It's sort of funny to see a wider – though still faint – recognition developing in the financial world that perhaps it's true that the more stimulus is applied in today's global economies, the faster it will hit a wall. Some may finally even begin to see one or more inbuilt mechanisms at work. I personally think it all harks back to what I've long said, that stimulus by governments and central banks may have a function in certain economic cycles, but that applying it without across the board and thorough debt restructuring is a borderline criminal and useless use (and waste) of present and future taxpayer money. Still, we all know by now what will happen when stimulus starts to stutter: ever more will be blindly thrown at that wall.
News that Japan's main pension fund will increasingly be allowed to move from bonds into – domestic – stocks was received as a piece of real good news this week, after the Nikkei lost some 15% in a few days time. It's still up over 30% for the year though, and that should have all of us wondering, especially the fund managers – and its beneficiaries-: What are the chances that the fund's move into stocks coincides with the Nikkei having surpassed its top? That the increased purchases may perhaps lift it for a few days, but the downward move is in regardless? It's hard not to chuckle a little when you see that the Tokyo government and the fund want to execute the move because bond yields are so low, and at the same time they announce it, those yields triple.
Pensions funds – and non-financial institutions in general – (tend to) always lag behind developments. Needless to say, being always behind can be a very expensive quality to have. Millions of ageing Japanese may not be terribly happy if their pension money is moved into the stock market and it retraces it gains right back to where it came from, for a 30% loss.
And the desperate game of Abenomics will have repercussions throughout the world. Not just in emerging markets, South Africa, Brazil, Thailand et al, that already see a lot of damage from investment banks, who float freely on cheap profits from various QEs, recalibrating their Abezombie money away from emerging economies. No, Abenomics will hit the US and Europe even harder. Because, as our roving reporter VK phrased it: "JGBs are the base of the pyramid in the global bond markets. Risk is priced in JGBs. So Abenomics has destabilized the base of the pyramid in global bond markets. Risk is being repriced accordingly."
Japan is the world's largest creditor. A little over a year ago, Bloomberg wrote :
Investments abroad grew 3.3% to 582 trillion yen ($7.3 trillion) in 2011, rising for the third year, the Finance Ministry said in Tokyo today. Currency gains cut the value of existing holdings but encouraged increased investment abroad. Foreign investors increased Japanese assets by an extra 17 trillion, leaving the net creditor position of the country little changed at 253 trillion yen ($3.25 trillion), the world’s largest, the data showed.
At today’s exchange rates 582 trillion yen is $5.77 trillion, and net credits are $2.51 trillion. A lot less. But both are still the same in yen. Today's $64,000 question: did Japan win or did they lose? One thing's for sure: it takes a lot more yen to buy Treasuries. And if you're Uncle Sam and one of your biggest investors runs into that sort of conundrum, it's hard to keep smiling. Moreover, the Japanese financial system could well be forced to sell off many of its foreign investments (i.e. bonds) and thereby substantially drive down their prices.
Japan is both the world's largest creditor and its largest debtor – when measured in debt to GDP , which is reported to be 245% – (its debt in dollars at almost $14 trillion is second only to the US). But since a lot of that debt is owed to Japanese citizens, it seems to matter less. Except perhaps when you're an ageing Japanese grandma, who will see her pension invested in a falling domestic stock market, and her government issue such enormous amounts of sovereign bonds as part of its miracle Abenomics program that the bonds she holds will plunge in value; a matter of when, not if.
But it's not just in Japan that stimulus goes awry. The US "silly recovery" remains in full swing. QE has facilitated another housing bubble, driven by large investors but marketed as a sign of solid growth. David Rosenberg reported this week that US real personal income fell at a 5.8% rate in Q1 2013. The Bureau of Economic Analysis (BEA) reported real per capita disposable income was revised lower again for the quarter. Real per capita disposable income contracted at a -9.03% annualized rate, while the personal savings rate was adjusted down to 2.3% (global rate is 25%). What recovery?
Even the UK blows another real estate bubble. Have you looked at your numbers at all recently, guys? Really, a housing recovery? English media report that incoming BofE chief Carney is expected to drive the sterling's value lower by about 15%. Hmm.. wonder what the others will do, sit by idly?
As we at The Automatic Earth have said since this crisis started, there's only one possible outcome to the beggar thy neighbor to the bottom race that is now taking shape: the US must and will lose it. The prettiest horse in the glue factory will receive so much capital in flight, it's going to wish it had played down that recovery story by a substantial margin. So when this plays out, what should Bernanke do, taper or go full throttle forward?
Never mind, it makes no difference. Perhaps it's more useful to talk about how the way down is not some unfortunate accident, that there are indeed inevitabilities, mechanisms even, involved. For instance, ominous data from Bloomberg indicate that in China last year, each $1 in credit added the equivalent of 17 cents in GDP, down from 29 cents last year and 83 cents in 2007. In the US and Europe, that number's on (or past) the verge of turning negative. Perhaps then, in today's toxic financial environment, stimulus is simply self-defeating?!
It's not just an abstract question. Here, for example, is an intriguing note from Comstock Partners:
If you believe, as we do, that economic growth will remain tepid at best and that the Fed, therefore, will not slow down its purchasing program anytime soon, S&P 500 earnings will fall far short of the big second-half increases that the “Street” is forecasting. If, on the other hand, you think that organic economic growth will be strong enough to enable the Fed to reduce its purchases, long-term rates will climb by enough to stop the economy in its tracks and result in the same negative outlook.
The bullish case for the market rests on continuing massive easing by the Fed, supposedly reasonable valuation for stocks, big increases in second half earnings and a more rapidly growing economy. The result has been a market that is overbought and overvalued.
Damned if you do, doomed if you don't. A market that cannot survive without stimulus. A principle illustrated perhaps even more poignantly, from a different angle, by Bruce Krasting:
I got an email from a friend who runs money for a hedge fund that got my interest:
… may want to take a look at convexity vortex in mbs market and implications…
“Convexity vortex’? What’s that about? A bit more from this fellow, I’ll call him ‘MP’:
… Some familiar with it say the vortex is 19 bps away .. 2.2% on ten year treasury, 3% on the CMM .. if breaks, MBS holders subject to extension and duration risk. Would now have to increase convexity hedging. Would lead to price gaps and significant selling. With shortage of treasuries due to bernank and co. and low liquidity, could be very disruptive.
A layman’s explanation of convexity:
When mortgage interest rates fall, the probability that an individual will re-finance a mortgage increases. When mortgage interest rates increase, the likelihood of a re-financing of the mortgage goes down. Therefore, in a rising rate environment, the average life of a pool of mortgages increases. For example, if a bond fund held Mortgage Backed Securities (MBS) with an assumed 10-year average life, AND interest rates rose, the average life of the MBS portfolio would be extended for a few years. This is convexity.
The last thing that a bond manager wants in a rising rate environment is to have the average maturity of the portfolio extended, as this adds to the losses. As a result, MBS players hedge their portfolios against “duration risk” by shorting Treasuries (ten-year paper). The higher rates go (and the speed that rates are increasing) forces more and more of the convexity selling.
So: if – as in when – mortgage interest rates rise, bond funds must sell Treasuries to cover their shorts. And since the US is busy fooling itself into a housing recovery, of course interests rates are rising (the markets at work, don't you know). They were at such a historic low until recently that people even started suggesting you were a fool for having missed the "opportunity" to buy at those rates. So rates only had one place to go from there. Ergo: as Bernanke tries to convince America that things are getting better, and if they're not he'll spend trillions of dollars more of your kids' money to make sure they are anyway, he at the same time forces institutional investors to start selling their Treasuries in huge quantities. Which runs counter, at an exact 180 degrees, to what he claims he's trying to accomplish. Krasting:
MP believes that there is a magic number of around 2.2% on the ten-year bond that will bring out an avalanche of convexity selling. The 2.2% tipping point is very close to where the T-bond sits today.
The fellow who brought this to my attention is a perm-bear on bonds. Given that, I sought out a confirmation from another guy (call him JH) who has been bullish on bonds for many years. JH sits on the bond desk of a big international bank. When I posed the question to the Bond Bull I got a surprising response:
… I don’t disagree – I would guess we have a huge concentration of mortgages that would go out of the money at 2.25% 10yr UST, slowing prepays, extending servicer portfolios, bringing on longer duration UST selling ……
So there is a vortex risk in front of us. The weaker the ten-year gets (higher yield), the more selling is required. [..]
Bernanke has recently said that the Fed is in the process of changing the monthly QE purchases. He has said that the amounts of POMO (QE) that is completed on a monthly basis will vary based on “incoming information”. From this I conclude that the Fed will, in the coming months, announce a taper of its purchases. When this happens, it’s likely that the bond market will “spike/knee-jerk” higher in yield – and when that happens the convexity selling will bring even higher yields.
The Fed isn’t going to like that result. They do not want to lose control of the long end of the yield curve. So, if and when the convexity selling hits post a QE Taper, the Fed might respond by increasing the next month’s QE in an attempt to drive long rates back down. Bernanke has basically promised to do just that. [..]
The bond bear, MP, had this to say about the Fed ramping up monthly QE in response to a market correction in yields:
… if Fed has to increase buying to stabilize, I would argue it is a very negative development for all markets.
The fact that two guys who trade bonds for a living are well aware of the ‘vortex risk’ as rates approach 2.2% tells me that all of the bond guys are watching this. So, to some extent, the news is already in ‘today’s print’ for bond yields. The opposite could also be the result. When a market understands that there will be forced selling at a certain level, the market always tries to push to the level where the stop-loss selling has to occur. To me, this suggests that the bond market is going to try to test the 2.2% rate.
US 10-year yields started off the week at 2.01%. On Tuesday they were briefly 2.23%, then closed out the week at 2.13%.
[..] if the bond market gets soft, the Fed will respond with a very large dose of monthly QE. [..] The inescapable conclusion from this scenario is that QE is FOREVER. Taper talk will prove to be just talk. When players come to understand that the only leg the markets are standing on is endless/massive QE, there will be a shudder of fear.
Yes, "QE is FOREVER" means that the financial world has – deliberately – positioned its wagers so that it will collapse without constant infusions of taxpayer money. Consider it a form of blackmail, Too Big To Fail 2.0. So what will governments and central bankers do? They will provide the infusions. Which will end up pushing bond yields up, not down. Which requires them to provide more. Rinse and repeat. Self-defeating. Rinse and defeat.
And then Krasting pulls us right back down into Japan (you can never ignore the world's largest creditor):
I would normally say that the ‘worst case’ will not happen. But there is something else going on in bond land that is running parallel to the Taper/convexity selling that the US is facing. Japan is looking at a very similar outcome (for much different reasons). As Kyle Bass pointed out last week, the promise of 2% inflation and 1% bond yields doesn’t have a happy ending. In an effort to cap Japanese bond yields, the Bank of Japan will respond with ever higher amounts of QE. The BOJ has to do this – the entire Abenomics goes up in smoke if the Japanese bond markets puke.
And draws the inevitable conclusion: if and when central banks and their policies end up stuck between a rock and a hard place, they lose control, and the markets will see that Ben Bernanke is just another naked emperor:
There are forces developing over the next few months that may push the BOJ and the Fed to take some extraordinary actions. That these two big CBs are facing the same potential outcome, at the same time, is troubling for me. I see this evolving story as a possible turning point. The key CB’s will have gone from Offense to Defense. For five years the CBs have enjoyed being on the offense. They have successfully controlled things so far. But I can’t imagine how they can continue to be “successful” when they are forced to defend (versus lead) the bond markets.
Perhaps today's stimulus is self-defeating simply because it is unleashed in a toxic financial environment, ridden with hidden debt. Perhaps it can only function when debts are properly restructured, defaulted upon, their holders bankrupted where applicable. And there's no chance of that: the most prolific debt holders are Wall Street banks, and their debts have been made more secret than the latest whereabouts of Jimmy Hoffa.
As long as that stays the way it is, QE is nothing but a very expensive – and very temporary – stop gap. Short term profits for the financial world, long term losses for you and me. There are no ifs or buts involved. There may never be a one on one piece of proof that QE, or stimulus in general, is self-defeating in some – or most – circumstances. But this comes very close. If ever there were a stage where the laws of physics meet the world of finance, it is right here. Anything other than this you can put down to either optimism bias or attempts to fool the greater sucker and suck in the greater fool.
We may be forced to conclude then that in today's world stimulus is self-defeating because it's stimulus itself that reveals the weak spots in an economy, and more stimulus reveals more weak spots. So maybe it's a better idea to stop applying it. Only, that will wreck the present financial system, which cannot survive unless QE is forever. To repeat myself: the more stimulus is applied in today's global economies, the faster it will hit a wall.
Photo top: Samuel H. Gottscho New York Financial district from Hotel Bossert 1933
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