By: Roy Salisbury | Friday, February 3 2017
Is there a Perfect Financial Storm out there ready to decimate the US economy? Stock markets in the 27 + trillion range and Bonds ln 47 trillion for a combined 74 + trillion and our GDP of 18.2 trillion. The referenced article puts combined bond debt at 47 trillion or 2.58 times GDP. Is this a prediction of a perfect financial storm that we cannot avoid?
“Worse “than the 1994 ‘Bond Massacre,'” with “sustained double-digit losses on bonds, subpar growth in developed markets, and balance sheet risks for banking systems….”
The backdrop: after 36 years of bond bull market, the amount of US bonds has ballooned to $47 trillion, up 24% from just ten years ago:
Bonds dwarfs the US stock market capitalization ($27 trillion). Bonds are a global phenomenon with even bigger bubbles elsewhere, particularly in NIRP countries, such as those in Europe, and in Japan. That’s why bonds matter. They’re enormous. And the damage they can do to investors is huge.
So how bad might the next bond bear market get? Paul Schmelzing, a visiting scholar at the Bank of England and an academic at Harvard where he concentrates on 20th century financial history, published an unpleasant scenario on the Bank of England’s blog. He doesn’t mince words:
[A]s rates reached their lowest level ever in 2016, investors rather worried about the “biggest bond market bubble in history” coming to a violent end. The sharp sell-off in global bonds following the US election seems to confirm their fears. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre.”
To arrive at his conclusion, he classifies bond bear markets into three types:
He explains that “historically, inflation acceleration has been a solid predictor of sharp bond selloffs.” But other “prominent episodes appear less correlated with fundamentals, and can inflict similar levels of losses.”
Type 1: The inflation reversal of 1967-1971 occurred as annual inflation shot from 1.6% to 5.9%, along with some pressures on the federal budget from the Vietnam War that pushed the deficit from 0.2% in 1965 to 2.8% in 1968. But even when the budget moved back into balance, Treasurys continued their rout:
The “inflation reversal” leaves bondholders particularly bruised, and is most clearly associated with fundamentals: namely a sharp turnaround in realized consumer price inflation (CPI).
Type 2: The Sharp Reversal of 1994, or the “Bond Massacre,” turned out to be short-lived. It wasn’t caused by inflation, fiscal policies, or Fed action. The Fed did begin to raise rates in May 1994, but the turmoil had started in Q3 1993 and peaked in early 1994. Instead:
[T]he dramatic increase in leveraged bond positions by both US hedge funds and mundane money managers set in motion self-reinforcing liquidations once uncertainty over emerging markets including Turkey, Venezuela, Mexico, and Malaysia – all of which experienced sharp capital flow volatility – put pressure on speculative positions.
Type 3: The value-at-risk (VAR) shock in Japan in 2003 occurred when fears spread that the Bank of Japan, which was already doing QE before it was called QE, would taper its purchases of Japanese Government Bonds. The yield curve, which had been extraordinarily flat, steepen sharply, as prices of longer-dated bonds sagged. These sagging prices hit banks, which hold large portfolios of JGBs, particularly hard. Their shares crashed to multi-year lows, and some received taxpayer bailouts:
[T]he sudden steepening of the JGB curve from the middle of 2003 posed a new set of challenges: calibrated risk management structures, known as “Value-at-Risk” models, required banks to shed JGB assets once their price started plummeting. Since most banks followed similar quantitative signals, and exerted a traditionally strong home bias in their fixed income portfolios, a concerted dumping of government bonds ensued.
Schmelzing concludes: A pessimistic reader could certainly identify gloomy ingredients for the “perfect storm”: the potential for a painful steepening of bond curves, after a sustained flattening as in 2003, coupled with monetary tightening; and a multi-year period of sustained losses due to a structural return of inflation as in 1967.
But he considered the Type-2 “meltdown,” as it happened in 1994, less likely. At the time, highly leveraged bond positions and external shocks came together. This time, there has been “progress on bank leverage regulations,” and “the current global capital flow cycle has already almost fully reversed from the cycle peak,” he writes.
Instead, it will more likely turn into a toxic combination of Type-1 and Type-2 bear markets:
Global inflation dynamics are picking up, at a time when Central bankers voice more tolerance for “inflation overshoots.” Though currently bank equity investors are cheering the steepening of yield curves, meanwhile, the 2003 Japan episode should fix regulators’ attention on the growing home-bias in government bonds.
Banks in some countries are particularly exposed to the VAR shock, including Italy, whose financial institutions hold 18% of their assets in Italian government debt, up from 12% in 2008. And “in most geographies,” banks hold these domestic government bonds mainly in “‘available-for-sale’ portfolio buckets, where they have to be marked-to-market.” That allowed banks to take the gains as central banks pushed down interest rates and inflated bond prices in recent years, but it now exposes them to losses and forced selling.
On balance, then, more than to a 1994-style meltdown, fixed income assets seem about to be confronted with dynamics similar to the second half of the 1960s, coupled with complications of a 2003-style curve steepening. By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias. And that would not conform to the rosy scenario.”
The needed bail out for this perfect storm would potentially make the 2007-2008 bailout (700 billion) look like spare change and guess what even the US government could not fund the needed capital leaving the American public to foot the bill forcing a massive recession/depression that would take generations to recover leaving America as weak as a 3rd world country.
The recent stimulus roughly 787 billion could not get the economic recovery to break 2 % floundering in the 1.8% range recently. We spent 1.487 trillion and stayed stuck in neutral based on a flawed plan drafted by career politicians with no fundamental understanding of what drives the US economy.
Government growth is not the answer yet the government’s (Federal, State and Local) now employs 21.995 million.
The only answer to the challenge is sustainable growth fueled by small and medium size businesses creating Jobs