Friday, June 3, 2016

The Global Bond Market Bubble Moves Further Into Negative Territory

While the financial media is focused on the U.S. jobs reports, a much more important data point was released today. Fitch Ratings reported global government debt with negative interest rates rose from $9.9 trillion in April to $10.4 trillion entering the month of June. The total was "only" $7 trillion back in February, meaning more and more bonds are entering negative territory at a breathtaking pace.

The biggest contributors to the total pie of negative bonds came from Japan and Italy. Germany has negative yields out to 9.5 years, and Japan stretches out 14. Why would someone ever buy a bond when the yields are negative? Greed. 

Bonds rise in value when interest rates fall, and they fall in value when interest rates rise. You can think of the process like a seesaw.

While the average yield on Japanese government debt is -0.06%, investors that purchased these bonds at the start of the year have made 5.2% on their holdings. Why? The yields are falling, and it doesn't matter if that is happening in positive or negative territory. For example; if you hypothetically bought a bond at -0.1% and the rates fell to -0.2% the underlying principal value of your bond has risen.

Here is the juicy part; Larger investors can leverage their positions in these markets by buying government debt with borrowed money. If you are buying $100,000 worth of Japanese bonds and you only used $10,000 of your own money (you borrowed the remaining $90,000), then your returns are supercharged.

Investors are purchasing bonds with the sole intention of flipping them to the next buyer and locking in on the capital gains. They are not "investing" for the long term because this would mean they are holding an asset that guarantees an annual loss (negative bonds mean you pay the government to hold them).

The same process occurred during the real estate boom in 2006-2007. Investors would purchase properties knowing if they rented them out they would have negative monthly cash flow. This was of no concern because they "knew" they could just flip the properties to the next buyer in just a few months and lock in on the capital gains.

The problem will arrive when bonds yields stop falling and begin to reverse course. At that moment investors will be holding bonds with a negative yield that are simultaneously losing principal value every month. In addition to this pricing dilemma it should be noted that the entity borrowing the money, the Japanese government, is bankrupt. At some point that "small problem" will become a big one that is priced into the bond and currency markets.

While I have no possible way of knowing when this insanity will stop and bond prices will peak, I can assure you when they begin to reverse course it will not be a calm and orderly walk to the exits.  Asset prices (stocks, bonds and real estate) which have experienced the benefit of lower and lower borrowing costs every year for the past 35 years during the secular bond bull market, will now begin fighting against the current as the bond bear markets begins.

......As a quick side note, based on the global bond market movement today following the jobs report it is likely the total number of negative yielding negative bonds is now significantly higher than $10.4 trillion.

For more see: Moving Closer To The Next Global Minsky Moment

Monday, May 30, 2016

Moving Closer To The Next Global Minsky Moment

Before the concept of printing money to purchase bonds was created, people believed the debt a person, corporation or government acquired would have to be paid back with the borrower's future income stream. If an entity became unable to service the debts based on their income they could look for creative ways to push back a default, such as borrowing money from other sources to pay interest on the original debt. Eventually the ability to borrow more money to pay interest ends because creditors realize they are providing capital that will never be returned. This point is often referred to as "The Minsky Moment" in a debt cycle.

We reached this point globally when the cracks began to appear in the global debt markets in the summer of 2007, it accelerated when the doors closed on two major Bear Stearns hedge funds in February 2008, and it reached a crescendo when the global debt markets completely froze following Lehman's bankruptcy in September 2008.

The same process has been occurring since the debt markets last collapsed in late 2008; individuals, corporations and governments are widely taking on more debt than they will ever be able to repay. Throughout this process confidence has risen and asset markets have been "bid up" as investors chase prices higher confidently believing this time will end differently.

Here is a snapshot of this process occurring in the United States. The following chart shows household and nonprofit organizations net worth as a percentage of disposable income. In other words, how assets are priced relative to the actual underlying income available to support them.

Will the story end differently this time? The short answer is no; it will ultimately end in disaster. In regards to how and when the story ends the answer becomes less clear. Why? We have entered a new age in global finance; Pre-Emptive Central Bank Invervention. In this new world central banks not only stand ready to protect the markets after a collapse, they are now pre-emtively entering markets to try and hold asset prices at artificially high levels. Their main responsibility is to keep asset bubbles from bursting.

How far can they push back the day of reckoning? We don't know because we have never seen or experienced a comparable event in history, but let's walk through an example of how a crisis may be pushed back longer than some investors believe possible....

We recently discussed why I believe Japan will be the opening act for the next major dislocation in the global debt markets (see The Coming Global Bond Market Disaster: Japan Prepares For The Opening Act). Very simple math shows you Japan's bond and currency markets represent an inevitable train wreck, but is there a way they can avert or push back their coming crisis?

The Bank of Japan is currently on pace to accumulate the lion's share of the outstanding government debt in Japan. What if, when they finished their accumulation process they announced they would "forgive" that debt? Essentially they would tell the government, "you no longer owe us the money." Another option would be to change the terms on the debt owed. Hypothetically, they could extend the duration out to 100 years and make the new interest rate 0.0%. That would effectively erase the debt even though it was still listed on the central bank's balance sheet as an asset.

What would be the outcome of this action? As I just said, no one has any idea, but walking through the thought process to try and determine potential outcomes is important. My guess is the consequences of this action would be a sharp reduction in the value of the Japanese currency in the foreign exchange markets. Japanese leaders have likely already discussed this potential endgame.

What could stop this from working? The decline in the value of the yen becomes so severe that it creates an unbearable level of inflation for Japanese citizens. Investors purchasing bonds in a highly inflationary environment would charge higher interest rates to compensate for the loss in future purchasing power. At that point the central bank becomes trapped. They will have to make a decision; either continue forward with QE to buy bonds and protect interest rates or defend the currency by stopping their purchases (or even selling), which would allow interest rates to soar. If rates rise to about 2%, then the annual cost to service just the interest alone on the government debt would overwhelm 100% of the annual tax receipts. At that point, the Minsky Moment has arrived and bankruptcy/default follows soon after.

This means the race is on, and we can only sit back and watch how it all unfolds. Can the central bank accumulate (and then forgive) enough debt before the currency receives too much punishment in the forex markets? My guess is the Bank of Japan will lose this race and you will witness the interest rate rising/inflation disaster I just described unfold for Japan on the world's financial stage. As the world watches in horror it will be the first major chink in the armor surrounding the collective belief in central banking omnipotence. Once investors understand central bankers have only delayed the real crisis building under the surface, the smart money will begin to rush to the exits and the rest will soon follow.

For more see: A View From The Peak: U.S. Stocks At The Crest Of The Tidal Wave