From Keith Decker of IceCap Asset Management
In 1888, Martha Matilda Harper became the world’s first professional beautician. In addition to inventing the first reclining shampoo chair, Ms. Harper became famous for opening the first ever, stand alone beauty salon.
Next up to dominate the industry was Elizabeth Arden. Her success was founded upon expanding the salon concept to 1000s of stores around the world, and for the distribution of her self made products, most notably lipstick.
Today’s top beautician is breaking the mold. His product and distribution are light years ahead of anything dreamed of by both Harper and Arden, and best of all he truly believes if he applies just the right amount of foundation, concealer and lipstick (especially lipstick), then he can make anything beautiful and attractive.
Up to this point, his business has been a self-declared, resounding success. His salon is in Frankfurt, Germany. His company has gathered over $5 billion in assets, and his clients total over 340 million people.
Yet recently, more and more people are realising that all isn’t as beautiful as meant to be. Cracks are building in the foundation, mascaras are running long, and worst of all, the lipstick has been smeared.
Mario Draghi’s days as both Beautician and President of the European Central Bank are starting to show their wear. While the headline news celebrates the outcome of France’s election, Europe’s governments and banks remain burdened in a financial struggle that even the very best lipstick cannot hide.
Two things are for certain.
- One, underneath all the financial make-up applied by Mario Draghi remains a fractured, unworkable Eurozone system.
- Two, the majority of investors around the world are not prepared to see what is truly behind Draghi’s scheme to delay the inevitable.
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Chart 1 below details the evolution of the global financial system since the 2008-09 credit crisis.
The good news is that after 7 years of financial oppression, those who have not benefitted from extreme monetary stimulus, the playing field will once again be level for all players.
The bad news is that after 7 years of financial oppression, those who cannot recognise the risks that have accumulated, are about to be red carded right off the field.
Let us explain.
For a number of reasons, the vast majority of investors around the world solely look at the stock market. Everything good and everything bad always comes from and away from the stock market.
In truth – the grease that keeps the world’s mighty economy and debt eating machine chomping through the night is ladened with interest rates.
Yet, few are able to see, speak or even dream about interest rates. The big banks are especially unable to articulate their importance.
Instead, their compliance-approved, snooze-worthy market commentaries occasionally dare to mention everyone’s favourite financial axiom – valuation. And even then, the trained eye can see the rather lack of conviction in the use of the word.
To better grasp the vital importance of this discussion, just know that long-term interest rates are to the bond market as oil prices are to the energy market.
From 2003 to 2008, oil prices shot to the moon dragging along every investment with even the slightest positive linkage.
The same also occurred in 2014 – but with a negative reaction when oil prices crashed from $100 to $50.
Yes, prior to the most recent devastating oil correction, people couldn’t get enough real estate in Alberta and Texas. And they couldn’t get enough energy stocks and their high paying dividends.
In both cases, the perceived risk was non-existent. Oil prices would only go in one direction – up, and that was the end of story. Well, we all know now that it wasn’t the end of the story. In fact, it was only the beginning of another story, one in which turned into a nightmare for all of those riding the great oil express.
Today, the exact same story is playing out.
Instead of it occurring in the oil patch and affecting a smaller segment of the investment universe, the story today is occurring in a field that covers the world from east to west, north to south and every nook and cranny in between.
This field of course, is the interest rate field and the entire bond structure used by investors everywhere.
As easy as 1-2-3
Returning to Toronto – understand that when the long-term interest rate bubble pops, two things happen:
- bond investments lose a lot of money
- piles of jobs are lost from the many companies dependent upon interest rates which so happens to include practically every bank, insurance and financing company.
So, from a pure fundamental, aggregate income and valuation perspective; the breaking of the bond market will have a serous downward impact on salaries, bonuses and perks in Toronto. That alone creates heavy pressure on house prices.
But, the other simultaneous whammy is the surge in mortgage rates which makes the amount qualified to borrow to decline as well. In other words, there will be less money available to buy houses and the money that is available, will not be able to borrow as much as it could before.
The result: prices go down, way down.
Understanding why this is about to occur is really the key to happiness.
The happiness occurs as there are several ways to prosper significantly once the crisis begins.
The process of why it will occur is explained in 3-easy steps.
Step 1: >$14 Trillion in QE
The foundation of the current bubble in the Toronto housing market (and the bubble in bond markets) was firmly established in 2008-09. Recall, that was the year the Americans and their Wall Street financial assassins created deathly lending products which eventually went boom in the middle of the night. It was the response to this boom that sowed the seeds for the next crisis, which just so happens to be manifesting itself today in Toronto’s housing market, and even more concerning – in the world’s bond market.
The chart next page, shows collectively, central banks of USA, Japan, Eurozone, and Britain created over $14 trillion out of thin air. Top government economists swore printing money would stimulate the economy, creating new jobs, raising taxable income which would pay down debt everywhere. But, instead of actually printing money and mailing a cheque to everyday average people to actually spend, economists decided to make an easy stimulus plan a complicated stimulus plan. It became complicated when the money was instead use to buy government bonds. The thought was that by buying government bonds, interest rates everywhere would decline which would benefit everyone.
In effect, this entire money printing or Quantitative Easing (QE) experiment was really one arm of the government lending to the other arm of government.
The intentions were good – after all, the thought was that this $14 trillion would be swished around the global economy faster than the speed of light. Instead, it actually had the opposite reaction as seen in Chart below that shows the Velocity of Money actually declining.
Now, just in case this $14 trillion wasn’t enough to heal the wounds, all of the world’s central banks agreed to add an extra layer of stimulus. Which brings us to Step 2.
Step 2: 672 interest rate cuts
Simultaneous to printing $14 Trillion, government economists also announced they would cut interest rates to the bone. And when we say bone – we mean 672 interest rate cuts over 7 years.
The thought was that 672 interest rate cuts would stimulate the global economy by making money super cheap to borrow, which would creates jobs and create more tax revenues for governments.
But central banks still weren’t done. Just to ensure their plan would work the ultimate cherry on top was added in the form of NEGATIVE INTEREST RATES.
Step 3: Negative Interest Rates
Just in case the $14 trillion of new money + 672 interest rate cuts were not enough, 5 of the world’s central banks played the sneakiest card of them all by creating NEGATIVE interest rates across Europe and Japan.
Whereas the thought that $14 trillion of money printing and 672 interest rate cuts would encourage people to borrow and spend, the thought was that the use of NEGATIVE interest rates would force people to spend.
Either way – savings and savers would really going to struggle.
In the end, the combination of steps 1 + 2 + 3 didn’t provide nearly the amount of global stimulus as thought.
The Bottom Line
Instead, it lowered short term, medium term, and long term interest rates to never before seen levels, merely encouraging borrowing from 2 groups of investors:
- Home buyers
Which of course squares the peg as follows:
$14 Trillion money printing
+ 672 interest rate cuts
+ Negative interest rates
= record low interest & mortgage rates
What investors must realize and understand today is that interest rates are the key cog in the global money wheel.
And over the past 7 years, this wheel has been flattened, pushed around and outright forced to look, feel and behave in a certain way.
However, where this becomes the most important foresight to hear – interest rates (and especially long-term interest rates) cannot remain in its current, forced/coerced/manipulated state forever.
Eventually it will change. The change will be abrupt. And it will definitely be the shock that breaks the housing market in Toronto and it will certainly be the shock that forces the Eurozone to restructure.
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The Majority are always wrong
IceCap is a global macro manager, and like other global macro managers, we see the risks and imbalances in the world today have very clearly been created by governments and their central banks. We know this. Governments know this. And the central banks especially know this.
Yet, just about everyone else doesn’t know this. And since the risks and imbalances created have reached astronomical levels, it has become very important to the central banks to ensure those that don’t know what is happening remain in the dark and are unable to see these risks and imbalances.
This is where all kinds of make-up, mascara and lipstick is needed to make everything look pretty and beautiful.
And when it comes to lipstick, no one in the financial world is better at applying it than the President of the European Central Bank. And, no one is better at wearing it than Italy.
Let us explain.
Chart 2 next page shows the interest rate Italy had to pay to borrow money for 10 years.
Everyone ought to know that the less you pay in interest the better – it means you can borrow more, your interest payments take up less of your income, and more importantly, it means lenders view you in a favourable light. When lenders do not view you in a favourable light – bad things happen, with the worst being no one will lend you any money at all. When this happens, you are shut out of the loan market. And when you are a government and sovereign state, you cannot ever be shut out of the lending market.
Once this happens – it is game over and out. As a country, being unable to borrow, means you are unable to pay policemen, the military, nurses, doctors, teachers, and garbage collectors. You are also unable to pensioners, engineers, social workers, and snow plough operators. And of equal importance, you are unable to repay old debt that is coming due. In other words – you’re in deep doo.
And, this is exactly what happened to Italy in 2011.
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Continue reading in the slideshow below (link)