Greek Bond Risk Laughable

As I wrote late last year, risk and reality are disconnected in so many investments today. Among the most laughable and most egregious disconnects today are bond prices/yields of Greek sovereign bonds.

A multi-year chart from Bloomberg illustrates this:


Whereas Greek yields in 2012 rose to 35%, indicating a significant risk to bondholders, today's yield is only 11.31%. Yet all we hear on a daily basis out of Europe is the danger of Greek default and possible exit from the EU, usually referred to as "Grexit".

The markets today in so many securities are totally fake, controlled directly or indirectly by Central Banks. The CB's are putting more fingers in more dykes daily. Similarly, most nations are issuing increasingly fictitious unemployment, economic and fiscal indicators. 

This means that economic observers and investors are increasingly flying blind since most of the data that they could count on in the past to give an idea of what is really going on in the world are completely unreliable/fake today.

Realize this and exercise extreme caution!

Central Banks and World Stock Markets

With few exceptions, the world’s stock and bond markets continue making new highs, all the while listening for the tiniest of clues that Central Banks (CB's) might be reversing gears or curtailing their apparently endless backstopping of securities.

But so far at least, any time things seem to get a little wobbly, especially after some slightly concerning remark from one or other mouthpieces of the world’s main CB's, one of their members steps up to the plate with news of new “liquidity injections” and soothing words.

But of course, propaganda notwithstanding, the underpinning economies and fiscal situations of most nations continue to deteriorate. So the pricing of securities and their actual free market values continue to diverge ever wider.

What is worse, the whole concept of risk seems to be disappearing. Take a look at sovereign bonds. It used to be that the bigger the risk that a nation could not repay its debt obligations, the higher the interest rate demanded to lend to that nation. Logical, huh? Well take a look at Spain's debt situation since 2008:

Now take a look at the yields on Spain's bonds!

Spain Government Bond 10Y Yields (courtesy of http://www.tradingeconomics.com)

So the divergence is pretty clear! Sometime in 2012, the markets began to let go of all pretense that there is any risk whatsoever in holding toxic debt, provided that CB's could be counted on to buy it up whenever things start to look dicey and real buyers had disappeared. This is the essence of "ZIRP", the so-called Zero Interest Policy espoused in one form or another by most of the world's CB's, which, in some cases has become "NIRP" or negative interest rate policy.
Of course, this engenders precisely the opposite behaviour by indebted nations to that required to reduce their reliance on borrowing. After all, if you can borrow for next to nothing, what the heck, right?

Of course, this moral hazard has spread throughout the world's economies, as subordinate interest rates for almost everything have been driven lower. Consumers continue to buy on credit, especially for big ticket items such as vehicles where interest rates are often next to zero. In the meantime, savers and pensioners are being ravaged. A yield of 2.5% on $1million in savings will only bring $25,000 annually. It's hard to live on that. And how many have saved a million, anyway?

Interestingly, when CB support becomes questionable, the markets begin to work again. Look at these charts of a selection of Government 10 Year Yields. What is the only one that makes any real market sense? Well, Greece, of course. And why? Because it is not certain whether Greece will remain a part of the EU. So in that case it could not depend on being backstopped by the European Central Bank (ECB). So Greece's bonds get priced accordingly.

The bottom line is that in an attempt to rescue the banking system (remember that most CB's are run to a large degree by bankers) and the economy, central banks have created enormous investment bubbles in securities that are artificially priced on a variant of the greater fool theory, where the greater fools to whom you can pitch your investments are the CB's.

But CB's may be slowly coming to be in fear of what they have created and increasingly, concerns are being expressed that the divergences between markets and reality can not continue indefinitely.

I urge all to observe the markets carefully as the day will come when CB's can't or won't continue to madly print and buy everything in sight in an attempt to keep it all glued together. When things get unglued this time, the carnage will be much worse than anything we have seen in recent history.

China, the Dollar and Sovereign Debt

Quite a few observers are suggesting that China could/will bring the U.S. down by suddenly dumping its dollar-denominated Treasuries and Bonds, thereby creating a mass exodus from the delicately-perched $US, dramatically raising bond yields and thereby interest rates in general, resulting in a global economic crash and a “reset” in currency values and a realignment of world powers. As the second largest holder of $U.S. sovereign debt (the Federal Reserve has now moved into the #1 position), it is certainly plausible for the Chinese to do this. But in my view this scenario, at least as a deliberate action, as opposed to a reaction to some other external trigger, is extremely unlikely. Why would the Chinese rock the boat unless the perceived benefits outweighed the associated costs (such as loss of the remaining value of their $U.S. denominated paper assets, crippling of their export-oriented manufacturing base, etc.)?

However, our financial system is increasingly perched atop an unstable ledge. Interest rates are held artificially low by constant central bank backstopping of sovereign debt in an attempt to keep the economy (and banks!) from collapsing. Remember, bond yields are inversely related to bond prices! The U.S. Federal Reserve, for example is pumping at least $85 Billion a month into Treasuries, bonds and other debt instruments. The resulting super-low-interest rate environment has created a mad scramble for investments that have a higher rate of return than the 1% or 2% available from traditional “safe” investment vehicles. Middle class savers can either join this scramble into increasingly higher-risk ventures or be savaged by returns lower than inflation. Those funding their own retirements are finding that even $2 Million savings earns a paltry $40,000 in annual interest. Meanwhile, stock markets have surged to record highs and sovereign debt yields, even for Italy and Spain, have declined. All this is taking place while outstanding sovereign debt continues to accumulate. The chart below shows the deteriorating European debt situation.

 The divergence between the actual situation and the financial pricing of risk in bonds and securities is increasing. As recently as last week, S&P downgraded France's credit rating. Did this cause French bond yields to rise? Of course not. They are stuck at a nice 2.2%. In layman terms, everything is increasingly out of whack in the financial, investment and monetary world. Price discovery is dying. Manipulation of interest rates and other markets is forcing money where money shouldn't be and forcing risk to be mispriced by a large margin. New bubbles are forming.

The Chinese and most everyone else with big money on the table know this but are riding out the trend supported by ever-increasing central bank intervention variously labeled as stimulus, quantitative easing, monetary aggregate adjustment, etc. So the Chinese seem to be preparing for that day, whether they, the Chinese, or some other event triggers a run from sovereign debt and the affected currencies, say, the Euro, the British Pound, the Yen and the $US. They have been purchasing large amounts of gold and entering into increasing numbers of Renminbi/Yuan currency swaps with other nations in an apparent move to initiate the internationalization of their currency as a possible prelude to eventual reserve currency status for their currency. 

Perhaps a rapid transition in mind-set is not imminent but some unexpected trigger could cause a rush for the exits at any time. It's really a state of mind as well as a collective assessment of when the end of the rope is reached for central bank printing actions. Most folks know none of this is repayable, after all, and the wiser ones are warily eying the exit doors for signs of  mass exodus. I suspect that the Chinese are in that category. They have too much to lose to be the last ones out the door.

The Next Financial Crisis

Many observers are predicting further banking and financial crises and collapses. Why? Well, the 2008-2009 collapse did little to cleanse the world's sovereign debt and fiscal deterioration or to correct banking and financial system excesses. We have kicked the proverbial can down the road. Beneath it all most indicators continue to atrophy. Sovereign debt keeps on rising and personal indebtedness across most countries is doing the same. The back-stops provided by the Federal Reserve, the European Central Bank, Bank of Japan and myriads of others along with increasingly ingenious albeit contrived rescue schemes have so far managed to prevent another, worse, collapse. The latest "solution" for America is in the realm of the surreal - a trillion dollar platinum coin that even the esteemed? Paul Krugman seems to endorse.
Attention of markets and the media have careened back and forth between Europe, China, Japan, the U.S., and the Middle East. Sometimes the focus is energy (as in oil), sometimes concern about the future of the EU or the breathtaking public debt in Japan or the insolvency of U.S. States or the U.S. itself. It seems that markets and media alike get tired of focusing on any one issue or part of the world for any length of time. Nothing has really changed in the European financial situation, for example. In fact everything continues to deteriorate. Yet bond yields have dropped for Spanish, Greek, Portuguese and other European debt. The focus has shifted once again away from Europe and back to the U.S., perhaps in part due to the mind-numbing pounding on the U.S.  fiscal cliff and the U.S. debt ceiling.
So, where is the next financial breakdown going to occur? Nobody knows, but I am going to focus on a potential U.S. flashpoint - U.S. Treasuries and Bonds.
In a previous post, I discussed a chart that was relevant to foreign holders of 30 Year U.S. T-bonds. The chart depicts the value of T-Bonds, corrected for the value of the US dollar, by incorporating the widely quoted U.S. dollar index. So, in other words, it shows how well a typical foreigner's investment in such bonds is doing after cashing in and converting to his home currency of Euros or Japanese Yen, or whatever. In my previous post I observed that foreign investors were doing very well indeed. But look at the chart today:

Are bondholders getting nervous? If they are and if they stampede to the exits to finally dump U.S. bonds, it will precipitate a major crisis for the U.S. and the world. The $US will go into a tailspin. The Federal Reserve will need to buy all bonds presented for redemption with freshly created dollars. Sellers will then convert their U.S. dollar proceeds into . . . what? Other currencies? Stocks? Gold, Silver? What do you think? Keep an eye on the above chart, updated by stockcharts.com once a day (evening Canada/US Eastern Time) to gauge the risk and progress of the U.S. bond bubble if indeed it becomes the flashpoint to the next financial crisis.

How well are foreign holders of US$ debt doing?

Folks have fretted over the possibility of a huge U.S. bond bubble for a long time. In particular, some have warned that China, in particular, might suddenly begin dumping large amounts of accumulated Treasuries. In fact, China has been dumping US Treasuries and the Federal Reserve has been forced to compensate by printing up the difference (quantitative easing) to a good degree. See here. But so far this exit from the US$ has been controlled. Partly this may be because other major currencies are also having trouble so that the US$ is seen as the best of the worst. Since the 2008 crisis, Central Banks around the world have been pumping - buying their own debt - see here. So, while the US debt infrastructure may slowly be crumbling, a fast look at the recent performance of US$ denominated long-term debt (30 year Treasuries) from the perspective of foreign holders shows that for the time being everything looks pretty good.

The above chart depicts the performance of 30-Year US Treasury Bonds in terms of the US$ index. Typical foreign holders make money in their own currencies if 1) the US$ rises and 2) the Bonds themselves rise. By charting the US$ index divided by the bond yield, we get an approximation of the combined effects of bond price and US$ price relative to other currencies.

Thus, while many participants may be nervously glancing at the EXIT doors to spot an incipient mass exodus which would precipitate an implosion of the so-called bubble, those exiting now are actually doing very well from an investment perspective. Anyway, the current focus is still on Europe - Greece, Portugal, Italy, etc. But markets will eventually turn to the biggest debtor of them all - the U.S.

Is Greece the next Lehman?

Is Greece the next Lehman? Well, there are many who are suggesting a comparison, including me, but I'll just point to some published thoughts.

Sanguine thoughts from the MainStream Media re: Currency Devaluations

It's amazing what is going mainstream. Here is MarketWatch's David Callaway using terms like "Race to the Bottom" in reference to competitive currency devaluations with warnings about conditions that could lead to another depression. Bond bubbles, commodity bubbles, stock market bubbles - I guess it is becoming OK to talk about these things now that the artificiality of rises in these entities is becoming patently obvious to all, while the FED (along with most major Central Banks) desperately tries to keep everything afloat on an increasing sea of liquidity courtesy of modern day printing aka "Quantitative Easing". Gee, until recently, this stuff could only be heard in blogs and "radical" alternative news sites.

Bond Bubble will Burst

Observers have been warning about the dangers of a bond bubble and what a collapse in such a huge market would mean. Recently, The Economist and many other mainstream publications have become more strident in expressing their prognostications and concerns. See this article from the Asia Times for an example.

Artificially low interest rates (aka free money) coupled with stimulus funds recklessly sloshing to and fro have inflated asset prices all over the globe. However, the most dangerous of these runups is likely the U.S. bond market. Banks, governments, agencies and investors have been borrowing short at close to zero percent interest and buying long bonds yielding 4 %. Just for good measure, anytime the bond market looked a little unsteady, the federal reserve steps in and buys a whole bunch. Sounds like bootstrapping, doesn't it? Anyway, this will need to be unwound sooner or later, just like any other market that has been driven up artificially (like the housing bubble in the U.S., sub-prime, etc.)

The big difference is that the U.S. bond market is very close to the top of the pyramid as far as the world monetary and financial systems are concerned. A failure in this market could crash the U.S. dollar, the world's reserve currency, in addition to crashing government financing capability and markets generally. If you think the sub-prime mess was bad, it would be a walk in the park compared to where a bond crash would take us.

While governments have been been frantically trying to defuse our crisis, they are really playing double or nothing and risking everything, including the very foundations of our financial and economic structures. Heaven help us all.

More here.

BAILOUTS & THE MORAL HAZARD

Economically and monetarily speaking, the Western world, particularly the U.S. has been in trouble for a long time. We've had a series of rolling crises which have been masked or papered over by the Federal Reserve, the U.S. Treasury, Wall Street and the Central Banks of the world, all in an attempt to keep the party going.

The bailouts have increased the problem of moral hazard. At the moment we are in a bailout phony money phase with artificially low interest rates, rising commodity and stock prices. watch out for the big bond bubble ahead along with many other problems most likely manifesting themselves in 2010.

For more see: http://bondbubble.info