Why You Shouldn't Believe the US Jobs Data

Earlier this month, the Bureau of Labor Statistics (BLS) released the latest jobs report data for July, showing that the US economy created 255,000 jobs. This was viewed as great news, and the financial markets and media seemed to breathe a collective sigh of relief.

That's because everyone was afraid it would be a lot worse.

You see, back in May of this year, the jobs report was nothing short of abysmal. After revisions, the number for May came in at just 24,000 jobs. This came on the heels of dramatic market instability in the first quarter of this year and a series of declining jobs reports preceding it:

• February (still normal): 233,000 jobs increase
• March (getting weaker): 186,000 jobs increase
• April (weaker still): 144,000 jobs increase
• May (falls off a cliff): 24,000 jobs increase

This trend seemed to be going in one direction, and it wasn't a good one. Thus, everyone was ecstatic when jobs shot back up in June by 292,000 (after revision). This positive sign was seemingly confirmed in July when the economy added 255,000 more jobs, beating all the expectations. Additionally, the hourly earnings for July were reported to increase by some 2.6% year-over-year.

Assuming all of this is true, these latest data points are certainly great signs for the US economy. But there's good reason to think the jobs data is just wrong.

Why does this matter?

It may not be obvious why anyone should care about the total number of jobs in the economy, provided your own job is still part of the total. As the old saying goes, it's a recession when your neighbor loses his job. It's a depression when you lose yours.

And in a sane world where the government did not take responsibility for managing the economy, the jobs data would not matter. In the world in which we actually live, however, it is one of the most important drivers of US fiscal and monetary policy. If the jobs data is too low, that means more spending by the US government, lower interest rates from the Federal Reserve, or both. Both types of policies have negative long-run consequences.

The jobs figures are also the primary numbers used by politicians to either celebrate or criticize the state of the US economy at any given moment. For this reason, we can expect them to make an appearance in the upcoming presidential debates. Hillary Clinton, running for a de facto third term of President Obama, will highlight the numbers if they remain strong through November. Meanwhile, we should expect Donald Trump to call them out if they weaken significantly.

So what does the other data say?

There are several other data points that point in the opposite direction of the jobs numbers. Here are a few of the most important ones:

GDP is basically stagnant

Gross Domestic Product (GDP) never makes the list of talking points when people want to praise the economic recovery during President Obama's tenure. That's because it's pretty awful by historical standards. Two charts make this point quite well.

First, here's a chart showing annual GDP growth for all years between 1950-2014, ranked from least to greatest. Years under President Obama's leadership are shown in red.

Second, here's a more zoomed in look at just the last several quarters. As you can see, things have recently been even worse than normal:

Now, as economic statistics go, GDP probably gets more emphasis from economists than it deserves. And it surely involves many complex calculations and assumptions to compute it each quarter. That said, it still conveys some information.

And right now, the GDP data is telling us that the US economy is still technically growing, but at a rate that is very weak by historical standards, just 1.2% in the latest quarter. It's not a recession; it's just not very good.

Corporate profits are falling

Even more telling than the GDP data is the dramatic decline in corporate profits over the last several quarters. US stocks may be near all-time highs, but their performance has had no connection with the performance of the underlying companies.

Here's the year-over-year change in corporate profits since 2000. All the data hasn't come in for Q2 2016, so here's how things looked through Q1:

As you can see, corporate profits have actually been declining (below 0 on the above chart) on a year-over-year basis for the past five quarters. This decline is expected to persist through Q2 2016 based on the earnings information that has been reported so far.

US tax receipts are basically flat compared to last year

Another bad sign comes from the tax receipt data from the US Treasury Department. For the first seven months of the year, total tax receipts are essentially flat compared to last year, down roughly $20 billion.

Meanwhile, if we look at receipts from income tax withheld--the amount pulled directly out of your paycheck by your employer--these figures are up just 1% year-to-date. Those gains were offset by declines in corporate taxes as well as other non-withheld income taxes.

Given that US tax policy has not radically changed since 2015, the slight decline in tax receipts seems to be driven by deteriorating economic activity overall.

Back to jobs

Bringing all of this data back together, we have the following:

• GDP growth is hovering around 1%, well below what anyone thinks is a normal level of expansion.
• Corporate profits have declined for 5 going-on 6 consecutive quarters now
• US tax receipts have actually declined slightly for July YTD, relative to the prior year

Of these, the latter two data points are particularly striking because they don't rely heavily on assumptions. Corporate profits are calculated according to established accounting principles and subject to regular audits, and one assumes (hopes?) that the Treasury Department knows how to count up all the money it receives.

All that is left is to ask some obvious questions:

If corporate profits have been steadily declining, is it likely that they are going to be creating a lot of new jobs in the US?

The number of jobs in the economy is increasing each month at an year-over-year rate greater than 1.5%, and hourly wages reportedly increased at more than 2% in the latest report. So officially, more people are working, and on average they are making more money. Given this, and the fact that we have a progressive income tax, how is it possible that income tax withholding is only up 1%?

Simply put, these are facts that do not fit together. At least one of these numbers seems wrong.

And basically, we have three core data points to indict: corporate profits, tax receipts, or the BLS jobs data. 

If corporate profits are the source of our problems, that would mean many corporations have artificially understated their profits. This seems unlikely.

If tax withholding data is wrong, that would mean, in essence, that the Treasury Department hasn't figured out how to use a summation formula. I try not to put much faith in the competence of government officials, but this seems like too much of a stretch.

Or, perhaps the BLS's assumptions for estimating job creation in the economy were wrong. The BLS samples a relatively small number of businesses and relies on survey data. It then uses complex assumptions to extrapolate the results into an estimated figure for the overall economy. Clearly, this is the data point that has the largest chance of error.

And in fact, they've been wrong before. Just last week, they announced major revisions to past estimates of wage increases, causing substantial declines to previously published results. But the July jobs data remained unchanged.

Based on the analysis above, it's our expectation that there will be more dramatic revisions to come in the future. Until that time, it's probably best to treat any and all optimistic pronouncements on the US economy with a very large grain of salt.

Chief Economist at Germany's Largest Bank Calls for 150 Billion Euro Bailout

More bad news for the EU this week as it continues to grasp for a solution to the ongoing banking crisis. The Chief Economist at Deutsche Bank, the largest bank in Germany, has openly called for 150 billion Euro bailout in an interview with a prominent German newspaper.

Readers will recall that Italy's largest banks have been collapsing in the markets under the weight of an absurd 360 billion euros of nonperforming loans, which account for 18% of their total loan portfolios. Given that nonperforming loans are just a nice way of saying "loans that will probably not be paid back," this constitutes an existential threat to the banks and, by extension, possibly the Italian financial system.

Predictably, this has been blamed on the successful Brexit vote, though the claim made very little sense, as we explained recently.

In response to this newly urgent crisis, Italian Prime Minister Matteo Renzi was pushing for a proper bailout of the banking system. European Union rules, however, technically prevent a full taxpayer-funded bailout, and require what is referred to as a bail-in first.

Given the obvious and justified unpopularity of bank bailouts, an alternative solution would seem preferable. The EU bail-in might prove to be an exception.

What's a Bail-in?
Basically, a bail-in requires that investors, bondholders, and then even uninsured depositors lose part of their money to the bank. While investors and bondholders ought to bear the loss in a failing company, the inclusion of uninsured depositors is a very different animal.

Under this mechanism, the depositors are effectively viewed as creditors. And in a way, this makes sense. After all, when you deposit money at the bank, you are effectively loaning the bank money, and this is why you (used to be able to) get some non-negligible amount of interest for your trouble. In a bail-in, part of this "loan" to the bank is simply waived. Part of the bank's liabilities disappear, improving their balance sheet and their chance of surviving

But while deposits are a loan in some sense, they are generally conceived of as something quite different. A loan is presumed to carry some risk. Meanwhile deposits are generally seen as risk-free, at least in our era of central banking and heavy regulation. The prospect of the bail-in changes this.

Once the first depositors of Europe Proper start having their deposits confiscated to help out an unstable financial institution, this perception of deposits as risk-free will promptly evaporate. If that happens, a bank run will follow, as depositors rushyy to withdraw their funds before any of their deposits suffer the same confiscation. This has the ultimate effect of further destabilizing the very institutions the bail-in was meant to save.

This occurs because no bank can survive a bank run. Under a fractional-reserve system like ours, no bank ever has enough cash on hand to pay off all their depositors' claims because some of the money has been lent out. While this may seem unsavory, there's nothing secret or illicit about it. Take a look at the balance sheet of any bank, and it will be perfectly apparent. For instance, here's a snip of Deutsche Bank's balance sheet as of 12/31/2015.

How this works is that the top three assets listed are all basically liquid and can be readily used to pay depositors. From there, each successive asset becomes more difficult to convert to cash, with some of them being effectively impossible (goodwill).

Thus, we can compare the total of the top three assets (132 billion euros total) to the much larger deposits listed in liabilities (567 billion euros). If a substantial portion of Deutsche Bank customers suddenly began to worry and pull their deposits out, Deutsche Bank (like any other bank) would have to get creative to meet the demands--possibly selling off securities, taking out loans from other banks or the central bank, and if things got really bad, calling in some existing loans and credit lines. If the problem is not confined to Deutsche Bank and many banks experience this panic simultaneously--a likely outcome if the bail-in mechanism is used on the Continent--it becomes even more difficult to resolve. This is the worst case scenario for the EU financial system, and yet as things stand currently, it is also their official remedy for failing banks.

That is, the EU's solution for the banking crisis is, in effect, to induce a larger one.

Deutsche Bank's leadership is now weighing in to try to prevent the catastrophe this would likely unleash in the short-run. Their economist's solution is to do a standard bailout instead, as the US did in the 2008 crisis. Which leads to a useful question...

Is a Bailout Better?
Like most economic questions, the answer to this one is "It depends." And in particular, it depends on your time horizon. Assuming the government itself won't go broke from the initiative, a bailout can likely succeed in minimizing an immediate crisis. However, it doesn't resolve the underlying problems that caused the crisis, and it all but ensures another one will occur in the future. The best case scenario is kicking the can down the road.

For this reason, it is highly attractive politically. Yes, a bailout is effectively corporate welfare for the most reckless and terribly managed institutions. That rarely plays well on the campaign trail. But it plays better than a complete financial crisis. Assuming electoral success or protecting one's legacy are key goals for the decision-makers, bailouts are an excellent idea.

If one's goal is long-term financial stability, not so much.

Each bailout paves the way for the next. Other institutions observe that their peers suffered no consequences from making risky financial bets that lost money. This encourages all of them to take more such bets in the future. If the bets work out, they get to keep the profits. If they do not, the taxpayer bears the losses. Economists refer to this as the problem of moral hazard. People that don't bear the costs of taking risks, tend to take more risks. If those people are bankers, it doesn't end well.

In the long-run, the best approach is to let failing institutions actually fail. Deposits, like Puerto Rican bonds, are never truly risk-free. The banking system will only have a chance at stability when this fact is widely understood--and when banks are forced to compete for customers by showing just how sound and conservative they are, rather than simply pointing to a government guarantee.

What Happens Next?
Deutsche Bank's recent pronouncement should be properly viewed as a recognition of reality. The goal of the EU and the European Central Bank is to prevent a short-term crisis, and the bail-in regulation is unlikely to fulfill this purpose. Since a free market solution is not going to make headway in the EU, a bailout is the default alternative.

Brexit as Economic Scapegoat

The overreaction against the historic Brexit decision is now in full swing. Financial markets around the world have fallen sharply, though the US has fared slightly better. Britain's FTSE 250 index has fallen 14 percent between Friday and Monday while the US S&P 500 was down 5.3% over the two-day stretch.

Yes, these are nothing if not tumultuous times in the financial markets in the wake of the Brexit. However, it's worth bearing in mind that nothing substantive has changed just yet. It's true that Prime Minister David Cameron has announced his intention to resign, but that event won't take place for a few months. It still remains an open question whether a Brexit will actually take place as the vote itself was non-binding. In the meantime, Britain is still subject to all the same trading and business rules as before. And any changes that do ultimately occur are likely to take well over a year to be determined and will be thoroughly analyzed and  telegraphed in advance.

Given all these obstacles to actual change, one may wonder why the markets are acting like the sky is falling. The answer, of course, is uncertainty. Markets hate uncertainty, and now Europe (and all equity markets to some extent) is full of it. Rather than waiting to see what the real consequences are, investors are selling out of risky assets and running to safe havens like gold, silver, and US Treasuries. This makes sense, if for no other reason than one knows that the rest of the herd will do it.

But again, it bears repeating. The Brexit vote, and the associated uncertainty, explains why financial markets have moved. Its impact on actual business thus far from the vote is and must be negligible.

That's why it was strange (yet somehow predictable) to see the government of Italy propose a new 40 billion euro bailout this week for its long-suffering banking industry. Like other banks around the world, Italy's public banks were hit hard in the two days of trading following Brexit--falling by roughly a third (33%) in that timeframe. Thus, the bailout proposal is being framed as a response or consequence of Brexit. Here's a quote from The Telegraph's write-up on this story:

The country [Italy] is the first serious casualty of Brexit contagion and a reminder that the economic destinies of Britain and the rest of Europe are intimately entwined. Morgan Stanley warned in a new report that eurozone GDP would contract by almost as much as British GDP in a "high stress scenario".

There's just one problem with this narrative. It doesn't make any sense.

Ironically, we learn why within the same Telegraph article that gave us the bad news. Quoting again (emphasis mine):

Italy’s banks are the Achilles Heel of the eurozone financial system. Non-performing loans have ratcheted up to 18pc of total balance sheets as a result the country’s slide into depression after the Lehman crisis.

"Non-performing loans" is a banking euphemism for loans that are not going to be paid back. And it probably goes without saying that 18% is a catastrophically high number. For sake of comparison, a similar ratio at the bank I work for, Umpqua Bank, was 0.29% in the most recently filed, publicly available annual report.* That is to say, Italy's banks have a ratio that is 62 times as high.

The reason we can't blame Brexit for this, however, is that these loans didn't go bad overnight. Unless Italy's banks were loaning an ungodly amount of money to investors so they could speculate in currency markets--which would be problematic in itself--then the Brexit vote cannot explain the looming failure of Italian banks. They were well on their way to failure before Brexit. But now, Brexit is being used as a convenient scapegoat for politicians and central bankers to push for emergency financial bailout measures that they've wanted to implement for some time. Brexit is not the cause, but the excuse. Additionally, Italy probably delayed announcing this proposal till after the vote to avoid giving a last-minute reminder to the British of the various financial calamities that awaited them in the EU if they decided to stay.

Whatever explains the timing, however, the problems with Italy's banks are as real as ever. And the proposed bailout is unlikely to provide even a short-run fix because direct bailouts of banking institutions like the sort being proposed are forbidden by EU rules. In the long run, this is actually a good thing--bailouts provide a bandage fix that effectively reward irresponsible behavior. But politics, in Italy and elsewhere, does not concern itself with the long-run. Thus, Italy could be the next flash point in the EU. And in that strange world, the ones in desperate need are actually the ones holding all the cards. As Zero Hedge points out, the Italians effectively have the ability to give the EU an ultimatum: either permit and/or fund the bank bailout, or face another exit referendum after the Italian economy descends further into chaos. After Brexit, it seems unlikely the EU would be willing to take another chance.

Expect the situation in Italy to be a harbinger of things to come, as unblemished optimism from officials and the mainstream media gives way to catastrophic warnings about the situation the Brexit has put us in. But Brexit did not cause the problems we face; rather, it is the excuse that officials are using to finally acknowledge the deep and substantial problems that have existed for some time.

In a US context, this almost certainly means that any possibility of an interest rate hike by the Federal Reserve is all but off the table, with Brexit offering the perfect out. The real question is when the Fed will shift from the narrative of a strong economic recovery to one of urgent damage control. If Brexit wasn't enough, perhaps the likely $2B default in Puerto Rico this week will do the trick?

*You almost certainly don't care about this, but technically, this is the non-performing assets to total assets ratio at Umpqua. Because the numerators includes things besides loans, it is likely to be a slightly higher than the non-performing loan to total assets (balance sheet) figure presented by The Telegraph for Italian banks. As a practical matter, what this means is that if we were to make a true apples to apples comparison, the Italian banks would look even worse. Also, it goes without saying that all views expressed here are strictly my own and in no way a reflection of the opinions or outlook of any decision-makers at Umpqua Bank.

Signs of the Next Financial Crisis? - Part 2

Yesterday, we discussed the recent weak employment numbers and took an in-depth look at the negative-yield bond bubble. Today, we're going to explore another alarming trend in the global--the massive growth in corporate debt.

First, let's look at the numbers. This chart from Bloomberg sums things up pretty well. Not quite a hockey stick shape, but we're getting there.

Since 2006, corporate debt has more than doubled to $6.64 trillion at the end of 2015. And as you likely know, economic growth over that same time period has not quite kept up with the growth in debt.

Of course, we should hasten to note that debt is not inherently a bad thing. On the contrary, the ability of individuals and businesses to take on debt improves our lives in innumerable ways. But as with any tool, it matters how you use it.

One of the major ways that corporations have been using debt is for share buybacks. And before we go further, it's worth explaining what exactly a share buyback is.

Share Buybacks Explained
Unlike the many opaque terms in finance, share buybacks are exactly what they sound like: it's when a public company buys back its shares from the people holding them. It has no practical impact on the company itself. As we have explained previously, changes in a company's share count or share price have essentially no direct impact on the company's actual operations. For example, a drop in the share price does not decrease the company's cash or resources, and a rise in the share price would not increase them.

However, since top managers typically own shares of the company and are ultimately responsible to the company's investors, they have a vested interest in seeing share prices go up as much as possible. Implementing a share buyback program is one strategy management uses to help achieve this goal of raising share prices.

Share buyback programs have a positive impact on the share prices in two ways. First, if the company is buying shares, there is an increase in the demand for the stock. As with any other market, this will have the effect of pushing prices upward. Second, a share buyback program decreases the number of shares outstanding. This in turn increases the ownership percentage for each outstanding share (any share held by someone or something besides the company entity itself). This also increases the closely watched earnings per share (EPS) figure.

Possibly obvious, but an example will clarify how this works. Say a company named Cat Co. has 2,000 shares outstanding and earned a net income of $2,500 in 2015. Let's also assume an initial share price of $20. In this situation, each individual share represents 0.05% (1 / 2,000) ownership of the company, and the EPS would be $1.25 ($2,500 / 2,000). With this EPS, we would calculate the price / earnings ratio (which is a common valuation metric) to be 16 ($20 share price / $1.25 EPS).

Now let's suppose the management at Cat Co. decides to implement a very aggressive share buyback program and decides to buy 750 shares. After the buyback is completed, there are just 1,250 shares outstanding, and let's assume the stock price went up to $32. Each share now represents 0.08% of the company, EPS has now risen to $2.00, and the P/E remains the same at 16. Nothing about the company's actual operations has changed, other than the fact that it had to spend cash to buy the shares. But management's decision was able to increase EPS and the share price by 60%. The figures used here are much larger (in percentage terms) than the share buyback programs that actually take place in the real world. But the underlying mechanics are the same. Management can directly influence the stock prices. And given that executive comp. is occasionally tied directly to share price, this is clearly an attractive option.

There's nothing necessarily wrong with share buyback programs. If a company has a lot of excess cash and has no attractive expansion opportunities to invest it in or debt to pay down, a share buyback might be a good option. It rewards investors directly, and will stop investors from complaining about idle assets sitting on the balance sheet. If the company still has enough cash on hand after the buyback, this should have no adverse consequences on the business itself.

That said, we should be more skeptical if a share buyback program is implemented using debt. Share buybacks do not generate new revenue and do not reduce expenses. At most, they can only slightly decrease future dividends payouts. Meanwhile debt must be repaid eventually and it adds interest expense. Thus, while a share buyback completed with excess cash has effectively no impact on the actual company, a share buyback completed on debt decreases the company's bottom line income and likely decreases net cash flow as well. In this way, it makes the company less stable than it otherwise would be, since it's effectively trading a short-term rise in the share price for a longer-term decline in profits.

In small doses, debt-fueled buybacks would not be a big story. If they are occurring en masse however, that could be cause for concern. The latter is what we've been seeing over the past few years.

Debt-fueled Buybacks
This chart from Society Generale, via Zero Hedge, compares the change in debt with the amount of net buyback activity.

This doesn't tell us that all new debt goes into buybacks, and it doesn't mean that all share buybacks are debt financed. But it does suggest a very strong connection between the two.

And it's not hard to see why companies would choose to go this route. The economy is not growing as fast as it normally does during an economic expansion, which limits the amount of profitable investments a company can make. But management still wants to raise EPS and the share price, even if the business isn't actually growing. Add in the historically low interest rates, and debt-backed share buyback programs suddenly make sense.

According to Bloomberg's calculations, share buybacks have amounted to $2 trillion since 2009. Not all of it is backed by debt, but the chart above indicates a significant portion is.

Of course, this doesn't mean that the companies involved are going to go bankrupt tomorrow. As long as interest rates remain relatively low, the debt may not prove to be a significant burden. But if corporate earnings continue to trend downward, as they did in Q1, and the economy slows down, many more corporations may be unable to weather the storm.

This rapid rise in debt-fueled share buybacks also suggests a degree of skepticism is necessary when considering the near record highs that stocks have reached. Share buybacks inherently increase stock prices. They can also make the underlying companies weaker in the process. If Q1 earnings are any guide, that appears to be what happened.

The Folly of Central Bank Policy
In a recent article, we showed how the artificially low-interest rate policies of the Federal Reserve and other central banks had effectively doomed pension funds and other investors to choose between a rock and a hard place. Either they own safe assets (bonds) with insufficient returns, or they choose riskier assets (stocks) that still only offer what used to be a regular return. This will speed up the collapse of many pension funds and wreak untold havoc for other retirees.

We've also previously explained how low and, even worse, negative interest rate policies around the world squeeze the profit margins for banks, among other maladies. This puts banks and the broader financial system at greater risk for failure.

Yesterday, we explained the significant asset bubble building with respect to negative-yielding bonds, which are also a direct by-product of central bank monetary policy (in addition to bank capital requirements).

Now, we can add debt-fueled share buybacks and exuberant corporate borrowing to the list as well. Few investors would stomach a company borrowing money at a high interest rate just to manage their short-term share price and EPS. But in a low interest rate environment, this activity becomes commonplace.

The cruel irony in all of this is that central banks have chosen their monetary policy with the alleged goals of stimulating and stabilizing the economy. In reality, their policies have dramatically increased the systemic risks in the global economic system. The next recession,* like the last one, will certainly be blamed on capitalism and the free market. But central banks are not a creature of the free market. They are just another arm of the government, and the blame for the next recession, when it does come, should lie squarely on them.

*As we noted yesterday, economics can't really tell us the timing of the next recession. Another recession always comes eventually, and that's about all we can say for sure. Based purely on time elapsed if nothing else, we appear to be about due though. It is also worth noting that talk of a new recession became a mainstream subject after the most recent jobs data. For example, JP Morgan recently released a report featured on Yahoo Finance suggesting the risk of a recession has not been this high since the recovery started. But again, none of this is remotely conclusive.

*(Cont.) Personally, and this is strictly my speculation, I think the next recession could happen as soon as this year. There are many major events that could prove to be the spark needed to set things in motion. Most significantly, there's the British vote on remaining in the EU, the yet-unresolved Puerto Rico debt problems, and perhaps most significant of all, the US presidential election. I think this last event will seal the deal if the others don't. In my view, the US appears poised to elect Donald Trump, a candidate who wants to start trade wars and has spoken openly a defaulting on the traditionally "risk-free" US Government debt. If that uncertainty is not enough to spook investors in this environment, I'm not sure what is. But again, that's just my speculation, and as you can see, it has more to do with politics and psychology than economics.

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.

Oil Price Hysteria and How Incentives Sabotage Cartels

As you may have heard, the stock market has been a bit of a disaster this year. American stocks have lost about 6% of their value since the beginning of the new year based on the Dow Jones Index, and daily swings of 3 or even 4 percent have not been uncommon. Most stock markets in Asia and Europe have performed even worse with greater losses and volatility. And while no single factor can adequately explain all of the turmoil we've seen, many commentators placed the blame on low oil prices.

Why does oil matter?

At first blush, this doesn't make much sense. It's easy to see why low oil prices would be bad for oil companies. But for just about everyone else, this would seem like a good thing. Consumers benefit from lower gas prices and have more money left over to spend or save. Meanwhile, companies benefit from reduced transportation costs, and will presumably earn higher profits as a result.

The analysis above is perfectly sound economics, yet somehow low oil prices have sent the broader market into a tantrum. The reason for this is that many of the struggling oil companies were heavily financed by debt. As their losses begin to mount, there is a high possibility that some will go bankrupt and fail to repay their loans. If enough bankruptcies occur, they could potentially destabilize the banks that gave them money, leading to a ripple effect that cascades through the overall economy.

In this way, high levels of debt tend to make the economy much more fragile than it otherwise would be. Problems that should be confined to a single industry or group of companies can quickly become problems for everyone. Of course, this is not an argument for bailing such companies out--which can only postpone an eventual collapse. But it is another good reason to oppose the artificially low interest rates established by the Federal Reserve, which encourage consumers and companies to borrow more money. Ironically, in the name of promoting economic stability, such policies make the broader economy more unstable. The current hysteria over oil prices is a reflection of this.

What will happen to oil prices?

Because oil prices actually do matter in the present economy, the market has been desperate for any news that might point to higher oil prices. This has led to an emotional roller coaster of sorts as each optimistic report was widely hailed, but then quickly fell flat as new details emerged. The following headlines give you some sense of the anxiety over this issue:

• Monday, Feb. 15 - Oil stages late gains as Saudi, Russia, Venezuela to meet
• Tuesday, Feb. 16 - Oil prices crash after Saudis fail to broker global production cut
• Wednesday, Feb. 17 - Oil prices get boost as Iran praises Saudi plan to freeze output
• Thursday, Feb. 18 - Oil prices fall on oversupply concerns after U.S. crude stocks hit record

As you can see, the market has been basically bipolar, and most of the focus is on the possibility output cuts from the major oil producing countries - Saudi Arabia and the Gulf states, including Iran, Iraq, Venezuela, and Russia.* The major news outlets clearly seem to have no idea whether a deal will occur or not. The prevailing view at any given time seems to depend on whatever statement was issued last. In reality, the likely outcome of these talks is pretty certain to eventually end in failure. And a basic understanding of economics helps us understand why.

The major oil producing countries mentioned above are facing many of the same problems right now. In varying degrees, the domestic economy of each country is dependent on oil exports, and they also use oil proceeds to finance a substantial portion of the government. Thus, low oil prices have led to weaker economies at home and growing government deficits. All of them would love to see oil prices go higher to reduce these current problems. But all of them are also desperate to get as much money out of their oil supplies as possible right now, precisely because of these same problems.

Their interests create a kind of Catch-22. Collectively, they would like to see lower oil production so that prices will eventually go up in response to reduced supply. But individually, they need to maximize their production to get the most revenue possible. This tension in interests is what tends to make all production- or price-fixing agreements highly unstable in a competitive system.

The short-term result tends to be that the players involved will formally or informally agree to cut production. This has the immediate effect of sending oil prices higher on the expectation that supply will soon fall. But because each player has such a compelling incentive to cheat and produce more than agreed to, the arrangements typically break down. This is true for countries competing in a global oil market. And it's also true for private companies in any open competitive environment. Cartels and price-fixing arrangements are often seen as key examples where markets can fail and governments may need to step in to protect consumers. But the incentives at work in a free market all but ensure cartels will be unsustainable.

Bringing it back to oil prices, this is great news if you're a fan of low gas prices. If you lent money to an oil company, however, probably not so much. As long as no major new wars break out in the Middle East, look for oil prices to stay low in the near-term until the markets have time to adjust.

*The US has recently become a major oil and natural gas producer as well. But because the US oil industry is largely decentralized to private actors, the US doesn't typically get included in such discussions.