The deafening cacophony on Wall Street for the past six years has been since
interest rates are at zero percent that there is no place else to put your
money except stocks. For most, it just doesn't matter that the ratio of Total
Market Cap to GDP is 125 percent, which is 15 percent points higher than in
2007 and the highest at any time outside of the tech bubble at the turn of
the century. Sovereign bond yields are at record lows across the globe and
the strategy for most investors is to ignore anemic economic growth rates and
just continue to plow more money into the market simply because, "there's no
place else to put your money."
But the epicenter for this market's upcoming earthquake will be in the FX
market. The US dollar has soared since May due to the overwhelming consensus
that while the Fed will be out of the QE business in October and raising rates
in 2015, Japan and the Eurozone are headed in the exact opposite direction.
The BOJ is already going full throttle with QE and the ECB announced last week
that its own asset back security purchase program would begin in October. The
Greenback is already up over 5 percent on the DXY in the past four months and
a continued increase in the dollar's values will start to significantly impair
the reported earnings on US based multinational corporations. This deflationary
force is one reason why stock prices could correct very soon.
But what is even more likely to occur is a sharp and massive reversal of the
dollar's fortunes. As stated before, nearly everyone on Wall Street is convinced
the Fed will be hiking rates next year. And now that the BOJ and ECB have committed
to go all-in on QE, how much more can they really do to cause their currencies
to depreciate further? With the Ten-year notes in Germany and Japan yielding
just .93 and .50 percent respectively, can these central banks really make
the case that borrowing costs are still too high to support GDP growth?
If robust U.S. GDP growth does not materialize this year as anticipated, just
as it has failed to do each year since the Great Recession ended, the dollar
will come under pressure. In fact, real GDP growth has not grown north of 2.5%
since 2006. With the Fed ending its massive bond purchases and the rest of
the developed world flirting with recession, it's hard to make a case why this
year's growth rate would be the exception -- U.S. GDP growth for the first
six months of this year is running at just 1 percent.
If the market perceives that Fed won't be able to hike rates next year and
may be forced back into the QE business due to a stalling U.S. economy, a reversal
in the yen carry trade will occur. Financial institutions have been borrowing
yen at near zero percent and investing into our bond and stock markets. Since
yields are higher in the U.S. and the direction of the yen was virtually guaranteed
to be headed lower due to the continued intervention from the BOJ, the trade
has been a double-win. However, if the dollar reverses course it will cause
a stampede of dollar sellers out through a small and narrowing door to sell
overvalued stocks and bonds in order to purchase back a rising yen.
Massive currency volatility is just one of the incredibly-destructive effects
resulting from this unprecedented manipulation of interest rates on the part
of global central bankers. The unwinding of the yen carry trade is one factor
that could bury the notion that stock prices can't fall while the Fed is at
the zero bound range.
Of course, the selloff in stocks would merely be a tremor that forebodes a
much greater earthquake -- one that would be devastating for both stocks and
bonds. The real quake I'm speaking of is the inevitable synchronized collapse
of global sovereign debt prices.
This is because the free market works a lot like plate tectonics. Continental
drift causes friction in the earth's lithosphere. The slippage of these plates
causes the earth to quake and is really nature's way of relieving pent-up pressures.
Smaller earthquakes tend to preclude larger ones from occurring by gradually
relieving that stress. Likewise, recessions and depressions relieve the imbalances
of debt and asset bubbles that build up in the economy. Trying to prevent minor
earthquakes and recessions from occurring can only lead to a complete catastrophe.
Central banks tried to avert a healing recession in 2008 by completely commandeering
the global sovereign debt market. And now, yields in Europe, Japan, and the
United States have never been lower in history. Record-low sovereign bond yields
should be the result of plummeting debt to GDP ratios and central bank balance
sheets that have shrunk down significantly to ensure inflation will be quiescent.
However, the exact opposite is the case. For example, U.S. National debt has
increased by $8.6 trillion since 2008 and the debt to GDP ratio has increased
from 64 percent, to 105 percent during that same time frame. In addition, the
Fed's balance sheet has jumped from $800 billion to $4.4 trillion in those
same years. Therefore, the credit quality has vastly decreased while the danger
of inflation has dramatically increased due to the growth in the monetary base.
Unless the economy is flirting with a deflationary depression, interest rates
would be much higher than they are today.
Central bankers should eventually achieve success in creating inflation above
the 2 percent target. But these money printers can't pick an arbitrary inflation
goal and stick the landing perfectly. It is likely that inflation will overshoot
the stated goals. The difficult choice would then be to either allow inflation
to run out of control or force bond sales. This means central banks would swing
from being a huge buyer of sovereign debt, to selling massive quantities of
bonds. In this scenario interest rates would not only mean revert very quickly
but most likely eclipse that level by a large degree.
In the case of Japan, the 10-year note averaged 3 percent from 1984 until
2014. A spike in yields from .50 percent to over, 3.0 percent would cause interest
expenses on sovereign debt to explode to the point where the economy would
be devastated. Much the same scenario holds true for the Eurozone and the United
States.
In contrast, if these central banks are unsuccessful in creating growth and
inflation, then the resulting economic malaise will cause bond investors to
lose faith in the government's ability to ensure debt service payments don't
outstrip the tax bases of these countries. This is exactly what occurred in
Europe during the recent debt crisis of 2010-2012. Once a market becomes convinced
that a nation can't pay back its debt in real terms the value of that debt
plummets.
Ultimately, this is the real crisis that awaits us on the other side of this
massive and unprecedented distortion in global bond yields. And is why this
equity market rally will end sadly in a massive quake that will make 2008 seem
like a mild tremor.
