Yielding nonsense spells trouble

Reading a publication called The Interest Rate Observer might sound awfully boring. But right now, it’s interesting. And that’s not a good thing.

Take for example this simple factoid. Telecom Italia’s bond, which expires in 2022 and carries low credit ratings from the likes of Moody’s and Fitch, is trading at a yield of 0.739%. The US government bonds expiring in 2022 have a yield of around 2.5%.

So a poorly rated Italian company is able to borrow money for less than the US government. That’s bonkers. Or, as Jim Grant, the author of The Interest Rate Observer puts it, the bond market is a hall of mirrors. A place where you get “a junk bond with a zero handle”, meaning it yields less than a percent.

The differential can be partially explained by central bank interest rates in the US vs Europe, and expected exchange rate moves. But it’s still absurd.

The trouble here isn’t the situation itself. Such absurdities helped Italy to very impressive economic growth of 1.5% for 2017. That’s not sarcasm, it really is impressive for Italy.

The trouble is in the reckoning it implies. Interest rates will go back to normal eventually. There are plenty of ways that could happen – inflation or monetary policy tightening, for example. But there is no way places like Italy and its companies can afford this.

And that’s when the problem reaches you.

Unintended consequences are around the corner

Always remember, monetary policy works largely by encouraging leverage. Hence the steady debt boom over time around the world.

Without a clear-out of the leverage through a recession, the firms that would’ve died become zombies instead. They’re unproductive and can’t expand. And they cannot survive the next interest rate upcycle. It’s a build-up of malinvestment.

The zombies sit on the resources which would’ve been used productively by the new firms had the old ones failed. But they weren’t allowed to. Hence the poor economic growth.

Where to from here for investors? It’s more difficult than it seems.

If interest rates are artificially low, and higher rates are unaffordable for those paying them, then a bond market rout is in the cards. Defaults.

The problem is, bonds are still the safe haven asset class. Buying government bonds when there’s trouble in financial markets is a reflex action for investors. Especially the so called “smart money”, because in their world, it’s all about who moves into bonds first. They make the trading gains as all the other buyers pile in afterwards.

This means bond values spike, even if bonds are the source of the trouble.

The weakest link

Bipolar bond markets aren’t the only confusing factor. Thanks to how interconnected markets are, it doesn’t matter which part of the system triggers the crisis. It’s the weakest link that takes the most pain.

For example, in 2006 many of the people warning about the implosion of sub-prime mortgages advised their clients to keep their capital safe outside of America. An American crisis would harm the US dollar and US debt.

But the opposite happened. As investors panicked, they bought US dollars and US government debt – the two safest investments according to the rules of the game. The weakest links were in southern Europe. That’s where the crisis led to the worst affects.

The same is likely this time around. Which bond market or economy breaks under higher yields is not the question. The question is where the damage will be worst. Which bond market will investors abandon?

It think the answer is still Europe. It has all the preconditions.

Too much debt, not much growth, absurd bond valuations, fragile banking systems, bad demographics and political problems. Not to mention, one central bank to bind them and rule them all, as Tolkien might say.

The stock market in an interest rate upcycle

So what about the stock market in all this?

Rising interest rates reduce company profitability. They have to pay more for their borrowings. The exception is banks, who can charge more for their lending.

That’s the simple version, anyway. The question is what happens to the stock market’s valuations. Lower profits don’t always mean lower stock prices.

Higher interest rates on offer in bonds make them more enticing relative to shares. Dividend yields could fall below interest rates, for example. But the capital losses on bonds as rates rise make them less attractive. Stocks can rise with inflation too.

Of course, as explained above, if interest rates go up too fast and trigger an economic or financial crisis, stocks will fall and bonds will be bought back up.

I think that’s why Goldman Sachs came to the following conclusion:

“The speed of rising interest rates poses a more immediate risk to equities than does the level of rates.

“This week we published an analysis of the relationship between bond yields, corporate growth, and equity valuations. One key observation from our analysis was that S&P 500 prices typically stop increasing when rates rise more quickly than a standard deviation in a month (currently equating to a rise in Treasury yields of roughly 20 bp), and equity prices decline when yields rise by more than two standard deviations (40 bp).

“This relationship has held true during the last 50 years irrespective of whether rising yields were driven by inflation or real rates.”

Slow and steady interest rate increases are bearable. Anything fast will trigger trouble. That suggests inflation is the key indicator to watch. Because it’ll force central banks to act, even if they know the pain it’ll cause in their bond markets.

The other question is how far interest rates will have to go. If inflation gets out of hand, rates might have to rise beyond the levels that overindebted governments and companies can handle.

Put all this together, stocks are hardly worth the risk. But what is?

Until next time,

Nick Hubble,
Capital & Conflict

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Category: Economics

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