The past couple weeks pundits from all over the financial community have been chiming in on the yield curve inversion.
As a recap: yield curve inversion is kinda this upside down world where the front months of a bond are priced lower (higher yield) than the longer dated maturities. It’s bass-ackward because we’d expect to be paid more for duration risk, not less.
Ok, so what? What does that mean?
In short, the market expects a recession. That’s why it’s inverted. Lower growth means lower rates.
A recession would bring the Fed to the “easing” table and rates would plunge again. This is why further out the duration curve bonds are now being priced at a lower yield than shorter duration. Yield inversion. Got it?
Certainly bond traders are smart. Smarter than equity traders. Disagree all you like, that’s just the way it is so this warrants our attention.
Plus, it’s a truism in the investment world that it’s never different this time.
And just look at how investors have been educated. Most any bond trader still working the tape today has experienced a near linear path which is another reason returning to this thesis is a very easy one to return to. Don’t believe me? Take a look.
It’s been a one way street, and going up against it has proven more painful than stepping on a Lego in the night on the way to the loo. Just ask any bond trader who’s been short in the last couple of decades. Horrible stuff.
Putting a recession aside, I think there is a bigger problem for investors to be chewing their fingernails on. The implications of more easy monetary policy.
Returning to our truism “it’s never different this time”. Something else that’s equally “never different this time” is that governments never pay off unsustainable debt. Nevaaahhh!
Which brings up a question:
How much more debt can the world’s sovereigns add to their balance sheets before something falls over?
To make it easy for you, here’s a visual of a few select countries sovereign debt situations today.
In all honesty, I don’t need to show you the charts. You’ve seen them all before. It’s more than we’ve ever experienced and then some.
I’m sure some more debt can be added. But how much? Obviously I don’t know and nobody else does either. That’s the problem.
This part of the equation is unknown because it is truly different this time. We’ve never been here before. Literally. So you can throw out all the textbooks on this stuff because there is no precedent.
As I mentioned multiple times before in these pages, the biggest reason for this phenomenal bond bull has been a global political and economic coordination between the world’s major countries and central banks.
The likes of which we’ve never seen before. EVER. And as mentioned when discussing the rise of “strong men”, we’re now in a quite different world than the last time we had a crisis to deal with (2008): Here’s what I promised then.
- Political cohesion and stability can no longer be relied upon as politics becomes inward looking with everything from trade deals to central bank swap lines being renegotiated or cancelled altogether.
- Global coordinated central bank action. The era of global coordinated monetary policy which we’ve been experiencing since the GFC, especially with the three largest players (ECB, Fed, and BoJ), will be looked back upon with nostalgia by the current clutch of central bankers who muddy the halls of power. Policy will increasingly be driven with greater sensitivity to nationalist rather than international concerns, which brings me to…
- Liquidity in the financial system which has stemmed from easing monetary policy is already contracting. In a world where derivatives traverse borders, connecting financial systems like never before, a liquidity crisis presents enormous tail risk in a leveraged world.
Thing is just as the US began raising rates and the rest of the world remained in “easy mode”, this helped punch emerging markets in the face and send the dollar higher.
So my point is this: we need to look at the entire globe because nothing happens in isolation and what happens in one market, especially a monstrous one like the sovereign bond market, ripples across the globe and affects other markets.
So turning our attention to that fustercluck that is the Eurozone, we find the following:
Where revolution is in the air.
Now, I don’t know about you but if I were forced to live my life eating snails and croissants, and was only allowed out of the house if I was holding a baguette while wearing a scarf, I’d most certainly be out in the streets yelling, “vas te faire foutre Macron” too.
But as maddening as those things so quintessentially French are, that’s not actually the reason as to why our French friends are all hot and bothered.
The media tell us it’s because Macron hit the peasants with a fuel tax and because, well, they’re thugs. But that’s a bit like saying that tofu is actually food. In other words, not especially accurate.
Much like Brexit, the French peasants are saying “non, Monsieur” to the globalists.
They’re saying non to the destruction of their culture. They’re saying non to the eye watering taxes. They’re saying non to what has by stealth been imposed on them. A political union run by a bunch of unelected foie-gras eating pointy shoes in Brussels.
Remember when back in 2005 the French and our clog-wearing friends, the Dutch, specifically voted against a political union? Juncker and his cronies took one look at the vote and went “pah” and brought it in via the backdoor anyway. And now folks are fed up.
And you’d think that with all the backlash that is now unfolding across Europe (because don’t look now but the “yellow vests” movement in France has leap frogged over to Belgium, Germany, and now Holland) we’d see these “leaders” rethink what they’re doing. You’d think that, but you know what? You’d be as wrong as Miley Cyrus swinging naked on a wrecking ball.
Consider that while France is in flames, Italy teeters, and Merkel finds herself increasingly marginalised, these podium donuts are pushing through “the UN Migration Compact”, which will criminalise all criticism of mass migration and has the effect of completely changing the definition of a refugee assigning them status equivalent of a citizen.
Now, you may think this a good thing. That’s not the point. Not a single citizen has ever been consulted on this and yet these “world leaders” next week are signing this and bringing it into force.
Back to the French who’re swapping out their baguettes for isht they can throw. Unlike Brexit, however, they’ve chosen not to do it at the ballot box but on the streets of France.
And speaking of Brexit, let’s look at what’s taking place with our pasty friends over in the land that manages somehow miraculously to not drown in rain.
Over there Theresa May’s government is now at risk of being held in contempt for failure to release the documents that detail her plan for the Brexit deal she’s put together.
She has to hide it from folks because she desperately needs to get it voted on behind peoples’ backs before they see what a useless piece of trash it really is. May clearly isn’t putting two and two together.
The yellow vests movement is a symptom of a wider problem, and May is part of that problem. That she can’t or doesn’t want to see this is proof that beneath the fancy clothes and polished veneer of sophistication there pulsates the brain of a sand flea.
Realise this: if Brexit fails, we’re seeing a massive failure in democracy.
Sadly, the Brits are not the only folks to find this a problem. Today, in much of the Western world, we have democracy in name. I mean every few years there is a podium donut contest full of earnest faces, packed neatly with $100,000 speeches prepared by teams of smart pointy shoes, though often enough they tend to result in more of the same.
Tell me what influence do we have on the wars our governments wage? What influence do we have on immigration policy? What influence do we have on what our kids are taught in schools? None!
Pretending we have some sort of say in this only makes it worse.
You may be asking what does this have to do with the yield curve inverting?
Well, any half wit who can add two and two can see that this is problematic for the governments of the member states of the EU.
But remember as I mentioned when discussing Italy, it’s the banking system that the ECB uses as both the carrot and the stick to ensure “compliance” from member states.
The ECB have a means of dealing with pesky, recalcitrant upstarts like our pasta-eating, sunglass-wearing, espresso-drinking friends.
Strip away all the bluster and noise and it’s clear that the nuclear weapon in the ECB arsenal is their ability to manage sovereign bond spreads and the liquidity in member states banks.
What do you do as a politician if your options are:
- Exit the EU and take the financial pain of having your banking system get hammered as ECB liquidity is withdrawn, or
- Keep ignoring your citizens and get booted out of office and maybe even physically harmed.
Neither option is great but one option will allow you to remain in power.
For the last 30 years the sovereign debt of the Western world nations has been untouchable. Sacrosanct. The central banks are behind them. And you don’t want to fight the central banks. That’s been the play, and by golly it’s been the right play.
But the world that enjoyed that environment was a world with completely different political leaders.
It was a world as similar to today’s world as chalk is to cheese.
I’d argue that watching the tape alone and ignoring these events is hugely risky. Remember going into Brexit? Well, the ticker tape watchers were caught completely off guard. Why? Because they were relying on the tape alone.
There were only a few of us who while watching the tape were focusing on the geopolitics and zeitgeist that was seething. Don’t say I didn’t warn you ahead of time.
Maybe I was lucky. Then again, maybe not. My best guess is we’re going to be seeing some serious bond market problems in the EU over the next few years.
Riddle Me This
Austerity has been imposed on many EU member states. And it’s no secret that austerity is deflationary, so here’s an easy question. If austerity is deflationary, what is the opposite?
[clickToTweet tweet=”Riddle me this: If austerity is deflationary, what is the opposite?” quote=”Riddle me this: If austerity is deflationary, what is the opposite?”]
And do you really think that the new incoming governments in Europe are going to abide by these austerity measures imposed by Brussels?
Yeah, me neither.
The End of a Failed Dictatorship
What we’re witnessing right here and now is the beginning of the end of a failed dictatorship, and that is the dictatorship of the EU.
If looking at the Fed and the inverted yield curve is big picture thinking, I’d urge you to think bigger picture.
When the European bond markets come unglued as populist governments exert their will, the Fed will have another problem to deal with.
Not only will the myth of sovereign bond stability be shattered, but a decent chunk of capital will go seeking “safety” in US markets. You tell me what happens to an inverted yield curve in the US then.
Have a great weekend, and thanks for reading!
“Consider a turkey that is fed every day. Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.” — Nassim Nicholas Taleb