Crisis, what crisis?

Three words that helped bring down the last Labour government in 1979, even though the man generally thought to have uttered them – Jim Callaghan – did not in fact do so. But the Sun journalist who fashioned that headline caught the popular impression of a government unaware of a very serious state of affairs which had sneaked up on it.

 

Crises are not often seen or predicted prior to the event. Despite the world now full of “experts” who fully predicted the 2007-08 crisis and hundreds of books on the matter, there were very few real visionaries. Most if not all of them were much maligned at the time and often dismissed as crackpots.

This recent article on Seeking Alpha shows the current state of play with the so-called black swan funds declining in AUM rapidly. The VIX volatility index tells the same story. Plain sailing ahead, no crisis in sight. Bernanke, Draghi et al have it all worked out and will protect you no matter what.

 

I do like the real definition of a black swan event.   It is a risk so small as to be inestimable. It is not the risk of dying when your main and reserve parachute fail to open as you fall to the ground, it is the risk of dying when you are playing golf when a parachutist lands on you after his two parachutes have failed.

 

I expect to be maligned and dismissed as a crackpot for this forecast. The imminent (less than 2 years) arrival of very high inflation whether it be described as hyperinflation, only the history books will tell us later and with it the investor reaction to demand an inflationary premium on fixed income assets.  The potential for an interest rate rise so catastrophic it will bring the house down.

 

The ability of rates to rise will depend on the central banks buying power. While sovereign base rates will remain anchored at the zero bound, anyone who can remember the 1994 bond market debacle will remember how steep the money market curve can get when there is a true duration shed. In extremis there are two basic stages to an inflationary scare in bond markets.

 

  1. A very steep curve if the central bank remains static.
  2. A much shorter curve as the market for long dated paper stops trading.

 

So when you wake and you pull up the US bond curve on your Bloomberg and it only goes out to 5 years you know you are in trouble, no matter how well they have rescaled the graph.

 

For all the deflationists, can we just agree that at some stage of money printing through balance sheet expansion, that cannot ever be reduced, we can create inflation. The fact that it hasn’t happened yet is not a good argument. Anyone who has played the children’s game “Buckaroo” will grasp this. (The game involves gradually adding weights to a spring loaded donkey before it bucks and everything falls off, the proverbial binary tipping point). If we increase the monetary base by another $20 trillion dollars hyperinflation will no doubt result. This is the current state of play and projected expansion.

In Japan last week the latest entry roared into the money printing arena and the Nikkei continued its dizzy ascent, now up 50% in the last 6 months while the yen currency weakened almost to the psychological 100 level. Money printing and inflation are extremely good for stocks and the Nikkei could continue benefit exponentially. What seemed to receive much less attention was the 3 point sell-off in 10 year JGBs.

 

Did someone finally say “ Hey, if you are trying to do everything you can to get at least 2% inflation which could potentially overshoot dramatically, I’m not sure these 10 year bonds at 0.315% are that good value!!!!”

 

While less dramatic in point terms than the percentage change in yield, as illustrated below, I think we can agree it’s rather concerning to have a 3 point move in a day when the last 2 years range is only 5 points. At the minimum, these are not good for the short gamma trader’s trousers.

Now let’s take a look at inflation. Here is a chart of the official US CPI levels versus original unbastardised CPI levels (Shadow Statistics data) which reflect the level of inflation we all actually experience.

Or a more tongue-in-cheek James Bond Index that we created recently, the cost of going to see a James Bond movie, arguably provides a very similar experience over the years.

Inflation has been overly debated but the general consensus being that everyone thinks their inflation rate is much closer to Shadow Statistics number than the official CPI. Clearly when a tremendous amount of government liabilities are index-linked, the more cynical of you might argue that making sure official inflation numbers are as low as possible serves a real purpose. Of course there must be some people who might believe the low official inflation number just as there are people who believe in Father Christmas.

 

As financial repression currently forces savers to hand over their hard earned cash at negative real interest rates, it also has allowed borrowers to finance themselves at very low rates. Sovereigns, corporates and individuals are merrily enjoying the cheapest financing in history with no obvious concerns that rates will ever not be abnormally low.

If variable mortgage rates go to 2007 levels, it is arguably that most homeowners will be unable to pay.

 

If companies have to finance at those levels, it is arguably that most will be unable to run a profitable business.

 

If governments have to finance at those levels, clearly the default template is in play.

 

Clearly we/they (the powers that be) need to keep rates low to avoid that unthinkable scenario.  How do they achieve this?

 

  1. Reduce the need to issue new debt by reducing the deficits. Hmmm. More chance of being killed on that golf course by the parachutist???
  2. Have the central bank buy all the new net issuance so no floating supply to spill over looking for a home. Not exactly a long term game plan but ever so marginally better than putting your head in a sandy bucket.
  3. Impose controls on domestic sales of bonds, require minimum holding percentages, forbid short sales and all the usual tricks of the financial repression trade.
  4. Keep denying that inflation is ever greater than 2% constantly reminding yourself of that famous Woody Allen infidelity sketch. Deny, deny, deny and deny again…

 

In these days of increased regulation, I have had to do a couple of finance exams recently and I noticed one of the questions was about the perceived risks in finance.

 

  1. Credit risk
  2. Settlement risk
  3. Liquidity risk
  4. Market risk
  5. Operational risk

 

 

As the black swan funds bleed premium into the volatility abyss, I couldn’t help thinking that maybe we have all become overly focused on all the risks above apart from actual market price risk. Is the chance of a rapid 5%+ back up in rates really zero?

 

The endgame would not really surprise anyone. We have massive debts with not enough growth to repay them.  We are having a huge money printing attempt to promote growth and inflate debts away, artificially holding interest rates down.  Some markets soar on the new liquidity. Eventually we reach a tipping point where capital at 0 percent becomes scarce and rates sky rocket higher.  During this huge period of market volatility, there will be large wealth transfers as failures, confiscations and asset price changes occur.

 

But strangely we all hope that this is not the case but secretly we know it is the most likely.

 

Let’s just have another look at that JGB chart.

 

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