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.”
The 3 month trend of Brent oil price volatility has reached its highest level since the 2008 financial crisis and before that, the 1st Gulf War in 1990/91. As the chart shows, it is even higher than after 9/11.
Yet there have been no developments in oil markets themselves to justify such a level. There has been no invasion of a major oil-producing state, or major disruption of supplies. On the contrary, this month’s International Energy Agency’s report comments:
“Commercial inventories in the OECD increased from March levels by 14.4 mb to stand at 3 065 mb by end-April, an impressive 222 mb above one year earlier. As the US driving season kicks off, OECD gasoline stocks stand above average levels and last year in absolute and days of forward demand terms. There is a similar picture in China”.
The volatility has instead occurred as a result of renewed conflict between the fundamentals of supply and demand, and developments in financial markets.
Money managers have piled into the oil futures markets since January, gambling on the arrival of further stimulus from the Bank of Japan and the European Central Bank. They also assumed correctly that the US Federal Reserve and Bank of England would back off the idea of interest rate rises.
We have therefore seen a repeat of last year’s January – May rally which saw prices rise by 50%, from $45/bbl to $70/bbl. The current rally has produced a more extreme result (from a lower base price), with Brent prices doubling from $27/bbl to $53/bbl. It has had equally flimsy foundations in terms of the fundamentals of supply and demand:
- The January 2015 rally was built on the myth that a decline in US oil rig count would impact supply. This ignored the major productivity improvements taking place as drilling switched from vertical to rotary rigs
- The narrative supporting the 2016 rally is based on an even more improbable myth – firstly, that an OPEC/Russia production freeze would occur and secondly, that the oil markets are now likely to quickly rebalance
Yet in reality, any production freeze would merely maintain current over-supply. As the IEA add:
“In any event, following three consecutive years of stock build at an average rate close to 1 mb/d there is an enormous inventory overhang to clear. This is likely to dampen prospects of a significant increase in oil prices.”
And, of course, the rally itself has proved counter-productive in terms of oil market rebalancing, as it has enabled US and other producers to hedge forward their production at acceptable margins through H2.
The real cause of the rally, and of the increased volatility, has been the US Federal Reserve’s backtracking on its promised 4 interest rate rises during 2016. Once these became doubtful, financial players began to sell the US$ and buy commodities as a supposed “store of value” – a repeat of what happened between 2009 – 2014. Now, of course, the reverse is happening as Brexit worries prompt traders to rush back into the US$ as a “safe haven”.
This volatility is good news for traders, but very bad news for anyone who actually uses oil and its derivatives:
- Oil demand was already likely to weaken over the summer months as China closes major parts of its industry in the Shanghai/Hangzhou/Ningbo region to provide blue skies for September’s G20 Summit
- There is also growing evidence that China’s own oil demand growth this year has not been based on domestic needs. As I noted back in March, China has become a net exporter of key products such as diesel, as it maintains refinery runs despite its lower growth in order to boost employment. In addition, it has been filling its strategic oil reserves at a greatly increased rate. As Reuters reported yesterday:
“China’s strong gain in crude oil imports isn’t a reflection of higher demand, in fact it’s likely that actual growth in consumption of oil products in China is non-existent.”
In turn, of course, China’s export drive is reducing margins for other Asian refiners. They were already struggling to find alternate markets for their exports as China becomes more self-sufficient. Now they are also having to compete with China’s own exports in 3rd party markets.
The key issue is that the current oil price rally has once again overturned the fundamentals of supply and demand. By thus adding to existing energy surpluses, it has increased the risk of long-term price deflation emerging. Supply has risen far more than demand all along the energy market value chains.
It also adds to worries that the fundamental assumptions behind the $3tn of energy market debt – $100/bbl oil and double-digit growth in China – are looking increasingly implausible. When financial markets wake up to this unpleasant fact, even more volatility could result.
It could be a very difficult H2 indeed.
Greece, Iran, China – suddenly real world issues are starting to dominate the headlines. And few people now believe that printing more money is the way to solve these issues. Instead, political leaders are being forced to take the hard decisions they have ducked for so long.
Financial markets are clearly reflecting the change. They are starting to make the long journey back to being based on the fundamentals of supply and demand. Of course, there are no guarantees that the right response will be made at each critical decision-point. Or, indeed, that each decision-point will be recognised when it occurs. As my co-author John Richardson has wisely commented:
“Quite often, it could thus be a case of “one step forward and two steps back”
Phase 1 of this Great Unwinding process began nearly a year ago when oil prices began to fall, and the US$ Index to reverse a 30-year downtrend against other major currencies. As the chart above shows:
- Oil prices have fallen 45% since then, and are now resuming their fall as the recent rally ends (blue line)
- The US$ Index has risen 18%, a quite extraordinary move for the world’s reserve currency (red)
- More recently, Phase 2 of the Unwinding has seen US 10 year interest rates up nearly 0.50% since May (green)
- It also seems likely that the US S&P 500 Index peaked in May, since when it has fallen a modest 2% (black)
In years to come, money managers will wonder how they managed to become obsessed with guessing games about the behaviour of the central banks, and lose sight of developments in the real world. They will also be amazed at the willingness of many traders to blindly follow the latest trend. And they will be shocked by the way regulators allowed the interests of financial players to dominate the markets they were supposed to serve.
But that is all in the future. In the short-term, we all have to manage the challenges created by the Great Unwinding of stimulus policies. The next few weeks are likely to highlight just how difficult a journey this could become.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 41%
Naphtha Europe, down 41%. “Prices fluctuated sharply through the week but ended significantly down from the previous weeks”
Benzene Europe, down 41%. “Demand was described as healthy despite some expectations of a slowdown over the summer holiday”
PTA China, down 31%. “Dropping polyester prices faced by end-users has seen low counter-bids from them, as they continue to see low demand and squeezed margins in the near term.”
HDPE US export, down 19%. “Most export spot prices held steady during the week.”
¥:$, down 20%
S&P 500 stock market index, up 6%
Attention has rightly been focused on the collapse of oil prices over the past 6 months. These have further to fall, but the major part of the move must now be behind us. After all, Brent was at $104/bbl when I first forecast the move in mid-August, and closed at $56/bbl last night, so probably “only” has $20/bbl-$30/bbl further downside.
But there are 2 elements to this Great Unwinding. The other is the surge in the value of the US$. The US$ Index (versus the world’s other major currencies) has already broken out of its 30-year downtrend since my August forecast.
I suspect the US$’s resurgence will now assume much greater importance as its impact becomes more widely recognised.. As I noted back in September:
- “The US$ Index has fluctuated 25% on several occasions between 72 and 90 since the middle of 2008
- First there was a ‘flight to safety’ in H2 2008, as the Financial Crisis took place
- Then the US Fed pushed the value down again with its first Quantitative Easing (QE)
- When traders tried to buy the US$ again in 2010, new QE programmes kept the $ weak..
“If we assume for a moment that the US$ continues to rise, then the recent flows of money into high-risk assets will quickly reverse. These have been largely created by the Fed’s decision to supply unlimited amounts of low-cost money:
- Pension funds and hedge funds have simply bought anything that offered a high yield, in a desperate effort to maintain their returns for investors and pensioners
- They have only thought about the need to focus on ‘reward’, and have ignored the fact that high reward usually also means ‘high risk’
“But if money flows back into the US$, then ‘risk’ will return with a bang. Who will buy all the assets that are being sold?”
Today, this is no longer a theoretical question, as the chart above shows. In the 6 months since I forecast the move, the Index has now reached the 100 level, last seen 12 years ago in Q1 2003. That is a massive move in such a short time. And as the New York Times notes:
“The soaring value of the American dollar is rippling across the globe. As it rises, it is threatening emerging economies where companies have taken on trillions’ worth of dollar-based debt in recent years.”
The scale of this risk is not at all well understood. And yet, as I noted last week, US$ debt in the Emerging Markets has grown 20-fold from $0.1tn to $2tn over the past decade. It is larger than the US high-yield corporate bond market, and 4x the size of Europe’s high-yield bond markets.
High yield always means high risk. But at least some investors have a good understanding of the risk in US and European bond markets. Very few have the same understanding of the Emerging Markets. Most investors have simply bought their bonds from a prospectus: they were desperate to gain a better yield than available in the West.
Now they will find out the hard way that that many of the companies in which they have invested cannot afford to repay the loan, due to the loan’s value having just increased dramatically due to the rise in the US$. The sorrowful sequence is as follows:
- Companies in Emerging Markets decided to borrow more cheaply by borrowing in US$
- Their aim was to take advantage of the US Federal Reserve’s zero interest rate policy
- But today they are finding out the real cost of the loan, as the capital value has risen by up to 50% in some cases, such as Russia
- So, of course, they are most unlikely to be able to repay the loan, especially as their profits are also under pressure from the slowdown in China and other Emerging Markets
The US$ has been in a downtrend for 30 years, since the Plaza Accord in 1985. Now, as often happens, the recovery is happening very fast indeed. It will be a very bumpy ride ahead.
EU policymakers like to pretend that the Eurozone debt crisis was resolved by the adoption of last March’s new Treaty. An even more disturbing thought is that they might even believe their own propaganda. Who knows?
But on the ground, it is crystal clear that the problems continue to multiply. Latest data from the Bank for International Settlements (the central bankers’ bank) shows lending within Europe continues to slow, as the blog will discuss on Saturday. This is not good news for the global growth agenda.
Meanwhile, the blog’s own Boom/Gloom Index remains stalled for a 3rd month at the 4.0 level (blue column) that has historically divided boom from gloom. And the austerity reading (red line) continues to rise.
The Index’s paralysis seems to mirror rising political uncertainty:
• Next Sunday sees the final round of the French presidential election
• Greece votes the same day for a new government
• Ireland votes later this month in its Eurozone treaty referendum
• The USA is entering presidential elections
Equally, jostling for power continues in Russia (after its recent election) and in China (ahead of the politburo changes in October).