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Bond Market and Hyperinflation

Global Economy, On the cover, Sin categoría

Special contribution from Amit Tal:

Something disturbing is happening in the bond markets. It seems to me that the bubble that developed in the last 45 years is coming to an end. This process will likely lead to negative consequences in the form of fast inflation -in the best case- or hyperinflation -in the worst case-. In my opinion, central banks are clueless.

The beginning of the credit bubble happened between 1981 and 1982. We can identify this point in a number of markets: the stock market, bond markets and traded foreign exchange. This bubble has continued over the past 45 years and I really believe that most policy makers and economists know of no other way to manage the economy.

But first, I want to illustrate how the mechanism of credit bubbles works. I will do it with parallels between all economic agents and markets (government, companies, households) and the average citizen. For example, let’s say that a person is interested in taking a loan and when the time comes and he or she has to pay the bank, the person doesn’t have the financial possibility at the moment. The person faces two options: bankruptcy or a bigger loan on more favorable term (lower interest rate). In the past 45 years, all markets have prefered the second option.

If we can understand this mechanism, we can understand this chart: 30y treasury yield. Any increase of interest rates (which could cause the mechanism of credit markets to stop working), caused a crisis in the market. Do these crises suddenly look better from a different perspective? They actually helped prevent the greatest crisis of them all – the explosion of the credit bubble.

Is there a chance that central banks know this and try to do everything in their hands to prevent this explosion? A looki at the bond market proves so.

For me, it looks like the market must have crises to prevent a very high rise in interest rates that would cause an explosion of the big bubble. Have central banks created these crises in recent years: the answer is YES.

So what has changed now?

I think this time it will end differently. Mostly due to the actions of central banks in the last 8 years. Once inflation started to build in the United States, the Federal Reserve wanted to raise interest rates. However, this action will no longer work, and brings more inflation.

How It Works?

US raises interest rates. Money out of other countries (Japan, China, Eurozone) escapes, interest rates of those countries rise, and central banks inject even more money to their bond markets to prevent the explosion of the big bubble. This creates even more inflation. This would require the United States to raise interest rates again. This is a circle that feeds itself. Using interest rates no longer works. I don’t think the Federal Reserve understands this and probably will raise rates in March.

Let’s take China as example. US moves cause it to burn its foreign exchange reserves. The Chinese understand their currency is going to hell, and start to buy any property, creating wild inflation, which requires the United States to raise interest rates again. And it repeats itself.

 

Fast inflation. Just the beginning. China CPI

 

This circle is happening in all countries .

 

So is there an alternative?

If the central banks leave the bond market alone, it will complement the shortfall. In other words, lead the way to an explosion of the credit market. 2008 would be a holiday trip compared to what will happen in this case.  I do not think this option is realistic, so the bubble will be fed.

So how to trade in the current situation?

When there is an inflationary situation, the last thing you want is to be out of the market.

It means: Long aggressively on indices (which have risen a lot already, but it’s nothing). But keep an eye on the debt crisis. The US dollar will be the king in this situation.

Finally, I would like to share two graphs that help to show the break deviation in the bond market.

The first chart is 5y treasury yield over ץthe past 45 years. We can say it is breaking a pattern of 45 years. This is just the start.

The next chart is DXY. Breaking a pattern of 45 year

 

Conclusions

I think that the markets have opened the Pandora’s Box. The result can be hyperinflation (if central banks launch new programs), followed by the collapse of the largest bubble in history.

Or we are already heading for an explosion of the biggest bubble in history.

 

A Special contribution from Amit Tal “The Big Shorts trade”
@amital13

Video: Earnings Season, Europe Risk Rises and Why the German Surplus is not a Negative

Global Economy, Media, On the cover, Sin categoría

In this short video we explain

. Earnings Season: So far, better… But let´s be cautious.
. Europe Risk Rises: French elections and Greece back on the map.
… and Why the German Surplus is not a Negative.

Daniel Lacalle. PhD in Economics and author of “Life In The Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.

Video courtesy Tressis Gestion

The End Of Earnings Recession in Europe?

Europe, Global Economy, On the cover, Sin categoría

It seems that the earnings season in Europe is showing us its kind face after more than six years of disappointments and constant downward revisions (read). The earnings recession has been evident in domestic turnover, tax bases and the ability to repay debt, which did not improve in Europe despite the low interest rates – because cash generation was deteriorating more quickly.

According to Morgan Stanley, out of the 75 companies that have reported – although it is only a small part, 15% of the market capitalization – 43% have beaten estimates by 5% or more, while only 29% have disappointed. The rest were”in line” with expectations. So far, these have been the best results of the past 6 years.

Faith in earnings recovery is centered on four pillars:

. Better commodity prices – which helps oil companies and electricity generators -,

. improvement in the performance of banks with more inflation and less provisions,

. upward revisions of global growth

. …and widespread margin improvement.

There are still many results to analyze, but it is worth noting that this recent improvement is promising, albeit not without risks.

– It is true that a little inflation would help the financial sector to get their head above water and breathe a little. Banks are trying their own medicine. They spent years demanding monetary expansion and now they suffer the collapse of margins due to negative real interests. But the European banks’ writedown trend is far from over, and the burden of NPLs (non-performing loans), which exceeds €200 billion, still require a large number of capital increases. The recent results by Deutsche Bank show that the pain is far from over.

– The recent increase in commodities has not generated the positive results that consensus expected in energy. The results of the large European conglomerates are, so far, quite poor, with only one exception, Total, that has been doing its homework for many years.

– We have to pay attention to the negative surprise in the earnings of Consumer Staples, a 7% negative surprise and 5% overall decline, as European growth expectations come mainly from the hope of higher consumption.

Of course, analysts and investment banks are encouraged by the increase in inflation. However, we have to pay more attention to core inflation, since we may encounter a stagflation problem if prices rise due to food and energy while the economy remains anemic.

In any case, we must highlight the good news. If the positive surprise in earnings is maintained until the end of the results season and extended to 2017 guidance, we could be facing the end of the earnings recession, which is an essential factor to believe in a true recovery.

If this profits recession is not reversed in 2017, we could face a much greater problem. Why?

If profits do not start to grow in Europe in 2017, the “tailwind” effect of low interest rates and cheap commodities will dissipate before companies have improved their ability to reduce debt.

European companies can be the positive surprise of 2017 despite the political turmoil and the likely ECB tapering.

Many investors tell me all this does not matter, because European stocks are cheaper than the US market. Let me give a warning. It’s almost always the same. Apart from the fact that the composition of the indices is very different -technology and high added value in the US compared to low-growth banks and conglomerates in Europe-, investors must remember that when US companies have excess cash and liquidity, they buy back shares and increase dividends. European companies, the vast majority, don’t.

We have to follow the earnings trend. It’s tedious and less sexy than talking about political conspiracies, but without an obvious and unquestionable improvement in corporate profits, the European rebound will be nothing but a mirage… again.

Daniel Lacalle. PhD in Economics and author of “Life In The Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.

Graph courtesy Morgan Stanley

Oil and Frexit: Two Concerns in a Complacent Environment

Energy, Europe, Global Economy, On the cover, Sin categoría

We cannot deny that we are in an environment where global growth and leading indicators show more positive prospects than expected. We have gone from fear to hope – as we explained here – and the US data once again shows strength after the declines seen before the elections. Add to that an increase in expectations of oil demand and the improvement in manufacturing index in Europe.

However, there are two risks. Inflation is mostly coming from energy import costs, and the risk of default from France is rising in the face of the threat to “leave the Euro”

The report of the IEA (International Energy Agency) published yesterday shows us positive and negative data.

Demand growth revised upwards to +1.6 mb/d

  • OPEC production is down 1 mb/d y/y
  • Non-OPEC output is down 0.4 mb/d y/y
  • OECD stocks fall at a rate of 800 kb/d in 4Q.
  • This is balanced by high absolute level of stocks.
  • and US supply growth revised up by 0.1 mbd, now forecast to grow 520 kb/d Dec ’17 vs Dec ’16

Oil demand has been revised upwards to 1.6 million barrels a day by 2017, which indicates that after years of anaemic economic growth and poor demand, it can be a signal a global of improvement. But we must be cautious, given the high level of inventories and the likely seasonal effect. At the moment, OPEC production cuts may seem like a “success”, but as it happens, US production continues to pick up. In addition, the response from consumers happens faster, with substitution and technology accelerating. The world cannot afford an oil shock because of a short-term policy of producers.

It has always been said that the world goes into crisis when the oil burden – the cost of importing oil over total GDP – exceeds 5%. It is rather the opposite, energy overpricing is triggered by the inflationary effect of stimulus policies, and overcapacity and debt remain, triggering a crisis.

At the moment the rise in oil prices comes because producers cut supply, but the impact of these incorrect decisions always generates a response from consumers that accelerates the substitution and diversification of non-cartel producers.

What is the problem? For consumer economies it will have an impact on growth. Imports soar, competitiveness is eroded… but there is some hope. Just as the 2016 oil price recovery did not reduce Spain or Europe’s growth – in fact, it was better than expected – it should not be a recession-leading factor in 2017 as prices remain low. The fact that oil is below $ 57 a barrel (Brent) and is anchored in a very narrow trading range despite the production cuts, shows us that the marklet is very well supplied.

Frexit. The biggest bankruptcy in history?

A couple of days ago, David Rachline of the National Front in France, decided to go to the manual of unicorns ‘Made In Varoufakis and Podemos‘ and state that “the debt of France is about 2 trillion euros, about 1.7 are issued under French law, which means that they can be re-denominated.” Easy, isn’t it?. Your loans in euros can be returned in French Francs … and he thinks – he says – that nothing will happen.

Nothing. Only the collapse of France’s pension and social security system, which is mostly invested in sovereign debt, the destruction of the savings of millions of citizens, and the bankruptcy domino of the French banks. Let us remember that more than 40% of France’s Government Debt is held by the French savers, pensions and institutions.

No amount of money printing would mitigate the impact of an effective default in France, and the contagion on the rest of the Eurozone.

The magic idea of ​​thinking that sinking the currency and defaulting is going to improve the economy is based on three lies:

  • That a default will not affect new credit and access to future financing. To think that they are going to default and investors will lend France more, and cheaper, is so ridiculous it can only be defended by a politician with a straight face.
  • That defaulting does not affect citizens. Not only are their savings and pensions destroyed, so are their deposits – by devaluation and the inevitable bank run -, but access to credit from SMEs and families disappears, even if they want to invent a thousand public banks printing papers.
  • That they can “contain” the brutal impact (which the National Front themselves expect) with a fictitious second currency that will be “closely pegged” to the euro while the transition takes place. A trainwreck in slow motion. It would collapse the Euro and the “closely pegged” currency as well.

If France were to carry out this atrocity, it would be the biggest credit event seen in recent history and, considering that the assets of the French banking system exceed the country’s GDP by more than three times, it would be an implosion that no serious person would think would go away printing French Francs.

Banks’ outstanding home sovereign and sub-sovereign securities represented 6.4 per cent of total assets in the EU as of February 2016, according to Standard & Poor’s… A credit event of the magnitude of France re-denominating its debt, and the subsequent contagion risk throughout the Eurozone, would lead French and European banks to collapse.

Someone should tell LePen that her plan has already been carried out. By Argentina. And its currency lost 13 zeros in 40 years.

It is terrifying to see that citizens are led to believe in these fake magical proposals to which the totalitarian populists have accustomed us. But it is even scarier to see that the European populists believe these ideas have not worked in the past because they were not implemented by them. The idea that economic imbalances caused by printing money without control is solved by printing even more money with much less control. Brilliant.

The good news is that crisis after crisis, each credit event after another, it becomes increasingly clear that the populists’ technical capacity to destroy the economy and plunge their citizens’ wealth with magical “solutions” is diminishing.

French candidates must warn of the devastating effect of these pyromaniac ideas.

It is sad to see that there is still someone out there who believes that sinking the currency and defaulting will make us richer and borrow at lower costs. It shows us that we did not explain currently our past generations that Santa Claus does not exist.

 

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.