefit from a lower interest rate from that available in their own country, as their capital repayments increase

As I warned last month in Budgeting for the Great Reckoning:

“The problem, of course, is that it will take years to undo the damage that has been done. Stimulus policies have created highly dangerous bubbles in many financial markets, which may well burst before too long. They have also meant it is most unlikely that governments will be able to keep their pension promises, as I warned a year ago. .

“It is still possible to hope that “something may turn up” to support “business as usual” Budgets. But hope is not a strategy. Today’s economic problems are already creating political and social unrest. And unfortunately, the outlook for 2017 – 2019 is that the economic, political and social landscape will become ever more uncertain.

“I always prefer to be optimistic. But I fear that this is one of those occasions when it is better to plan for the worst, even whilst hoping that it might not happen. Those who took this advice in October 2007, when I suggested Budgeting for a Downturn, will not need reminding of its potential value.”

Great Unwinding creates Great Divergence in financial markets

Index Dec15

Most traders prefer to be with the crowd – then, at least, they can’t be personally blamed if things go wrong.  Instead, they can claim that “nobody could have seen the change coming”.  So as we approach year-end, many traders are becoming very nervous as the Great Unwinding of policymaker stimulus means that markets start to go their own way:

  • As I discussed on Monday, US 10-year interest rates have seen a major increase, even though the US Federal Reserve has kept short-term rates at zero
  • Even worse, German interest rates have continued to fall as the European Central Bank keeps buying: the 10-year yield is just 0.48% and the 5-year yield actually negative

The same worrying pattern can be seen within the US S&P 500 itself – the world’s major stock market index:

  • It is only up around 1% on the year, but the FANG tech stocks are living in their own bubble
  • Facebook, Amazon, Netflix and Google are up around 60% as a group

This divergence is very typical at the end of a major market move.  Momentum wanes, and trading becomes concentrated in just a few areas.  Traders rush to be part of the remaining action, creating a bandwagon effect on prices. In the end, of course, the bubble can often then burst with a bang.  Shanghai provided a spectacular example in the summer, when it fell 45% between mid-June and late August.

What happens if a Shanghai collapse happens in the West next year?  As we all know, the Chinese government rushed to protect their market, just as Western governments rushed to protect markets in 2008.  Would they, could they, do this again?  This is the question explored in an excellent Financial Times analysis by John Dizard last week:

We now have a bit over 14 months until a new US president and Congress are sworn in. Until then, the national policymaking process will not be functioning. If a decision on financial laws or regulations has not been made yet, it will be on hold until early 2017….That means that you will have to come up with your own contingency plans for rescue from systemic risk…This is why those better-informed or better-connected large institutions are setting up credit lines and access to collateral in advance. Unless you move relatively soon, rather than wait for actual trouble to develop, that is credit and collateral that you will not get.

“I am quite confident the banks will stay open. What about your portfolios? Will they be open?”

The uncertainty means that even major companies are showing signs of strain.  US banks have had to postpone the planned $5.5bn sale of debt to back Carlyle’s leveraged buyout of Veritas from Symantec. And giant telecoms company Vodafone was forced to withdraw a planned 30-year bond issue.  Nobody is suggesting Vodafone is going bust – but their problem in raising cash from the market is a warning sign of potential problems ahead.

It is not difficult to make the case that a false market has been created in the S&P 500: 

  • 70% of all US trading is now being done by the high frequency traders, and these modern-day highwaymen have no interest in providing liquidity if markets do start to close down
  • Equally worrying is that earnings have been been supported by record levels of share buybacks, usually aimed at boosting the value of CEO’s share options
  • The Wall Street Journal says buybacks are “up more than 80% from a decade ago“, whilst Marketwatch has reported:

“The sums involved are staggering. In 2014, S&P 500 companies bought back $553bn in shares, in addition to paying shareholders $350bn in dividends. Total returns to shareholders equalled $904bn, a bit shy of reported earnings of $909bn.”

The chart of the Boom/Gloom Index above confirms that market confidence has dropped sharply since the beginning of the year – it is currently almost half its January peak.  And there are clearly headwinds for earnings and buybacks:

  • Earnings are already being hit by the strength of the US$
  • Buybacks have often been financed by borrowing, which is more expensive at today’s interest rates

What we know is that the first 3 phases of the Great Unwinding are now underway:  the fall in the oil price, the rise of the US$, and the rise in US 10-year interest rates.  Only the 4th is still to come – the bursting of the S&P 500 stock market bubble.  And as I will discuss on Friday, political risk is rising at the same time.  It could be a difficult 2016.