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Tuesday, May 26, 2009

With Each Interest Rate Tick Higher, Another "Green Shoot" Dies

"There isn't enough capital in the world to buy the new sovereign issuance required to finance the giant fiscal deficits that countries are so intent on running. There is simply not enough money out there," -Kyle Bass

FN: Giddy talk of "green shoots" has completely drowned out a more sober and rational assessment of the global situation. Random statistical noise in various minor economic indicators have over the past two months resulted in wild exclamations of "the worst is definitely over".

It most certainly is not.

With every major economy in the world attempting to solve this economic crisis with both loose monetary and fiscal policy, it was only a matter of time before the global credit markets would reach their limits.

These limits have almost been reached.

The long end of every curve of every major economy has been steadily climbing. The rate of change has now accelerated and interest rates on these important benchmarks have now reached "pre-crisis" levels. In a ZIRP world this is definitely a bad sign. Formerly respectable governments from the US to the UK have gone the "banana republic" route and started monetizing their debts in a desperate attempt to prevent long rates from rising, to no avail. A veritable tsunami of debit issuance now sits just over the horizon, waiting to dumped on a crippled and saturated global debt market.

The UK will eventually lose it's coveted triple 'AAA' rating and the US cannot be far behind. Rising rates will drag everything from mortgage rates to credit card rates higher. Everything from residential and commercial real estate to businesses will feel the pain of higher borrowing costs. The central banks of the world have no more real options left. They've lowered the rates they control to zero and have flooded the financial system with liquidity. Their balance sheets are now swollen with toxic assets and outright debt monetization won't bring rates down.

With each interest rate tick higher another "green shoot" dies...

US bonds sale faces market resistance:

"The US Treasury is facing an ordeal by fire this week as it tries to sell $100bn (£62bn) of bonds to a deeply sceptical market amid growing fears of a sovereign bond crisis in the Anglo-Saxon world.

The interest yield on 10-year US Treasuries – the benchmark price of long-term credit for the global system – jumped 33 basis points last week to 3.45pc week on contagion effects after Standard & Poor's issued a warning on Britain's "AAA" credit rating.

The yield has risen over 90 basis points since March when the US Federal Reserve first announced its controversial plan to buy Treasury bonds directly, a move designed to force down the borrowing costs and help stabilise the housing market.

The yield-spike may be nearing the point where it threatens to short-circuit economic recovery. While lower spreads on mortgage rates have kept a lid on home loan costs so far, mortgage rates have nevertheless crept back up to 5pc.

The Obama administration needs to raise $2 trillion this year to cover the fiscal stimulus plan and the bank bail-outs. It has to fund $900bn by September.

"The dynamic is just getting overwhelming," said RBC Capital Markets.

The US Treasury is selling $40bn of two-year notes on Tuesday, $35bn of five-year bonds on Wednesday, and $25bn of seven-year debt on Thursday. While the US has not yet suffered the indignity of a failed auction – unlike Britain and Germany – traders are watching closely to see what share is being purchased by US government itself in pure "monetisation" of the deficit.

Don Kohn, the Fed's vice-chair, said over the weekend that Fed actions would add $1 trillion of stimulus to the US economy over time and had already prevented "fire sales" of assets.

"The preliminary evidence suggest that our programme has worked," he said.

The US is not alone in facing a deficit crisis. Governments worldwide have to raise some $6 trillion in debt this year, with huge demands in Japan and Europe. Kyle Bass from the US fund Hayman Advisors said the markets were choking on debt.

"There isn't enough capital in the world to buy the new sovereign issuance required to finance the giant fiscal deficits that countries are so intent on running. There is simply not enough money out there," he said. "If the US loses control of long rates, they will not be able to arrest asset price declines. If they print too much money, they will debase the dollar and cause stagflation.

"The bottom line is that there is no global 'get out of jail free' card for anyone", he said.

The US is acutely vulnerable because it relies heavily on foreign goodwill. China and Japan alone hold 23pc of America's $6,369bn federal debt. Suspicions that Washington is trying to engineer a stealth default by letting the dollar slide could cause patience to snap, even if Asian exporters would themselves suffer if they harmed their chief market.

The dollar has fallen 11pc against a basket of currencies since early March. Mutterings of a "dollar crisis" may now constrain the Fed as it tries to shore up the bond market. It has so far bought $116bn of Treasuries as part of its "credit easing" blitz, out of a $300bn pool.

When the Fed first said it was going to buy Treasuries in March the 10-year yield to dropped instantly from 3pc to near 2.5pc, but shock effect has since worn off. Any effort to step up purchases might backfire in the current jittery mood.

In the late 1940s the Fed was able to cap the 10-year yield at around 2pc, but that was a different world. The US commanded half global GDP and had a colossal trade surplus. The Fed could carry out its experiment without worrying about foreign dissent.

Fed chair Ben Bernanke has long argued that central banks can bring down long-term borrowing rates by purchasing bonds "at essentially no cost". His frequent writings rarely ask whether foreigner investors – from a different cultural universe – will tolerate such conduct.

Mr Bernanke is betting that under a floating currency regime there is no risk of repeating the disaster of October 1931, when the Fed had to raise rates twice to stem foreign gold withdrawals, with catastrophic consequences. This assumption may be tested.

It is not clear where the capital will come from to cover global bond issues. Asian central banks and Mid-East oil exporters have cut back on their purchases of US and European bonds as reserve accumulation slows. Russia has slashed its holding by a third to support growth at home. Even Japan's state pension fund has become a net seller of bonds for the first time this year the country's population ages.

Japan's public debt will reach 200pc of GDP next year. Warnings by the Japan's DPJ opposition party that, if elected this autumn, it would not purchase any more US debt unless issued in yen, is a sign that the political mood in Asia is turning hostile to US policy.

There is no evidence yet that foreigners are in the process of dumping US Treasuries. Brad Setser from the US Council on Foreign Relations said global central banks added $60bn to their US holdings in the first three weeks of May.

This is bitter-sweet for Washington. It suggests that private buyers are pulling out, leaving foreign powers as buyer-of-last resort.

We just have to hope that G20 creditors agree to put a clothes peg on their nose and keep buying Western debt until the crisis passes, for the sake of the world."


harbingo said...

Whither the Dollars and Gold from here?
Ben do you expect Gold to hit 5,000 when all is said and done?
Dollar down some 11% in such short time? Is it dead now compared to Euro and GBP and Asians?

(not a gold bug, btw)

Financial Ninja in Training NYC said...

Welcome back Ben!!!

I wanted to ask you if you still feel that it's not time for inflation.

In my view, unless there is a serious market crash, hyper-inflation is a very strong scenario.
Another scenario would be a market crash soon, followed by a more extreme stimulus that hurls us into hyper-inflation.

You are correct to assume that in the current environment, the risk of inflation is non-existent. I however believe that the FED will print trillions, and monetize trillions before this year is over.
The ball will be in China's corner.

What are your thoughts on this?

Alan said...

Ninja In Training -

I don't want to answer for Ben, but I think he may answer in the following way:

Inflation only results from a NET expansion of money and credit WITH sufficient velocity. The rate of contraction (i.e., debt destruction, including that which has not been properly marked) dwarves the amount of money that has been created thus far.

Further, the velocity of money has fallen off a cliff, which reduces the effectiveness of programs so far, such that they do not even offset the de-leveraging in a meaningful way.

The critical variable, IMHO, will not be the amount of money injected or monetized per se, but the potential for a bond market crash (which I have also written about and believe is coming).

Financial Ninja in Training NYC said...

Alan - Thanks for your input.

In the event of a bond market crash, the Gov't (and everyone else) will face deflation and a funding crunch the likes of which we can't imagine. That scenario will almost certainly be followed by civil unrest.

It is my view, that everything and anything will be done to avoid this. For example, banks can be fully nationalized and credit dispersed to everyone. Theoretically, salaries can be increased, and debt payments frozen indefinitely.

Hyper-inflation can be forced on the world even if the current dynamics all point to the opposite.
The ultimate goal being to devalue all USD denominated debt and the dollar as well.

Alan said...

Ninja in Training -

I share your view about the implications of a bond crash. Ironically, most view that scenario as having profound hyperinflationary implications, while I also view it as the opposite - a near-certain deflationary death spiral. The market likes to presume a
high correlation between the value of Treasuries and the Dollar and from what I have researched, it simply is not the case. I have observed a more inverse relationship.

I'm a little unclear as to how you believe that the scenarios that you laid out would be a catalyst for hyperinflation.

For instance, the nationalization of banks merely moves private balance sheets into the public realm. The implosion of debt value remains intact, however. As far as the sovereign authority over lending, unless the US is willing to FORCE credit on its citizenry (which I just don't see as a viable possibility), I don't believe that it will accomplish anything. The talking heads like to pretend that the massive reductions in new credit are due to unavailability. From the data I have seen (and can't recall a single source right now), the catalyst lies in the demand side. Private balance sheets must REDUCE debt and are doing so. I believe this will continue for years upon years.

Again, I'm not sure how mandatory salary increases would work. We have a form of wage price floors already with the minimum wage. Basic economic theory dictates that this leads to an increase in unemployment, which is counterproductive to what the objectives of the policy would be. Factor in global wage arbitrage and it would seem doomed before inception.

The ability to inflate - or reflate for that matter - is based on expectation. I believe it was Munchau over the weekend that wrote an excellent piece about this ability. I do not believe that there is a sustainable ability to create monetary inflation, especially because at this point, it would seem that for every new policy, new expenditure, the bond market will be watching closely, not for inflation, but for the tipping point where they believe crowding out and/or stealth default will occur dramatically.

And I do agree, govt will attempt anything and everything, no matter how ultimately destructive it is.

I appreciate your viewpoints and would enjoy hearing additional elaboration.

hbl said...

"It is not clear where the capital will come from to cover global bond issues."Apparently that's what everyone said in Japan too. I think it will come from:

1. Increased savings
2. Banks (to spend bailout money of various types and to replace maturing private sector debt assets)
3. Flight to safety and deflation trade
4. QE

Detailed thoughts here.

As for the short term correction, in David Rosenberg's latest piece he says:

"Looking at the split between the real rate and nominals, the entire surge in Treasury yields has come from a resurrection in inflation expectations, and this in turn has coincided with the breakout in the commodity complex and breakdown in the dollar."

Financial Ninja in Training NYC said...

Alan -

You have some interesting arguments.
To answer your question and highlight my view of the situation I am going to outline a certain scenario.

The Bond Market crashes, and there's no one to purchase any debt (US, UK, Japan's, EU's)
Most world governments will feel a terrible crunch with banks going bust and deflation pushing prices down (because most will be out of a job). One Dollar will buy a lot more then it would right now or in 1970. This scenario will likely bring with it dramatic geo-political changes and likely a global war.

Having said that, the powers around the world are keenly aware of this and will not let it happen. Right now, we are on a cusp of everyone realizing that the stimuli and all measures taken will simply not work (they haven't realized that yet). Once this occurs, pro-active measures will be taken by governments around the world. What kind of measures?
Here's what seems logical:

Entire banking systems are completely nationalized by their respective governments, and credit given to any companies and individuals in order to stimulate demand. The interest could be minimal, and the payments can be frozen under any premise of "hardship".

If large credit lines are offered to working people with virtually no interest they will use them.
Banks main goal is profit, that is why the credit dried up. If the gov't is put in charge of banking and credit, their main goal will be to stimulate demand even at a loss.

Debt will be monetized and currencies devalued. Since almost all countries will be doing this, the FX rates won't change much (they might even be fixed).
Salaries will be raised on the high and middle end of the scale (not the lower minimum wage). This will keep most skilled workers in their places. Companies will thus be able to issue debt and take on credit in order to pay increasing salaries, and the gov't will act to purchase all of their debt and fund their liabilities.
The beauty of this approach is that most outstanding and foreign liabilities will be wiped out. The only money that a country will owe it will owe to itself.
This will not be a free market economy and banks will be nothing more than gov't owned utility companies.

What I am describing is not a part of any established economic theory. It is simply a way to avoid a total meltdown, until a new global financial system is conceptualized and put in place.

biofuel said...

Hi Alan,

You point out rightly that the demand side of credit is weak; but why – because the income is not there to service the increasing debt. Wouldn’t increasing salaries help households to “earn” their way out of debt? The whole process would speed up. That is the issue here: those who would like to spend don’t because they don’t have cash, and those who have cash to spend won’t because they would rather see it “grow” and park it with hedge funds and the like to disperse to the populace as credit.

Salaries must start growing, and I think there are some indications that the current administration understands this.

Alan said...

Ninja in Training and Biofuel -

Good discussion going. My counterpoint to your scenarios would be that they do not occur within a vacuum. I don't know how those things could possibly occur without precipitating the very catastrophe they were trying to avoid: loss of faith in the ability of the US to repay its debt.

The crowding out effect is not about an aversion of exposure to bonds in an inflationary environment. It's about a complete distortion of market dynamics - caused by govt interference - that makes govt the last ones standing. The collapse in demand is the end game as you all have noted. The more that govt crowds out private capital, the more detrimental - and expedient - the outcome will be.

The loss of AAA ratings is not due to perceived bond value attributable to the monetary environment, but rather the QUALITY of CREDIT. That is of the utmost importance I believe.

That is why the build-up of sovereign debt is also not specifically indicative of an inflationary environment. It must exceed credit destruction AND be perceived as NOT MERELY serviceable, but also principal repayable. This is the anchor that I believe will pull this ship to the bottom of the sea.

While on the consumer side, I agree that higher salaries would help facilitate this, there isn't a conceivable way I can think of where the forceable action of it would not lead to global wage arbitrage in addition to the scenario above. And the free market simply will not support it on its own.

The money has to come from somewhere. And, at a price.

Financial Ninja in Training NYC said...

Alan -

You have very good points, and I would agree with you on all of them if it wasn't for us having different perspectives.

The fact is, all of your points come from a perspective of the world functioning in a free market economy trying to fix itself with private capital.

My perspective is a controlled world economy that is devoid of private investment capital. Where all governments print money and operate at huge losses. The negative aspect is made irrelevant due to the fact that it will not only be US that is doing this, but the world at large at an organized level.

The loss of faith in the US and other governments to repay will not be avoided but in fact embraced. That will be the catalyst for the need of the governments around the world to assume control over the financial system. The quality of credit will be made irrelevant in a controlled world economy.

I believe this will be a transition process where gov't acts as a caretaker and steers our economy to a new financial system that will in a way wipe the board clean, and let everyone start from scratch again.

In light of this perspective, the current out of control spending can be explained. As well as a number of other seemingly bad financial decisions being taken since the start of this crisis.

It is in my view, that the present system cannot be fixed and made to function as before. An entirely new concept has to be created and a new system built upon it for the world economy to function normally.

Bobby and Jean the amateur world travelers said...

salaries don't have to go up. Thank you globalization.
The administration can do nothing to raise them. Labor costs up, jobs out of country. Thank you HR and labor laws.
We need to get productive or more competitive. No Corp tax should help.

If the admin had power housing prices wouldn't go down, they can't make salaries go up.
Everything must go down first.

biofuel said...

The current rapid deficit growth must be temporary, and it seems everyone understands this. The idea is that the deficits are there while a deep reform/adjustment occurs in the economy. The questions are: can the temporary deficits be managed well without negative side-effects and whether the lenders believe that the reform/adjustment undertaken in the economy would allow the incurred debt to be repaid.

It would be appropriate that those who had benefited the most in the boom years support the adjustment, but this would not happen. Seems like Medicare/Medicaid will be reformed to save cash to fill the hole picked up by the government from the “private banking”. After that there are Social Security and the military. The letter will be preserved untouched as long as possible. After that, repayment would be done through sale of current not-for-sale technology, concessions and acceptance of the dictate of the lender. Aside assuming losses of “the private enterprise”, the government also does some purely financial manipulations to support real estate prices and educational lending. That’s about all.

And that is the essence of the problem: would these reforms/adjustments be enough to repay the debt? There has not been a paradigmatic shift in the industry, on the production side of things. Talk to almost anyone and you hear about moving production abroad for either cheap labor or growth potential. There is no WILL to invest at home. And how would others invest in us if we ourselves are unwilling to do so.

Of course, many others likely see the same dynamic and perhaps someone would attempt to change it down the road. But if we extrapolate from the present trajectory it leads to the US becoming an agricultural colony of Asia in about a generation.

Ninja in training,

Not everyone in the world is in the same situation as the US. And second, the government is not a bunch of aliens, but a collection of people who have needs and desires, wives, mistresses, children, etc; and happen to be former and future executives of major US banks, companies, etc. “A clean plate” is impossible. The “government” will protect and screw the “plate” toward those interests that control it. Otherwise I agree with you.

Anonymous said...

When will this "crap" rally die?

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chrispycrunch said...

The new crisis may be when the US and the world both realize that no one wants to buy US debt. Another crisis perhaps in the form of USD collapse and rising commodities (fueling higher interest rates and self-created inflation) may come about. This remains to be seen.

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