Tuesday, July 16, 2019

"The World Is Upside Down"

"The World Is Upside Down"
by Brian Maher

"The times are out of joint. $13 trillion of global sovereign debt trades at negative yields. Over half of European government debt sorts into this infinitely curious category. In all, 40% of global debt presently yields negative returns. Dwell for one moment on the majesty of it...

Bonds are loans — at bottom. A government requires monies for X, for Y, for Z. But its present tax haul will not see it through. So it appears before the market with an empty hat… and goes hawking its bonds. To fetch investors, it must sugar the offer with handsome yields. And longer-dated bonds require more sugaring than short-term bonds. Investors are — after all — consenting to rope down their money for years and years. At times decades. 

The Dangerous Future: The future is fraught… and perilous. What if the issuing government defaults on its debts? What if some calamity in waiting sinks the value of these bonds? We must further consider inflation’s effect as the years pass… Inflation nibbles through bonds like termites through the framing of an old house… as they have nibbled through the gray matter within Paul Krugman’s skull. Investors therefore demand compensation to outpace inflation’s insidious thieving. The business can be complicated. But here you have the general sketch.

Now recall the present state of the world…

Reality Turned Upside Down: 40% of global debt trades at negative yields. It as if these bondholders believe the future is more certain than the present. Why else would they let their money go for years — and demand nothing in return? But they are not merely demanding nothing. They are demanding less than nothing. They are paying to lend governments their money. That is, they are being knowingly and willingly squeezed — if they hold these bonds to maturity.

You have $100 to loan out. A prospective lendee offers to hand you back $90 in two years. Do you accept the terms? If so… may you please leave us your name and telephone number? We have a proposal.

Yet hordes of bond investors have sat down to similar arrangements... if you can believe it. During the financial panic of 1873, no London investment house would approach American bonds “even if signed by an angel of Heaven.” Investors today are willing to purchase government bonds — evidently — even if signed by an angel of Hell. Well and truly... the winds blow from strange quarters. Yet we should not be thoroughly surprised.

What Happened to Armageddon? For decades Armageddonists (certainly not us!) have hollered that the national debt would do us all in. Investors would question the ability of the United States government to meet its debts, they insisted. It would frighten off new investors. And investors would heave their existing bonds overboard.

This we have heard for years… First at $5 trillion, and then at $10. Then $15 trillion. Then $20. The same debt presently ranges to $22.4 trillion. Yet the United States government remains standing. Meantime, investors keep piling into Treasury debt and clobbering down yields… as if U.S. bonds bore the signature of God Himself.

Yes, the times are off. Here is additional evidence…

The Unlikely Case for a Rate Cut: The Federal Reserve is preparing to lower interest rates in two weeks. Market odds of a rate cut presently rise to 100% — a certainty. The central bank customarily lowers interest rates when the economy languishes; when it needs a push. Yet Q1 GDP expanded 3.1% (Q2 GDP comes out later this month). June retail numbers trounced expectations… expanding 4.6% year over year. And core inflation put up its largest number since last January. Meantime, unemployment remains sunk at 50-year depths.

Here at The Daily Reckoning, we take official figures with heaps of table salt. But they are the official figures. And the Federal Reserve takes them very heavily. We must therefore give them a notice. All the while, the stock market once again floats at record heights.

And so we ask: Are these the signs of a wallowing economy? Why the rate cuts? A fellow might even argue the precise opposite — that the numbers plea a case for rate hikes. But such are the times we inhabit.

A Rate Cut Might Be Emergency Medicine: Many are labeling a rate cut this month “insurance.” It is better to be safe, they insist… than sorry. But what if a rate cut represents not insurance — but emergency medicine? To gauge the economic health, we turn away from GDP, official unemployment and the delirious stock market...

The Cass Freight Index Report tracks the movement of goods and products nationwide. That is, the Cass Freight Index Report tracks the real economy. Many consider it a highly accurate thermometer of economic conditions. And for the seventh consecutive month… freight volume dropped in June. Reports Cass: "With the 5.3% drop in June following the 6.0% drop in May, we repeat our message from last month: The shipments index has gone from “warning of a potential slowdown” to “signaling an economic contraction.”

Beware the Steepening of the Yield Curve: We have reckoned often about the inverted yield curve. An inverted yield curve is a nearly perfect omen of recession. And the inversion has “steepened” of late — a menace greater yet.

Albert Edwards, Société Générale analyst: "A far more immediate and present danger of recession occurs when after inversion, a rapid steepening occurs. That event usually informs investors the cycle is over and it is time to flee for the hills. The final recessionary shoe has now fallen... Rapid curve steepening is now occurring, suggesting recession may indeed either be imminent or else it has already arrived."

Meantime, the Federal Reserve’s New York headquarters runs a recession probability index. Since 1960, all readings above 30% have preceded recession. We are aware of no exceptions. Its latest reading is 32.9%. Reports Morgan Stanley Wealth Management CIO Lisa Shalett: “Recession probability models have entered warning territory and it may be unavoidable.” 

We suspect Ms. Shalett is correct. But when? Within three months of the next rate cut is our guess — by October, that is. 

Into the Ditch: Unfortunately, the next recession will not put the world on the road back to normal. It could, by clearing out today’s false prosperity. The economy could then start out again with honest capitalism.  But the central banks will seize the wheel, turn the vehicle around… and send it veering into a ditch. Then governments will come along after to drag it out with Modern Monetary Theory. It will try to spend its way out, that is. But ultimately, it will only deepen the ditch.."

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