You’ve lived through the tech bubble. And the housing bubble. So what’s next?
Put it like this and the answer is obvious. There’s only one major asset class left. And its prices are near historic highs. The next bubble is a bond bubble.
Bond prices around the world have steadily risen for decades. Conversely, interest rates have been falling. The two are opposite sides of the same coin.
The trouble with bubbles is that you can’t afford to miss out, but you can’t afford to be holding the Old Maid when they pop either. These two emotions end up causing the very behaviour they warn against. People pile into tech stocks just when the bubble is defying all logic. Then they’re among the first to be wiped out.
So what is the bond bubble? Well, it’s a more complicated bubble than the previous two. But it’s not unprecedented. In fact, recent events are suspiciously familiar. And today’s Financial Times has plenty of articles about the bond bubble, without realising it.
The world’s most famous bond market is top of the news – Argentina. The FT estimates that one of the US’ major bond fund firms, Franklin Templeton, lost more than a billion US dollars on its Argentine position alone. Bond manager PIMCO has even bigger holdings of Argentine debt.
But what’s making Argentine bonds tumble?
The biggest worry is whether Argentina can meet its financing needs in the coming years, while navigating a looming recession and runaway inflation ahead of a presidential election next year. Oxford Economics estimates the overall funding needs for the rest of 2018 and 2019 at $77bn — a challenging number even with a more favourable backdrop.
With interest rates at 60%, and a currency that halved this year, not many people could finance that much debt.
The Argentines have tried every door out of the mess in the past. Now they’ve swung back to door number 1, the International Monetary Fund (IMF). The trouble is, this didn’t work out so well in 2001, explains the FT: “IMF wrestles with history in tackling Argentine peso crisis.”
But Argentina is far away. And bond investors were burned so many times in the past, it’s hardly surprising.
Getting a little closer to home, we have Turkey. The currency crisis there is making it hard for companies to repay their debts because those debts are often denominated in foreign currencies. A falling Turkish lira means you need more of them to service the same euro or US dollar-denominated debt.
For many companies who didn’t borrow in foreign currencies, the problem pops up differently. The cost of oil and other commodities is surging as the currency drops, cutting profitability and the ability to repay debt.
Last week, everyone was busy analysing which dominos would fall of their own accord, triggering the chain reaction. Moody’s debt ratings agency downgraded 18 banks in anticipation.
On Friday, companies began announcing their missed debt repayments. A vehicle rental firm and an energy firm were among the first, with a power plan going offline. On Saturday, a major Turkish shoe retailer announced it was in talks with creditors to restructure debt.
The point is, it’s not just sovereign debt that’s in a bubble. Corporate debt is too.
All roads lead to Rome, and then the ECB
The FT’s coverage of the bond bubble continued on to Italy. And Italy is the key. It is too big to bail out, too important to let fail, and too eurosceptic to control. Britain’s ties to the country in terms of trade and financial markets are enough to cause a major crisis at home if there’s a problem.
Confirming a suspicion I had expected to spend some time researching, the FT declared, “Italy has less than three months to raise the bulk of its remaining annual financing needs — amounting to about €63bn in fresh debt — as its bond sales programme lags behind those of other big eurozone sovereigns.”
May’s bond crisis in the Italian market spooked politicians. They stopped trying to raise funds as planned and delayed their bond issuance. Now, with Italian bond yields and spreads back near European sovereign debt crisis highs, they’re running out of time to raise the money.
Italy’s budget committee president has already made clear he expects the European Central Bank (ECB) to finance Italy’s spending. That’d likely be a violation of ECB rules.
Not only that, but the coming monthly issue of Zero Hour Alert, due Friday, has another urgent warning. It’s about a secret plan to kill off the euro on the sly. You may never know who was really to blame for the euro’s demise without reading it.
With an Italian budget battle due in October, Italian refinancing needs spiking, an Italian banking system that’s exposed to Turkey’s lira crisis, an end to ECB quantitative easing in support of Italy, and a secret plan to end the euro, what could possibly go wrong?
Bond bubbles are different (more dangerous)
The bursting tech bubble and housing bubble did plenty of damage. But bond bubbles are very different. They put at risk a far wider range of important things in our lives. Which is ironic given most people know a little about stocks, but not bonds.
One difference between a bond bubble and the two we had last decade is particularly important. Property values and stocks are a measure of asset wealth. They’re investments.
But bonds are not just an asset, they are also a liability. They must be repaid, or defaulted upon. A drop in bond values doesn’t just have a wealth effect. It also has an effect on the borrower. Without that debt, governments and companies cannot function the way we rely on them to.
Worse, bonds are how central banks manage their money supply. One of ECB President Mario Draghi’s excuses for his unconventional monetary policy to rescue Italy was that a crash in Italian bonds impedes his ability to implement monetary policy. It’s shifty reasoning, but it does expose that a problem in the bond market is a problem for monetary policy.
There’s a very direct and simple way this could play out. If ratings agencies downgrade European sovereign bonds enough, the ECB can no longer purchase them by law…
Escaping the fallout of the tech bubble would’ve been fairly easy, to a great extent. The housing bubble would’ve been more difficult – there are many reasons to own you own home, even if the price isn’t likely to go up.
But escaping a bond rout is impossible. Your government, likely your employer, your shareholdings, your pension and your bank will all be affected directly. You can’t just dump your bonds and worry about something else instead.
Put all these together and you can see how a bond bubble threatens more than just your wealth. It threatens the functioning of financial markets, governments, companies and monetary policy altogether. It threatens the ability to govern. It threatens the continuation of past GDP, not just GDP growth.
The coming bond crisis will wreak havoc unlike anything we’ve seen before.
If at first you don’t succeed, but get bailed out, try try again
If the bond bubble crisis gets bad enough, the basic rules of the financial system will be discarded. And politicians will come up with odd solutions. One of which I want to mention mainly for how entertaining it is.
In a wonderful example of history repeating, in May the ECB announced plans to securitise European sovereign debt.
The idea is precisely the same as securitising mortgage debt. By creating a pool of government bonds and then allowing investors to invest in that pool via different levels of payment prioritisation, and therefore risk, the total level of risk can appear to fall.
By “appear to fall” I mean that the sum of all parts will be given a lower risk rating by credit ratings agencies than the average of the individual bonds. Diversification works.
The trouble is, just as with American mortgages, the information that investors and credit ratings agencies rely on when building these pools is nonsense. Their default risk is far higher than credit ratings agencies can politically correctly declare.
The true purpose behind the initiative is to build a stepping stone towards eurobonds. These are joint bonds issued by members of the eurozone in a similar structure to the securitised sovereign debt.
This is an initiative we can look forward to in coming months as the bond bubble plays out.
There’s not much else to look forward to though. Find out what’s coming this October here.
Until next time,
Nick Hubble
Capital & Conflict
Category: Geopolitics