by Jeffrey Miller, Partner, Eight Bridges Capital Management
June 12th, 2016
Yes, and how many years can a mountain exist
Before it’s washed to the sea?
Bob Dylan, Blowin’ In the Wind
There is a mountain of overvalued debt in the world, and folks are beginning to wonder how long it can exist before it washes out to sea. About $8 trillion in debt around the world is currently trading at a negative interest rate, implying that the holders of this debt expect deflation for the foreseeable future. Smart, rational investors around the world are bemoaning the stupidity of this situation in increasing numbers, but central bankers push onward with their quest to drive rates even lower, in the hope (wrongly) that lower rates will spur lending by banks and investing by companies. Yes, you read that right – the geniuses in Brussels think that lower rates will make banks want to lend more. Why? Because that’s what their broken models tell them. Don’t believe me? Watch this video on the inner workings of the ECB’s bond buying operations. Skip ahead to the 2:30 mark for the explanation of why they are doing it, but be sure you’re alone, because if you actually have a brain and think about what he says, you’re going to want to scream. If you want to understand the crazy distortions in bond markets today, take 3 ½ minutes to check it out.
In the U.S., the picture is a bit better, but the weak jobs report in early June took down the market’s expectations for near-term Fed rate hikes significantly. This caused financials, which had been acting well of late, to sell off this past week, as they are desperate for higher rates in order to make lending more profitable. Unfortunately, they have hordes of Ph.Ds at the Fed and ECB standing in their way. (Did you know that there are 750 Ph.Ds on the staff of the Federal Reserve alone?) These economists all follow the Keynesian theory that we have a consumption problem – ie, that consumers aren’t buying enough stuff to create scarcity and drive up inflation to their preferred target. For some reason, they think that lower rates will drive consumption, despite the fact that ultra-low rates for the past seven years have failed to do just that. They think that consumption is a borrowing-cost problem, when in reality it’s an income problem. And they are the ones that are creating it. How? By stripping massive amounts of interest income out of the economy. When the Fed buys bonds and artificially lowers interest rates below their natural market-level, they are stripping income from the economy. That 5% in interest payments that the government used to pay to savers, insurance companies and pension plans is now under 2%, and mostly paid to the Fed. What does the Fed do with its interest payments? Nothing. It simply gives it back to the Treasury. All that income is taken out of the system. Sure, some investors move on to other yield investments, which explains the overvaluation of income stocks like utilities and telecoms, but there is more uncertainty in these securities, more volatility in their prices, and therefore a lower propensity to spend the income they generate – so savers hoard their assets instead of spending the income. This explains the really low velocity of money in the U.S. economy, because when savers, like retirees in Florida, can’t earn enough income from bank CDs and Treasuries, but are forced into risky assets they really don’t want to own just to earn enough income to pay the rent and food, they aren’t going to be out there spending on anything but the basics. That new outfit? It can wait. New golf clubs? Last year’s work just fine, thanks. Fancy meals out? I’ll stay home and cook instead. So when these savers fail to spend, the Fed, and its 750 Ph.Ds, decide that well, our models show that lower rates should boost spending (how? they never explain, because it doesn’t work), so we’re going to just lower them more, or put off raising them, despite the evidence (see Japan) that low rates do not create inflation or more spending – they kill it.
If you want to create more spending and monetary velocity, you need to increase consumers income. You need to get them more income today than they had yesterday, and they need to feel confident that that increase in income is safe and sustainable. Want to increase spending at restaurants in Florida? Take Fed Funds to 6% again. Want to make pension plans solvent? Take Fed Funds to 6% again. Want see banks falling all over themselves to make loans to small businesses again? Take Fed Funds to 6%. It’s simple. Don’t believe me? Give every saver with $500,000 in investable assets an additional $25,000 a year in income and see what happens. The Fed has the power to increase incomes tomorrow if it wanted, but it doesn’t really understand that. Incomes create spending, which will create the inflation they want. Don’t believe me? Give every person of working age in the U.S. one million dollars tomorrow and see what happens to inflation – there will be lines out the door of every Best Buy and auto dealer in the country. Too simple? Maybe. But directionally, that’s how it works. Unfortunately for the global economy, the inmates running they central banks insane asylums don’t get it.
So what’s an investor to do in such an environment? I don’t think the sovereign debt of countries that have their own currency and an accommodative central bank (CB) is much of an issue. So long as the CBs are willing to finance the debt, and continually roll it over, then it never really needs to be repaid and taxes don’t have to be diverted from spending to pay it down. How long can this go on for? Forever. When debt comes due, the CB can just print more money, hand it to the Treasury, who gives it back to the Fed for its bonds, and voila – no more debt. Or, they just issue more debt that the CB buys, and they leave the same nominal amount outstanding. So the U.S., China, U.K., Japan and other countries with their own currencies are fine. The Eurozone countries are in a bit more precarious position, particularly because Germany doesn’t really seem to understand this mechanism and balks at “bailing out” weaker members of the currency union. For now, the ECB seems to be pushing on without them, and rolling their debt, but the restrictions Germany wants to impose on its Eurozone partners could eventually lead to further crisis. For now, however, I think that sovereign debt fears are overblown in the face of an overwhelming cover bid from CBs around the world.
Corporate debt is a different animal – while the ECB is now buying corporate bonds in addition to sovereigns, its ability to roll over a bond from a distressed borrower is somewhat in question in my mind. If you have a corporate borrower that runs into issues and doesn’t have the cash flow to pay back its debts, what will the ECB do? Extend and pretend?