Via Mark J. Grant, author of Out of the Box,
Alarm clock starts ringing
Who could that be singing
It’s me baby,
With your wake-up call!
-Toby Keith, How Do You Like Me Now
A great friend of mine and one of the best bond traders on Wall Street said this recently: “Get ready for The Great Bond Shortage in North America. If it has a cusip and it is rated, it is going higher/tighter.” I am down with his observation. The compression in bond spreads since the Fed started all of their “made-up/newly printed money for free” antics is the root of all of this and I do not expect a change anytime soon. There are various estimations for the 2013 net new issue supply in all sectors of Fixed Income but I peg it around $400 billion. Around $800 billion will be paid to bond holders during the year in coupon payments and, if reinvested, will cause a supply deficit of about $400 billion for the year. Exacerbating all of this is the Fed, who will buy around $500 billion in MBS this year and perhaps the same amount in Treasuries which could take $1 trillion out of the market all by itself. Consequently we face a lack of bonds denominated somewhere between $900 billion and $1.4 trillion, depending upon the Fed, which will increase the rolling train of compression, lower interest rates further in all likelihood and cause great angst for investors who will find very little of value left in the Fixed Income markets. Safety; yes but yield; no.
While this is taking place we will find a different scenario in the equity markets. The Fed will not be investing money directly in equities and so the liquidity that has propped the stock markets during the Treasury buying phase and will help at the margin with the MBS purchases is not going to have such a dramatic influence in my opinion as the MBS cash is likely to flow back into other segments of the bond markets and not so much into equities. There is also the American Fiscal Cliff, the worsening recession in Europe, the slow-down in China and the possibility of some political event in Greece, Spain, Portugal or Ireland as the funding nations in Europe get strained and could break during 2013. There is a point I assure you and I think we are verging on it where the people of various nations, under their own strain of recession, just cannot afford the grand scheme of European Union and revolt. The IMF is already getting testy with Greece and when Spain shows up hat in hand, their data is found to be inaccurate and the price tag far past the ridiculous estimations of the EU/ECB then “buddy can you spare me a dime” may fall on deaf ears. It should be noted that during the worst year of the Great Depression, 1933, that America had an unemployment rate of 25% which is exactly where we find both Spain and Greece today. A telling sign of things to come perhaps?
“We all know what to do, we just don’t know how to get re-elected after we have done it.”
A New Dynamic Since 2008
We all hear this is the next new, new thing and it will be different this time as the talking heads blather with wild abandon. Not wishing to join this group either in theory or style I am always quite reticent to walk into this space but the world since 2008 has been different than in past difficulties in one very poignant manner. The world’s three major central banks have all acted in concert and so we have been dealing with, really, just one set of responses that have been conducted on a global scale. Since we cannot invest off-planet or in some parallel universe the options that we have then are quite limited which is why, in my opinion, that the focus on Inflation or Deflation, historically always the epicenter of the discussion when major changes are made to monetary supply or fiscal policy, is not getting played out in the manner that most might suppose. I will go further, it is not Inflation or Deflation that are going to matter in the short run, though it will later; it will be the lack of bonds of any sort to purchase and a stock market that may be dangerously out of sync with the fundamentals opening the possibility of a crash and not a small one if it occurs. Institutional investors are edgy, that I can tell you with certainty, and it would not take much to see a flight from equities into bonds/commodities/gold regardless of the available yields and just because the money was relatively safe. Americans lost thirty-six percent of their wealth during 2008/2009 and while memories are short the pain of that experience has not yet been forgotten.
Inflation and Deflation, it should be noted, only work in operative systems. The question then becomes what takes place if the system breaks down and value, of any sort, is no longer present and that would be the scenario labeled “Crash.” Recently the senior spokesperson for bonds, the eminent Bill Gross, suggested buying Gold and I can well understand the rationale for his comment. If so much money is printed and so little regard is placed upon fundamental economic principles then the Real Estate crash of several years ago will look like child’s play by comparison. Then if you add in a Europe that could implode from the demands of the troubled nations, some sort of social revolution taking place in the same countries or the sounder nations refusing to fund or even being unable to fund then we have an economically impaired world that is squared and cubed by worthless currencies. Remember assets are not only relative, which is how we approach them in a functioning system, but they are absolute and indicative at the same time. All three operate in tandem and while the latter two are mostly ignored; they are there none-the-less. If gold becomes the reserve currency and is trading at $8,000 or $10,000 an ounce then the value of the Dollar, the Euro or the Yuan is close to worthless. The Inflation factor of food and other goods with costs that are prohibitive to buy basic essentials is another option but that would be even worse in my opinion. This is not the way of it yet but there is a tipping point where so much capital is created that a currency loses its value as a tool of purchase.
“Money for nothing and chicks for free” may play out for awhile in the glitter of Friday and Saturday night but Sunday through Thursday may write another story. Inflation and Deflation have another edge and that is Valuation which is why “Crash” may precede their better known cousins based upon Valuation which would be a systemic breakdown of the first order. Gold, silver and metals are really a currency option at some point if the value of paper money is found to be wanting. It won’t be the Dollar as evaluated against some other currency but the value of any and all of them that may come into question. The path would be out of equities and into bonds with yields not only falling to zero but perhaps through zero and then out of bonds and into cash and then out of cash and into gold and other metals. “Systemic Breakdown” would be the functioning words.
“As happens sometimes, a moment settled and hovered and remained for much more than a moment. And sound stopped and movement stopped for much, much more than a moment.”
-John Steinbeck, Of Mice and Men
Late Friday the Stabilization Funds of Europe lost their “AAA” rating mostly having to do with the economic deterioration in France. If Germany follows then it may be the first step in some sort of breakdown. At the same time America has been downgraded and our step over the Fiscal Cliff could have the same sort of affect here. I think that it be accurately said that easy credit, loose money and an overabundance of capital caused the events of 2008/2009 and since then the central banks have pumped even more liquidity into the system begging the very real question if we aren’t in for some sort of do-over of those events. No one is sure, I am not sure, but the possibility is no longer some other universe outlier or black swan that cannot be sniffed in the early morning breeze. If the mood changes and all currencies are viewed as lacking value then relative comparisons are hardly the point. Milton Friedman and Ben Bernanke have argued that the events of 1929 were caused by a contraction in money supply and hence our current policy but what is the other side of this coin if monetary expansion and capital supply is so great that the valuation of every currency declines as a result of their lack of worth; there is the appropriate question in my view.
Another interesting aspect of this consideration is what people do if there is no yield and the equity markets are in decline. If investors cannot generate enough income, one way or another, then what becomes of the seniors and others on a fixed income? Will it be the inability to pay mortgages, rents and then defaults and then bank failures? Some very unpleasant consequences to consider but if the expansion of money and credit are to continue unabated here and in Europe and if Draghi’s “Save the World” speech gets enacted then where does it all stop and what happens in America and Europe if there is no end in sight?
“No, you’re wrong there—quite wrong there. The bank is something else than men. It happens that every man in a bank hates what the bank does, and yet the bank does it. The bank is something more than men, I tell you. It’s the monster. Men made it, but they can’t control it.”
-John Steinbeck, The Grapes of Wrath