Global bond investors have found a new worry. 10 year interest rates in Spain, the world’s 12th largest economy, have risen alarmingly in recent weeks. As the chart shows, they are now above 7% (blue column) compared to 4% when the blog first focused on the Eurozone crisis (red).
7% is a critical level, as it marks the point at which countries can usually no longer support the burden of interest cost involved. During the current crisis, it has also marked the moment when countries such as Ireland and Portugal have had to receive a bail-out.
This is why the blog has continued to argue that there are sound reasons for the current record differentials between interest rates being paid by the PIIGS (Portugal, Ireland, Italy, Greece, Spain) and the JUUGS (Japan, UK, USA, Germany, Switzerland).
Interestingly, some major bond fund managers have recently begun to express similar views. Thus Jeffrey Rosenberg, chief fixed income investment strategist for Blackrock (who have $3.7tn under management), noted recently in respect of the low interest rates in the JUUGS:
“You’re not talking about a bubble because a bubble is about greed. That’s not a reflection of ‘I expect prices to go higher and I have to jump in,’ that’s a reflection of ‘I want to preserve my principal.’ Negative yields reflect fear.”
The blog’s Boom/Gloom Index (blue column) reaches its 3rd anniversary this month.
It was introduced to help monitor sentiment in financial markets, on the basis that “many markets are clearly being ruled by sentiment”. It has since done a good job in identifying peaks and troughs:
• Peaks have been focused on periods when central banks have rushed to provide liquidity via quantitative easing and other stimulus programmes
• Thus the Index was strong from June 2009-June 2010, and from September 2010-June 2011
• The main trough has been seen since August 2011. This highlights the key flaw in the central banks’ thinking
• Their Quantitative Easing and bank lending programmes wrongly assume that markets face liquidity problems, rather than solvency risks
The Austerity measure (red line) in the chart highlights this issue. It shows how governments are increasingly being forced to abandon stimulus programmes, due to lack of cash. Investors increasingly worry that countries such as the PIIGS (Portugal, Ireland, Italy, Greece, Spain) will never repay their debts.
Thus June sees a sharp jump in the Austerity reading, back to levels last seen in May/June 2010 when the Eurozone crisis first properly erupted. In turn, this has pushed the Index below its neutral 4.0 reading and back into Gloom territory.
This highlights how the stimulus policies have been able to create short-term economic growth and major asset bubbles (oil/commodities prices, China real estate etc). But they have not created the conditions for sustainable long-term expansion.
The blog’s series on the VUCA world today reaches C for Complexity.
Interest rates are key to company profitability. They determine rates of return for new investments, and their affordability. They also have a major influence on consumer spending patterns.
The debate over their future direction is just one example of current Complexity:
• Financial investors mostly argue that rates will go higher, perhaps much higher, in the major economies
• The world’s largest bond fund, PIMCO, even argued in January 2010 that UK bonds were sitting on a ‘bed of nitro-glycerine’
The blog has never agreed with this view.
It argues that the ageing Western population means investors now focus on return of capital. They also need to save more and spend less, as they are uncomfortably aware that their pensions are too small to fund their extra decade of life expectancy compared to previous generations.
It also coined the term JUUGS to describe the countries whose bonds would be perceived to provide the greatest safety – Japan, UK, USA, Germany and Switzerland. It has since followed their progress by comparison with the PIIGS (Portugal, Ireland, Italy, Greece, Spain).
The chart above shows 10-year interest rates today (blue column) in the PIIGS and JUUGS versus May 2010 (red):
• Average rates in the PIIGS were 5.8%, double the 2.7% in the JUUGS
• Today, they average 12% in the PIIGS, and just 1% in the JUUGS
• Rates have risen in all the PIIGS, whilst falling in all the JUUGS
The blog originally set out its argument in the Financial Times in September 2010. It was then developed further as chapter 2 of Boom, Gloom and the New Normal last June.
It argues that Japan is the role model for what is happening today. The JUUGS’ interest rates are only following the path taken there in recent decades. The reason for the correlation is that Japan’s own babyboomer generation are ~10 years older than in Western countries.
Of course, it could be that the blog has simply been lucky so far with the results of its argument. And it agrees rates could certainly jump if demand ever returned to Supercycle levels, as expected by the market consensus.
Thus the debate over interest rates highlights the Complexity of the financial world. Those whose judgement turns out to be wrong may well lose a large amount of money as a result.
On 7 September 2008, in its now famous warning that a financial crisis was imminent, the blog noted that “‘Deleveraging’ is an ugly word, and it has ugly implications“.
The chart above shows just how ugly these implications are becoming for the PIIGS countries (Portugal, Italy, Ireland, Greece, Spain).
It is based on data produced since 2009 by the Bank for International Settlements (the central bankers’ bank), and shows the major EU lending flows to the PIIGS. It includes data just published for December 2011:
• Lending to Italy (a G7 group member) has fallen 37%
• Lending to Spain (the world’s 12th largest economy) has fallen 40%*
• Lending to Greece (now in default) is down 54%
• Lending to Portugal is down 32%, and to Ireland down 41%
Major countries simply cannot continue to operate ‘as normal’ when these vast sums of money are being withdrawn from their banking systems:
• Italy has lost $352bn, equal to 32% of its GDP
• Spain has lost $$313bn, 21% of GDP
• Greece has lost $99bn, 33% of GDP
• Portugal has lost $75bn, 32%: Ireland has lost $203bn, 93%
Overall, $1.04tn has been withdrawn, a 39% reduction since December 2009. This is equal to 23% of the PIIGS’ combined GDP.
These numbers, of course, explain why the European Central Bank (ECB) made its emergency €1tn ($1.4tn) loans at the end of December. It says it was seriously concerned “a dangerous loop involving low economic activity, funding stress for banks and a reduction in lending” might occur. This is central bank-speak for saying that the European banking system might well have collapsed.
But the ECB’s lending under the Long Term Refinancing Obligation was just that, lending. It dealt with the immediate cash-flow problem in December. But it did not deal with the solvency issue. Many of these loans will never be repaid, as the assets behind them are now worthless.
* Netherlands lending to Spain is estimated in line with June 2011 levels, as the data is not yet available
Some things are too ‘obvious’ for highly-paid professionals in the financial world to accept. If life was this simple, then clients might ask why their fees were so high. Therefore they maintain a fiction that what is obvious is not the full story.
Interest rates are a classic example of a simple issue which is over-complicated by the professionals. They really depend on just one factor:
• Do I trust you to repay the money?
If the answer is ‘no’, then I won’t lend the money. This is what happened to Greece, and now threatens the other PIIGS (Portugal, Ireland, Italy, Greece, Spain). As the chart shows, their interest rates have risen sharply since May 2010, when the blog began warning of the crisis ahead.
Spain’s new prime minister summed up the issue this week, when he warned:
“Spain is facing an economic situation of extreme difficulty, I repeat, of extreme difficulty, and anyone who doesn’t understand that is fooling themselves.”
Spain is the 12th largest economy in the world. Its $1.4tn GDP is larger than S Korea’s ($1tn), and similar to India’s ($1.6tn). If it is in “extreme difficulty”, then any investor is going to become even more concerned about return of capital, rather than return on capital.
Investing with the JUUGS (Japan, UK, USA, Germany, Switzerland) thus becomes an even simpler decision. As the chart also shows, their interest rates continue to fall, as more and more savers seek safety.
It really is that simple.
Interest rates are key to the direction of the global economy.
But not in the way that was true during the 1982-2007 economic SuperCycle. Then, there was a global surplus of savings, due to the vast numbers of people in the Wealth Creating 25 – 54 age group.
So interest rates reduced dramatically in most countries, with the USA leading the way. Its 10 year government bond rates reduced from 15% in 1982 to just 5% by 2007.
Today’s market is increasingly dominated by the New Old generation of people aged 55+. As one would expect, older people are more concerned about security rather than growth. They value ‘return of capital’ more than ‘return on capital.
Thus a new UK investor survey reports that “protecting the value of existing assets” was the main priority. In turn, this means that investors are very nervous about markets where governments are borrowing too much, and have no plan to repay their debts.
This is why investors now prefer the JUUGS (Japan, USA, UK, Germany, Switzerland) to the PIIGS (Portugal, Ireland, Italy, Greece, Spain). The chart above updates the position since the blog first launched the concept (today’s interest rates = red line; August 2011 = blue column) :
• In August 2010, rates in the PIIGS averaged 5.9%: now they are 14.5%
• Rates in the JUUGS were 2.05%, now they are 1.5%
These demographically-driven changes have confused even the world’s largest bond investors, PIMCO, who suffered a rare year of major under-performance in 2011. They worried (rightly, of course) about the rising level of debt in some of the JUUGS – but failed for a while to realise this was not investors’ primary concern.
The key question at the start of 2012 is what happens next in the Eurozone. As the chart shows, Greece’s interest rate has gone ‘off the chart’ at 38%. And now, the real threat is contagion to Germany. As the Financial Times warns:
“If the euro stays together, it will only be because Germany pays, one way or another – hurting their bonds. If the euro breaks down…German finances would be trashed by the need to rescue its banks”.
Nobody knows how this very serious situation may play out.
We can all hope for good sense and wise policy to prevail. But hope is not a strategy, and can easily turn into wishful thinking. The blog will continue to keep a very close eye on developments.