Monday, June 6, 2016

Signs of the Next Financial Crisis? - Part 1

The US economy received very bad news on Friday in the May jobs report. The economic consensus's average prediction was that around 160,000 new jobs would be created, but instead, the actual number came in at just 38,000, missing expectations by more than 75%. Adding to the bad news was the fact that previously reported jobs figures in April and May were also adjusted downward. This chart from Zero Hedge shows the trend over recent periods.

This item comes against a backdrop of generally bad economic news. In Q1, GDP growth checked in at a disappointing 0.8% growth after initial forecasts from the Fed placed it as high as 2.5% and then rapidly fell. Meanwhile, Q1 earnings for public companies listed on the S&P index declined by 7.1% on a year-over-year basis (driven significantly, but not exclusively, by low oil prices wreaking havoc on the energy sector).

With all that said, these few negative data points and trends are not sufficient to tell us that the next downturn is here. But they should cast doubt on the optimistic economic narratives that have been pushed lately both by President Obama and the leaders of the Fed. Contrary to those in power, the economy is not stronger than ever, and there are real risks of a new economic crisis--one which, in my opinion, is likely to be worse than the last.

Our purpose is to discuss some of the most significant risks and explain them in a way that everyone can understand, without a background in economics or finance. These are the two major risks we'll address over the next two days:

  • Massive bubble in negative-yielding bonds (part 1)
  • Significant rise in corporate debt without an accompanying rise in profits (part 2)
Before we get started, I should hasten to note that economics can't tell us when the next crisis will occur. And since it's better to be general and correct than precise and wrong, I'm not claiming to predict another recession within the next quarter or year. Instead, my argument is simply that the current conditions and trends are inherently unsustainable. Put another way, certain aspects of the current financial system amount to a powder keg. And though I can't say when and what the spark will be, it still seems prudent to comment on the danger posed.

Negative-yield Bond Bubble
Negative-yielding bonds are a relatively new phenomenon, but their prevalence in the economy has grown rapidly. Recently, the total amount of negative-yielding bonds in the global economy reached $10 trillion. For the sake of comparison, the total value of the subprime mortgage market was around $1.3 trillion.

A Basic Explanation of Bonds
To understand why negative-yield bonds are a big deal, we have to first understand how bonds and their yields work. Details vary, but the basic idea is rather simple. Bonds are effectively standardized loans that are used primarily by governments and corporations. The verbiage used to describe bonds is a little confusing; we would say that governments issue bonds and investors buy them. This means the investors are lending the government (or corporation) money and the government commits to pay them back a predetermined amount at a given date as well as pay them interest periodically.

The standardized nature of bonds is what makes them different from what we'd typically think of as loans. Since they have consistent terms and the obligations are payable to the holder, bonds can be bought and sold among different investors without even involving the original issuer. This is why it makes sense to speak of the price of bonds (for example, US Treasury bonds), even though we wouldn't usually speak of a price for loans.

In the realm of bonds, yield is simply the annual rate of return the investor expects to earn at the time the bond is purchased. So if I give you a loan for $100 (or, you sell me a $100 bond), and you agree to repay me $108 in a year's time, that bond would have a yield of 8% ( (108/100) - 1 ). Now, imagine I get desperate for cash for some reason and I don't want to wait the full year to get my money back. Alternatively, interest rates might have gone up so my 8% return no longer looks so appealing. In any case, I decide to sell the bond (my right to get paid back) to Jason for less than I bought it--say, $90. In this case, now Jason's yield on that same bond would actually rise to 20% ( (108/90) - 1 ). In this way, yields and prices are inversely related. If prices go up, yields go down, and vice versa. Similarly, if demand for bonds goes up, all things equal, prices will tend to rise and thus decrease yields. If demand falls or supply increases, the opposite would occur.

The same dynamics driving my hypothetical example above take place on a global scale, albeit with much more complexity and much lower yields involved.

Causes of Negative Yields
In recent years, demand for bonds has risen considerably, driving up prices and making yields actually go negative. There's few different drivers of this. The first is that government bonds are the preferred vehicle that central banks like the Fed use to try to inject new money into the economy. This is what happened during the various rounds of quantitative easing by the Fed. The Fed literally creates new money and then buys government bonds from investors in the market. US bonds comprise the largest part of the Fed's balance sheet, $2.46 trillion as of the most recent report. Another source of demand is banks and other entities that are incentivized to hold government bonds, which are considered safe assets, in order to meet their capital and collateral requirements. And finally, there's everyone else. With interest rates set at historic lows by central banks, it's impossible for anyone to make a reasonable return in normal savings vehicles like certificates of deposit or savings accounts. Bonds typically offer a slightly higher yield than such options, making them more attractive. The general trend doesn't hold for negative-yield bonds, but as we'll see shortly, some investors actually are profiting off buying the negative-yields and thus may still see them as a better investment option than a plain savings account. Finally, government bonds are seen as a source of safety for regular investors.* After the turmoil in the stock market in Q1, the demand for bonds has gone up as investors look for safer waters.

So the combination of all this demand has driven yields negative, which almost seems to be a logical impossibility. In our example above, that would mean I'd give you $100 and you'd promise to give me $99 in a year from now. Who would possibly agree to such a transaction?

Well, central banks would be willing to do so. They're buying bonds to implement their monetary policy strategy, not to make a return. (Also, if you had the power to create money, you probably wouldn't be too concerned about losing money either.) Similarly, banks that are holding bonds to meet capital or collateral requirements might be somewhat insensitive to negative returns as well, provided they lack better alternatives. But surely, other investors wouldn't do it. Right?

The Greater Fool Theory
In fact, it appears some investors are actively pursuing such a strategy. Stranger still, they have made money. This is possible because monetary policy and investor fear continue increasing demand for bonds, driving up bond prices and driving down yields. As a result, it's possible to buy a bond yielding -0.1%, and then wait for economic conditions to get more terrifying and possibly have another central bank announce a stimulus. As things get worse, the prevailing interest rates and yields might fall further. All of a sudden, the initial -0.1% bond is more valuable and I can sell it at a profit to someone willing to take on a -0.2% yield.

And now we see why this fits the textbook definition of a bubble. There are only a limited number of participants, albeit big ones, who have real reasons for holding negative-yield debt (mostly banks and central banks). Most everyone else in this rapidly expanding market is investing in the greater fool theory. That is, negative-yield bonds don't make sense as an investment unless you can sell them to someone who is willing to accept an even more negative-yield bond.

In this way, it can be seen as analogous to dot-com bubble of the late 1990s or housing bubble of the 2000s. At the end of the 1990s, people weren't investing in every new start-up because it was logical to assume they would generally turn out to be profitable, sustainable companies. They invested because the stock prices just kept going up and it didn't matter what the underlying company was doing. Similarly, people bought expensive houses they couldn't afford in the 2000s because it was an investment, and housing prices always go up...except when they don't.

So it is with negative-yield bonds. Investments that don't make intrinsic sense are profitable as long as you find someone willing to take on a more unprofitable investment. And like all bubbles, this one is not sustainable. At some point, there is always a last fool. The question is what happens then, when yields are too low to attract more buyers?

After the Last Fool
The answer is a difficult one. In the absence of central bank intervention, bond prices would have to fall to attract buyers, causing yields to rise. The major risk is that this could quickly create a panic, given that many participants are effectively betting on rates continuing to decline indefinitely. If the fall in bond prices (rise in yields) is significant, it could also imperil even the more stable bondholders like the banks. If prices fall enough to make banks undercapitalized, they could be forced to liquidate, again reinforcing the vicious cycle. Note that these impacts would be less severe in a positive yield environment because yields would be closer to what we might consider normal. Just as housing prices collapsed harder in more speculative and inflated markets (Phoenix, Miami, Las Vegas), bond prices and yields will spike more dramatically if they are deep in the negative yields when it occurs.

Of course, central banks will probably try to prevent yields rising at all costs to avoid the risk of such a panic. They would create more money and step into buy the bonds to prevent demand from collapsing. But this policy carries its own risks. For instance, it could cause investors to flee to currencies that have a more predictable central bank policy--if that happened, it would actually exacerbate the very panic it sought to prevent as investors sell off bonds in the central bank's currency.

The key point to recognize here is that negative-yielding bonds are an asset bubble as surely as the ones that preceded them. At some point, it will burst as well.**

Be sure to check out part 2 tomorrow where we discuss the economic risks associated with rising corporate debt.

*The Financial Times offers another reason why investors might hold negative-yielding bonds, effectively as a cash alternative for very wealthy investors. This amounts to paying the government to hold your money, as they note, but could be attractive if banks start charging negative interest rates. Thus far, however, the practice of charging customers negative interest rates is very limited and seems unlikely to scale up. For this reason, it seems conservative investors would probably favor cash over negative-yielding assets.

**Note that the analysis above assumed that the underlying governments would not be perceived as any kind of default risk. If that were to change and a government was viewed at risk, this could spark the same kind of sell-off discussed above.

Hat tip to Jason Stapleton who explained the risks of negative-yielding bonds on his podcast last week, and whose analysis served as part of the basis for this discussion.

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