My Comments: You can call me an alarmist if you like, I really don’t care. We are long overdue for a market correction, from both a stock value perspective and interest rate perspective. If you don’t believe it’s coming, I have some nice real estate just east of Daytona Beach I can sell you for peanuts.
By Ambrose Evans-Pritchard / 10 Jun 2015
The global deflation trade is unwinding with a vengeance. Yields on 10-year Bunds blew through 1pc today, spearheading a violent repricing of credit across the world.
The scale is starting to match the ‘taper tantrum’ of mid-2013 when the US Federal Reserve issued its first gentle warning that quantitative easing would not last forever, and that the long-feared inflexion point was nearing in the international monetary cycle.
Paper losses over the last three months have reached $1.2 trillion. Yields have jumped by 175 basis points in Indonesia, 160 in South Africa, 150 in Turkey, 130 in Mexico, and 80 in Australia.
The epicentre is in the eurozone as the “QE” bet goes horribly wrong. Bund yields hit 1.05pc this morning before falling back in wild trading, up 100 basis points since March. French, Italian, and Spanish yields have moved in lockstep.
A parallel drama is unfolding in America where the Pimco Total Return Fund has just revealed that it slashed its holdings of US debt to 8.5pc of total assets in May, from 23.4pc a month earlier. This sort of move in the staid fixed income markets is exceedingly rare.
The 10-year US Treasury yield – still the global benchmark price of money – has jumped 48 points to 2.47pc in eight trading sessions. “It is capitulation out there, and a lot of pain,” said Marc Ostwald from ADM.
The bond crash has been an accident waiting to happen for months. Money supply aggregates have been surging all this year in Europe and the US, setting a trap for a small army of hedge funds and ‘prop desks’ trying to squeeze a few last drops out of a spent deflation trade. “We we’re too dogmatic,” confessed one bond trader at RBS.
Data collected by Gabriel Stein at Oxford Economics shows that ‘narrow’ M1 money in the eurozone has been growing at a rate of 16.2pc (annualized) over the last six months. You do not have to be monetarist expert to see the glaring anomaly.
Broader M3 money has been rising at an 8.4pc rate on the same measure, a pace not seen since 2008. Economic historians will one day ask how it was possible for €2 trillion of eurozone bonds – a third of the government bond market – to have been trading at negative yields in the early spring of 2015 even as the reflation hammer was already coming down with crushing force.
“It was the greater fool theory. They always thought there would be some other sucker to buy at an even higher price. Now we are returning to sanity,” said Mr Stein.
M3 growth in the US has been running at an 8pc rate this year, roughly in line with post-war averages. The growth scare earlier this year has subsided, as was to be expected from the monetary data.
The economy has weathered the strong dollar shock and seems to have shaken off a four-month mystery malaise. It created 280,000 jobs in May. Bank of America’s GDP ‘tracker’ is running at a 2.9pc rate this quarter.
Capital Economics calculates that hourly earnings have been rising at a rate of 2.9pc over the last three months, the fastest since the six-year expansion began.
Bond vigilantes – supposed to have a sixth sense for incipient inflation, their nemesis – strangely missed this money surge on both sides of the Atlantic. Yet M1 is typically a six-month leading indicator for the economy, and M3 leads by a year or so. The monetary mechanisms may be damaged but it would be courting fate to assume that they have broken down altogether.
Jefferies is pencilling in a headline rate of 3pc by the fourth quarter as higher oil prices feed through. If they are right, we will be facing a radically different economic landscape within six months.
This has plainly been a bond market bubble, one that is unwinding with particular ferocity because new regulations have driven market-makers out of the business and caused liquidity to evaporate. Laurent Crosnier from Amundi puts it pithily: “rather than yield at no risk, bonds have been offering risk at no yield.”
Funds thought they were on to a one-way bet as the European Central Bank launched quantitative easing, buying €60bn of eurozone bonds each month at a time when fiscal retrenchment was causing fresh supply to dry up. They expected Bunds to vanish from the market altogether as Berlin increases its budget surplus to €18bn this year and retires debt.
Instead they have discovered that the reflationary lift from QE overwhelms the ‘scarcity effect’ on bonds. Contrary to mythology – and a lot of muddled statements by central bankers who ought to know better – QE does not achieve its results by driving down yields, at least not if conducted properly and if assets are purchased from outside the banking system. It works through money creation. This in turn lifts yields.
The ECB’s Mario Draghi has achieved his objective. He has (for now) defeated deflation in Europe. After six years of fiscal overkill, monetary contraction, and an economic depression, the region is coming back to life.
How this now unfolds for the world as a whole depends on the pace of tightening by the Fed. Futures contracts are still not pricing in a full rate rise in September. They are strangely disregarding the message from the Fed’s own voting committee – the so-called ‘dots’ – that further rises will follow relatively soon and hard.
The Fed is implicitly forecasting rates of 1.875pc by the end of next year. Markets are betting on 1.25pc, brazenly defying the rate-setters in a strange game of chicken.
The International Monetary Fund warned in April that this mispricing is dangerous, fearing a “cascade of disruptive adjustments” once the Fed actually pulls the trigger.
Nobody knows what will happen when the spigot of cheap dollar liquidity is actually turned off. Dollar debts outside US jurisdiction have ballooned from $2 trillion to $9 trillion in fifteen years, leaving the world more dollarised and more vulnerable to Fed action than at any time since the fixed exchange system of the Gold Standard.
Total debt has risen by 30 percentage points to a record 275pc of GDP in the developed world since the Lehman crisis, and by 35 points to a record 180pc in emerging markets.
The pathologies of “secular stagnation” are still with us. China is still flooding the world with excess manufacturing capacity. The global savings rate is still at an all-time high of 26pc of GDP, implying more of the same savings glut and the same debilitating lack of demand that lies behind the Long Slump.
As Stephen King from HSBC wrote in a poignant report – “The World Economy’s Titanic Problem”- we have used up almost all our fiscal and monetary ammunition, and may face the next global economic downturn with no lifeboats whenever it comes.
The US is perhaps strong enough to withstand the rigours of monetary tightening. It is less clear whether others are so resilient. The risk is that rising borrowing costs in the US will set off a worldwide margin call on dollar debtors – or a “super taper tantrum” as the IMF calls it – that short-circuits the fragile global recovery and ultimately ricochets back into the US itself. In the end it could tip us all back into deflation.
“We at the Fed take the potential international implications of our policies seriously,” said Bill Dudley, head of the New York Fed. Yet in the same speech to a Bloomberg forum six weeks ago he also let slip that interest rates should naturally be 3.5pc once inflation returns to 2pc, a thought worth pondering.
Furthermore, he hinted that Fed may opt for the fast tightening cycle of the mid-1990s, an episode that caught markets badly off guard and led to the East Asia crisis and Russia’s default.
The bond reductions this week are an early warning that it will not be easy to wean the world off six years of zero rates across the G10, and off dollar largesse on a scale never seen before. Central banks have no safe margin for error.