"China’s direct contribution to global growth is enormous, but perhaps equally as important is its role in generating growth in developed and emerging economies. A slowdown, whether significant or extreme, in the Chinese economy heralds very bad news for asset prices around the world. A growth crisis centered in Asia will further exacerbate the instability and volatility in Japan and have a devastating impact on second derivative marketplaces such as Australia, Brazil and developing markets in South East Asia. The combination of rich valuations and further threats to growth has led us to dramatically reduce risk in the portfolio and actively position ourselves to withstand the uncertainty and instability ahead"
It is easy to get the impression that the naysayers are wrong on Europe. After all the predictions of Armageddon, ten-year government bond yields for Spain and Italy fell to the 4% level, France which is retreating into old-fashioned socialism was able to borrow at about 2%, and one of the best performing bond investments has been until recently – wait for it – Greek government bonds! Admittedly, bond yields have risen from those lows, but so have they everywhere. It is clear when one stands back from all the usual euro-rhetoric that as a threat to the global financial system it is a case of panic over. Well, no. Europe has not recapitalized its banking system the way the US has (at great taxpayer expense, of course). Therefore, it is much more vulnerable. Where European governments and regulators have failed to make their banks more secure it is because they tied their strategy to growth arising from an economic recovery that has failed to materialize. The reality is that the Eurozone GDP levels are only being supported at the moment by the consumption of savings; in orther words, the consumption of personal wealth. Wealth that is not infinite; and held by those not likely to tolerate footing the bill for much longer.
Earlier we noted the rather peculiarly truthful (lack of optimistically-biased bullshit) annual report from the BIS as reading ZeroHedge-sermon-like. There is a smorgasbord of data, charts, and quotes strewn throughout the 204-page melodrama but one caught our eye. Reflecting on the fact that governments in several major economies currently benefit from historically low funding costs, and yet at the same time, rising debt levels have increased their exposure to higher interest rates, the BIS projects the dismal reality that any rise in interest rates without an equal increase in the output growth rate will further undermine fiscal sustainability. Although predicting when and how a correction in long-term rates will unfold is difficult, it is possible to examine the potential impact on the sustainability of public finances and how any normalization of rates (or Abe's success in creating 2% 'inflation' in Japan) leads the nation's debt-to-GDP ratio to explode to a surely-Krugman-mind-blowing 600% debt-to-GDP.
Kyle Bass covers three critical topics in this excellent in-depth interview before turning to a very wide-ranging and interesting Q&A session. The topics he focuses on are Central bank expansion (with a mind-numbing array of awe-full numbers to explain just where the $10 trillion of freshly created money has gone), Japan's near-term outlook ("the next 18 months in Japan will redefine the economic orthodoxy of the west"), and most importantly since, as he notes, "we are investing in things that are propped up and somewhat made up," the psychology of negative outcomes. The latter, Bass explains, is one of the most frequently discussed topics at his firm, as he points out that "denial" is extremely popular in the financial markets. Simply put, Bass explains, we do not want to admit that there is this serious (potentially perilous) outcome that disallows the world to continue on the way it has, and that is why so many people, whether self-preserving or self-dealing, miss all the warning signs and get this wrong - "it's really important to understand that people do not want to come to the [quantitatively correct but potentially catastrophic] conclusion; and that's why things are priced the way they are in the marketplace." Perhaps this sentence best sums up his realism and world view: "I would like to live in a world where it's all rainbows and unicorns and we can make Krugman the President - but intellectually it's simply dishonest."
Now that the BOJ's "interventionalism" in the capital markets is increasingly losing steam, as the soaring realized volatility in equity and bond markets squarely puts into question its credibility and its ability to enforce its core mandate (which, according to the Bank of Japan Act "states that the Bank's monetary policy should be aimed at achieving price stability, thereby contributing to the sound development of the national economy) Japan is left with one wildcard: the Government Pension Investment Fund (GPIF), which as of December 31 held some ¥111.9 trillion in assets, of which ¥67.3 trillion, or 60.1% in Japanese Government Bonds. Perhaps more importantly, the GPIF also held "just" ¥14.5 trillion in domestic stocks, or 12.9% of total, far less than the minimum allocation to bonds (current floor of 59%). It is this massive potential buying dry powder that has led to numerous hints in the press (first in Bloomberg in February, then in Reuters last week, and then in the Japanese Nikkei this morning all of which have been intended to serve as a - brief - risk-on catalyst) that a capital reallocation in the GPIF is imminent to allow for much more domestic equity buying, now that the threat of the BOJ's open-ended QE is barely sufficient to avoid a bear market crash in the Nikkei in under two weeks.
There are some problems, however.
These are not easy times for the global bond market. We’re looking at US Treasuries market (more below), and reckon this morning’s 10-yr spike to 2.23 is only the start. We could see more aggressive price declines as the curve steepens further. It’s only partly based on the better economic outlook and fears of the QE Taper. Japan banks will be among the biggest sellers due to the volatility and “death by carry”. Forget the stories Japan banks were buyers at the wides.. that’s wishful thinking from Treasury holders long and wrong on the US bond market. Unfortunately, each passing day sees the BoJ's credibility chipped away.
However, the best argument why the type of Quantitative Easing imposed by Ben Bernanke, and the associated "necessary and sufficient" condition to exit this greatest of all monetary experiments, or eventually allow Ben and Kuroda to taper QE, i.e., the "great rotation" from government bonds into stocks (because otherwise both the Fed and the BOJ will be stuck monetizing and monetizing and monetizing until one day, soon, they own all government bonds), will never work in Japan is a simple one. And quite visual...
I see this evolving story as a possible turning point. The key CB's will have gone from Offense to Defense.
In the 1940s, the Fed adopted pegging operations to protect the financial system against rising interest rates and to ensure the smooth financing of the war effort. In effect, the Fed became part of the Treasury’s debt management team; as the budget deficit hit 25% of GDP in WW2, it capped 1Y notes at 87.5bps and 30Y bonds at 2.5%. From the massive bond holdings of its domestic banks to its exploding public debt, Japan today faces a situation very similar to the US in the 1940s. When the long-term rate climbs above 2%, the BoJ will probably adopt outright measures to underpin JGB prices to prevent turmoil in the financial system and a fiscal crisis - and just as Kyle Bass noted yesterday, they are going to need a bigger boat as direct financial repression in Japan is unavoidable.
If JGB investors 'believe' as Richard Koo earlier noted, in the BoJ's new actions and Abenomics (to double the monetary base and generate inflation), then, Kyle Bass explains, a rational investor is likely to sell a portion if not all of them. The BoJ only has JPY10 trillion cushion (after the JPY60 trillion deficit) to soak up this 'rational investor paradox' selling and this is dwarfed by the holdings of JGBs in the largest Japanese banks (who are now starting to rotate away from JGBs into foreign bonds). Simply out, Bass exclaims, they are going to have make the plan even bigger... if they are to successfully contain rates. With a quadrillion JPY of JGBs out there, if a mere 5% is sold (from 'Abe'lievers) then Japan's Turbo QE is not big enough which leads to the paradoxical increase in the QQE, moar inflationary 'belief', and moar selling pressure... The BoJ has been in the market every day but 2 since April 4th trying to hold rates down (and is failing)...
Brokers, placement agents, middle men, promoters, consultants, financial intermediaries…call them whatever you wish. They have existed in the financial space since man invented a way to exchange one thing of value for another.
We feel that now there is a Bermuda Triangle of economics - a space where everything tends to disappear without radar contact, a black hole in which rationality and science is replaced by hope, superstition and nonsense pundits pretending to understand the real drivers of the economy. The Bermuda Triangle in real life runs from Bermuda to Puerto Rico to Miami. The Economic Bermuda Triangle (EBT) one runs from high stock market valuations to high unemployment to low growth/productivity. There is a myth that the sunken Atlantis could be in the middle of this triangle. It has been renamed Modern Monetary Theory (MMT) to make it suit the black hole's main premise of ensuring there is a fancy name for what is essentially the same economic recipe: print and spend money, then wait and pray for better weather. The EBT is getting harder and harder to justify - if for nothing else because the constant reminders of crisis keep us all defensive and non-committed to investing beyond the next quarter. We all naively think we can exit the "risk-on" trade before anyone else. We are due for a new crisis. We have governments and central banks proactively pursuing bubbles. A long time ago, policymakers entered a one-way street where reversing is, if not illegal, then impossible.
There have been quite a few bold predictions, since the beginning of the year, that the dollar was set to soar and that the great "bond bull market" was dead. The primary thesis behind these views was that the economy was set to strengthen and inflation would begin to seep its way back into the system. Furthermore, the "Great Rotation" of bonds into stocks, on the back of said economic strength, would push interest rates substantially higher. While we have no doubt that at some point down the road that inflation will become an issue, interest rates will rise and the dollar will strengthen - it just won't be anytime soon. A wave of "disinflation" is currently engulfing the globe. The deflationary pressures that weigh on the consumer and the economy are likely going to keep downward pressure on rates for some time to come as the Fed comes to realize that they have been caught in the same "liquidity trap" that has plagued Japan for a generation. The real concern for investors, and individuals, is the actual economy.
It’s amazing what people can trick themselves into believing and even shout about when you tell them exactly what they want to hear. It was disappointing to see Brad DeLong’s latest defense of Fed policy, which was published this past weekend and trumpeted far and wide by like-minded bloggers. If you take DeLong’s word for it, you would think that the only policy risk that concerns hedge fund managers is a return to full employment. He suggests that these managers criticize existing policy only because they’ve made bad bets that are losing money, while they naively expect the Fed’s “political masters” to bail them out. Well, every one of these claims is blatantly false. DeLong’s story is irresponsible and arrogant, really. And since he flouts the truth in his worst articles and ignores half the picture in much of the rest, we’ll take a stab here at a more balanced summary of the pros and cons of the Fed’s current policies. We’ll try to capture the discussion that’s occurring within the investment community that DeLong ridicules. Firstly, the benefits of existing policies are well understood. Monetary stimulus has certainly contributed to the meager growth of recent years. And jobs that are preserved in the near-term have helped to mitigate the rise in long-term unemployment, which can weigh on the economy for years to come. These are the primary benefits of monetary stimulus, and we don’t recall any hedge fund managers disputing them. But the ultimate success or failure of today’s policies won’t be determined by these benefits alone – there are many delayed effects and unintended consequences. Here are seven long-term risks that aren’t mentioned in DeLong’s article...
So, apparently, according to Jon Hilsenrath, "QE to Infinity" is actually "finite" after all. There is no doubt that the Federal Reserve will do everything in its power to try and "talk" the markets down and "signal" policy changes well in advance of actual action. However, that is unlikely to matter. The problem with the financial markets today is the speed at which things occur. High frequency trading, algorithmic programs, program trading combined with market participant's "herd mentality" is not influenced by actions but rather by perception. As stated above, with margin debt at historically high levels when the "herd" begins to turn it will not be a slow and methodical process but rather a stampede with little regard to valuation or fundamental measures. The reality is that the stock market is extremely vulnerable to a sharp correction. Currently, complacency is near record levels and no one sees a severe market retracement as a possibility. The common belief is that there is "no bubble" in assets and the Federal Reserve has everything under control. Of course, that is what we heard at the peak of the markets in 2000 and 2008 just before the "race for the door." This time will be no different.