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In Limbo or Playing Limbo?

We often refer to the state of being ‘in limbo’ as stuck on the edge of hell with no resolution… But remember, limbo is also a dance from Trinidad in which people compete to dance lower and lower under a bar until someone eventually collapses. This week in The Big Call we ask, how low can global bond yields go; and what could raise the bar, or will bond yields be stuck at current levels forever?

Bond bull alive and kicking?

The secular trend of declining bond yields has seen prices rise inexorably during a 30-year bull market. Our call from April 7th was to go long TLT on a short-term view – which has returned a decent 3.5% to date. But how long can this return continue in the face of rising leverage and deteriorating demographics? That’s something we considered in the Are You On This Yet? section of The Hack on May 19th

Drowning in debt

Jawad Mian’s thought-provoking symposium this week, A Dozen Ideas to Get You Thinking Differently, sets up our discussion nicely:

“The US economic return on additional debt has fallen to about 20 cents on the dollar. That means 80 cents is servicing existing debt, which has been borrowed for the purpose of supporting unproductive consumption and jobs. This makes economic growth very sensitive to changes in interest rates.”

The diminishing return of each new unit of debt is making it harder and harder for governments and corporations alike to juice their growth and returns. With debt levels so high, the service costs become punishing. To avoid a default, interest rates must remain structurally lower for longer just to support the present debt. Furthermore, the debt has to grow just to service the exisitng debt. Think about that for a second?

Are higher rates already the death knell for the US economy?

“It would only take a 20% backup in interest rates before the debt service becomes problematic (depending on duration and the amount of outstanding debt). The 10-year Treasury yield nearly doubled from the summer 2016 low, which suggests the US economy is about to slow down, rather sooner than later.”

The economy is slowing, and yet with these debt levels across the world, the growth rate required to get out from under them is essentially mathematically impossible to achieve:

The path of least resistance for central banks becomes structurally lower interest rates, since a widespread debt jubilee is too politically unpopular, for now. That comes later.

Central banks are stuck between a rock and a hard place.

  • how to prevent those low rates blowing up (even bigger) asset bubbles
  • how to keep banks profitable so they can recapitalise organically
  • how to have any levers of monetary policy left during the next major downturn

Across the world central banks are in a bind, and so developed bond markets are sleepwalking toward a Japanese-style scenario of negative bond yields and a deflationary psychology.

*  *  *

Global bonds – The world tour

China

At the government level Chinese debt-to-GDP looks very reasonable at around 43%; but if we add in all the local debt, state-owned enterprises, and other forms of debt we get estimates of more like 250% of GDP, which makes China look rather Japanese. China does, however, have one advantage, which is a high GDP growth rate that can be used to shrink that debt load – but with so much growth generated from debt-fuelled investment rather than consumption, it will be hard structurally to grow the economy whilst weaning it off the debt.

Chinese government bond yields have been on the rise, which may actually reflect positive fundamentals in the economy. As Jim Walker’s Wealthy Nations observed in March,

“The rise in rates is a reflection of success and economic acceleration, not a reflection of economic problems. China will increase interest rates not because the authorities are worried about over-indebtedness and/or the amount of credit being extended.”

Cyclically, then, China seems OK for now – the PBOC has been stepping in with liquidity when needed as they try to steer the economy towards some corrective actions. However, the jury is out on how long they can keep this up.

For more in-depth consideration of Chinese debt dynamics, remember to check out CrossBorder Capital’s “The Financial Silk Road”.

US

The 10-year Treasury currently yields around 2.2%, a very low return by historical standards, especially when debt-to-GDP has ballooned to over 100%. Both metrics are now at their post-war level. Will foreigners question the US’s creditworthiness and abandon their debt?

As long as the USD remains the global reserve currency, demand for dollar debt will be high; and only the US bond market has the depth for this size of capital flows – i.e. many holders of Treasuries buy them for reasons other than risk/reward.

OK – but the world could abandon the dollar… Sure, but what’s the next largest alternative? The euro…

Greece

The Grecian debt crisis is now entering its seventh year of tedium. In that time debt-to-GDP has mushroomed from 126% to 179% – a debt level no nation has ever emerged from without some form of default or devaluation. Yet Greek bond yields have fallen from >30% in 2012 to just under 6% today.

With a succession of bailouts, Greece has trundled along on life support. As the old Soviet joke goes, ‘So long as they pretend to pay us, we will pretend to work’.

But what do people who want euro-denominated collateral do, then?

Germany

The 10-year yields are on the floor – 0.25%! This is due to a flight to quality in the Eurozone: If the EU breaks up, you are best off with bunds because the Germans have greater fiscal rectitude (although debt/GDP is still near 70%), and a new Deutsche Mark would be worth a lot more than a freshly minted drachma.

So what are we learning here? Bond yields – especially government ones – are not really reflecting economic risk/reward anymore. They reflect a belief that central banks will ease into perpetuity – or at the very least a belief in the ‘greater fool theory’.

This isn’t theoretical economics confined to classroom textbooks; we only have to look to Japan to see this train wreck in action.

Japan

Japan has a debt-to-GDP ratio of 250%! Yet the 10-year bond yields just a handful of basis points. What could possibly explain this? Deflation. Decades of deflation have meant that owners of any fixed monetary asset will see its value increase over time. Japan was stuck in a debt-deflation cycle until the recent advent of ‘Abenomics’ – the competitive devaluation and money-printing game that everybody else had been playing.

Either way, Japan has avoided default through extremely low interest rates, extremely high domestic bond holdings, and a highly cohesive society, all in combination with a weak currency and an export-led economy. Is this the future for other developed sovereign bonds?

The BoJ have only a plan A: Buy up all the bonds in issue. And after that? You can be sure that Japan will be at the vanguard of the next economic and monetary experiment. Remember that debt jubilee I mentioned?

Japan Debt to GDP vs Japanese Bond Yields

Source: Bloomberg

Could we see a bond scare?

The reality appears to be, it’s unlikely. Yes, an individual country like Greece can suffer a huge bond scare, but for larger nations with printing presses such as the US and Japan, the most likely outcome is simply more debt and more devaluation. And with plenty of money sloshing around chasing too few assets, bonds will probably continue to be bid.

The only thing that would reliably kill the bond market is higher interest rates from central banks. The trouble is, higher rates would also kill the market for everything else and trigger a depression.

Could an inflation scare occur? Demographics, unproductive debt, and technological advancements put the chance of a sustained period of inflation pretty low, despite (or because of) the best efforts of Central Bankers.

Baby Boomers are compounding the problem.

As we noted in The Hack on April 7th, ‘Baby Boomers Coming of Age’, the backdrop of an ageing demographic and massive pension black holes will structurally cap any rise in interest rates.

‘According to the Federal Reserve, unfunded state and local pension obligations have risen to $1.9 trillion from $292 billion since 2007. Throw in the private sector and that figure is far greater. At the same time pension funds have been pushed up the risk curve as interest rates from fixed income are simply inadequate. Baby Boomers have never been more exposed to equities and are going to start to drawdown their capital for retirement.’

The paradox is this: To fill that black hole and provide fixed income for retirement, we need bond yields above, say, 5%; but with yields above 5% the ability to service the debt mountain collapses and assets are liquidated. Wealth is devastated. Then, all those retirees will be shifting assets from equities into fixed income in the next decade, driving a huge wall of money into a bond market with diminishing yields.

What about cyclical considerations?

We have been stating for some time that the credit cycle is rolling over. Just last week Michael Lewitt noted:

“I no longer expect interest rates to rise significantly from current levels in the current cycle; they are more likely to fall as the economy stays weak and debt continues to build in both the public and private sectors. We could see short-term 25 or 50 basis point spikes in longer rates (10–30 years) based on an errant comment by a central banker or some piece of news, but rates are likely to stay down until the current business cycle, which is very long-in-the-tooth, ends.”

With the Fed raising rates into a slowdown, they will have to backpedal in the near future to soften the economic blow.

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