Greece And The Negative Interest Rates Could Be The Lynchpin Underneath The Bond And Derivatives Markets! (Part 1)

The swing factor in world demand for goods and commodities, China, is clearly falling away hence the huge inventories and lower prices and worldwide deflation! Whilst the Central Banks are trying to fulfill the roles the governments should fulfill through monetization they are making everything much worse with an unavoidable disastrous outcome.

Chinese output is clearly slowing, its gross domestic product is expected to rise by 7% this year, down from 10.4% five years ago though no economy has emerged to replace the fall in demand from the world’s growth engine. More realistically some industry analysts are arguing that Chinese growth is more likely to be sub 3% annually which would make sense considering the increased size of this $10trn economy and the decline in iron ore ($54/t) and copper prices ($2.88/lb.). Dr Copper is considered the benchmark able to forecast economic trends and health. As history shows eventually every “emerging” market will see severe declines in its annual growth rates even a controlled state economy like China. Next to declining GDP growth rates China has a $28 trillion problem, the country’s total government, corporate and household debt load as of mid-2014, according to McKinsey & Co. China’s debts are equal to 282% of the country’s total annual economic output of $10.4trn. And when you put China’s forex reserves that are estimated to be between $3.5 trillion to $4 trillion into context with its debts the huge forex reserves (global forex reserves are estimated to be $22trn) suddenly look much less! And like the rest of the world the central bank of China, the PBOC, is easing the credit requirements boosting the stock and bond markets but not dealing with the real underlying problems. And by now we all know that you can’t spend yourself out of a huge debt burden, just look at the real estate developers in China (how can you keep up prices of real estate if you have whole cities that are empty?) and the shale gas producers in the US.

Whilst the Chinese authorities were clamping down on real estate developers making financing much more difficult trying to avoid bubbles Chinese businesses started to tap the “loophole” of the offshore US dollar market. Though this loophole “benefit” is about to blow up in the face of the Chinese companies with the US dollar having risen by 25% at one point since June 2014 (on May 1, 2015 the US dollar index had risen to 95 +19%). Kaisa’s, a Shenzhen-based property developer, recent defaulting on $1 billion of bonds served as a reminder of the risks for overseas investors in China. Chinese companies have $275 billion in dollar-denominated bonds outstanding, according to data compiled by Bloomberg. China’s property developers alone have tapped international bond and equity markets to the tune of almost $79 billion.

Low interest rates allow non-economically viable companies to keep on producing contributing to oversupply

The continued access to ever-cheaper capital markets has been triggering overproduction and oversupply in the real estate, oil and many other markets.  The undesired effect of keeping rates artificially suppressed, is that otherwise insolvent companies are permitted to remain operational, contributing to oversupply and making it difficult for the market to reach equilibrium.

Another textbook example of this dynamic is the highly leveraged US shale complex which, by virtue of both artificially low borrowing costs and the Fed-driven hunt for yield, has retained access to capital markets in the midst of the oil slump and has thus continued to drill contributing to the very same price declines that put the entire space in jeopardy in the first place. The heavily indebted US shale companies — are forced to keep producing in order to keep what little revenue is still coming in flowing, a dynamic which is exacerbated when companies take on more, second lien, higher yielding debt (and thus more interest expense) to stay alive. Producers increase their output to make up for the revenue losses due to lower prices, exacerbating the problem of oversupply.

Deflation all over in oil, cotton, inventories and interest rates! With crude-oil inventories in the U.S. rose to 489 million barrels U.S. crude oil storage capacity utilization now up to 94% (489/520) with some 31m barrels of storage capacity left.

Source: U.S. Energy Information Administration, Weekly Petroleum Status Report and Working and Net Available Crude Oil Storage Capacity

Note: Inventories shown in the graph do not include pipeline fill, lease stocks, or oil in transit from Alaska. PADD is the Petroleum Administration for Defense District.

The US looks set to run out of oil storage capacity in just a few months' time. At Cushing, Oklahoma, one of the biggest oil-storage hubs in the U.S., crude oil is filling tanks to the brim. Last week, crude-oil inventories in the U.S. rose to 489 million barrels, an all-time high in records going back to 1982. The total estimated capacity is some 520m barrels. And it’s not just oil that is experiencing glut supply. Around the world, about 110 million bales of cotton are estimated to be sitting idle at textile mills or state warehouses at the end of this season, a record high since 1973 when the U.S. began to publish data on cotton stockpiles.

Huge surpluses are also seen in many finished-goods markets as the glut moves down the supply chain. In February, total inventories of manufactured durable goods in the U.S. rose to $413 billion, the highest level since 1992 when the Census Bureau began to publish the data. And now we are witnessing that China's appetite for metals has abated as demand for steel is now below levels last seen in 2008 which has in turn had a devastating effect on an iron ore market which had come to depend on Chinese demand. Anyway you can see the huge imbalances, oversupply, we are creating with the ultra low and negative interest rates followed by potentially huge breakdowns in the system.

Negative interest rates are spreading and are not exclusive to Europe any longer. In the last fortnight the first government bond ever with a negative yield was issued in Australia. Not many market watchers saw this coming, which underlines the seriousness of the problem. The problem is that very few people really understand what the situation in the world is, let alone the concept of negative interest rates, and what the consequences will be when the music stops.

Why would you pay for lending money instead of keeping cash or buying gold and silver?

Investors are “begging” to lend money to the government so that they can pay the government interest! I am of course being facetious. You "pay" the sovereign or even corporate borrower to lend money to them?  Or a bank pays you to borrow money on a house or property?  Negative interest rates change the rules of the game in the financial system, namely those who want to save money, have to pay money. Those who create debt, receive additional reward. It is the world upside down, but that is in fact what is happening.

It is the reverse world with the central banks trying to kick start the economies at any costs by making lending and saving money very unattractive. Think about the incentives here.  Wouldn't it be better to just take your money out of a bank or broker to avoid the negative interest and just bury it in a hole somewhere?  How about banks lending at negative interest rates for a home, wouldn't the bank be better off not making the loan and instead just sitting on the reserves? By the way hello zero velocity of money (see below)! The system is heading for a grinding halt.

On top of that there are now new regulations notified that clients can’t keep their cash in a safe deposit vault (JP Morgan) or that deposit holders can’t withdraw large cash amounts from their account (Switzerland). There seems to be a clampdown on cash going on! Very unhealthy.

The war on cash!

See below the numerous stories and blogs around the Internet that highlight what is becoming known as "the war on cash". Hello digital money, hello complete control!

• France's finance minister Michel Sapin blamed the Charlie Hebdo murders on the attacker's ability to buy weapons with cash. Result France announced capital controls that included €1,000 cap on cash payments a drop from €3,000. Spain restricts cash payments to £2,500 and Italy restricts them to £1,000.
• As mentioned J.P. Morgan Chase has put restrictions on borrowers from making cash payments on credit cards, mortgages, equity lines, auto loans and prohibiting the storage of cash in safety deposit boxes.
• Banks in the Euro zone that pay negative interest rates are looking at ways to prevent withdrawals of cash. It raises the question so when is a demand deposit account not a demand deposit account. Banks would not have sufficient cash on hand to cover mass withdrawals. Huge withdrawals to avoid negative interest rates would impact negatively their fractional reserves.
• The Swiss National Bank (SNB) is on record as stating that it doesn't like to see the hoarding of cash to circumvent their negative interest rate policy. Can banks actually refuse to give customers their cash that is legally theirs? It would seem that way. Although it should be emphasized that a deposit holder is a creditor of the bank and not the owner of the funds in its deposit.
• A number of banks in Sweden apparently have cashless branches and they refuse to pay out cash. Customers are moving their accounts to banks that will allow them access cash.
• In the US, customers who withdraw $5,000 or more are to be reported. Many banks have also instituted maximum cash withdrawals. Capital controls in the banking system it would seem are becoming normal.
• According to a report HSBC in the UK is interrogating customers on how they earn and spend their money and restricting large cash withdrawals to £5,000.
• The State of Louisiana passed a bill - Bill 195 that would make it easier to track the sales of stolen goods. The bill could have far-reaching consequences in effectively putting every flea market, goodwill, garage sales, Craigslist, and Kijiji out of business. Apparently, the bill requires that second hand goods be paid with credit cards, cheques, money orders, debit cards, or electronic transfer. They no longer can use cash. The bill also required that second hand sellers obtain a considerable amount of information on each buyer. The process seemed to fly in the face that a US dollar is legal tender for all debts.

The drums are clearly beating for a variety of assaults on cash. Holding large amounts of cash in your accounts in order to scoop up assets in the event of a financial meltdown might provide painful in the event of a system-wide bail-in. Remember you are a creditor of the bank with respect to your cash in a bank account.

Illiquidity is lurking everywhere even the Euribor went negative for the first time ever.

On April 21 the 3-Month Euribor fell below 0.00% for the first time ever banks are being paid to borrow from one another in the interbank money markets, "We are scared about the [repo] market freezing". Imagine banks are now paid to borrow from one another.........

Next to that people are afraid that the repo market could freeze up  

As fears of the repo market in Europe freezing appear to be confirmed according to an article by Reuters of April 20, “ECB risks freezing repo market, ICMA official says”. The European Central Bank (ECB) risks secured-lending or repo markets grinding to a halt unless it works more closely with national central banks (NCBs) to improve liquidity, a senior trade association official told Reuters. The €5.5trn ($6trn) repo market is vital for banks and companies to manage their cash balances, offering short-term loans in exchange for government debt as collateral.

Godfried de Vidts, the chair of the International Capital Market Association's European Repo Committee, said unless the ECB took action within the next few months, investors might start avoiding Eurozone bonds. That might push borrowing costs up in the longer term. "Investors could become reluctant to invest in euro zone debt," he said, noting that his committee had voiced its concerns to officials at the ECB. The ECB has allowed bonds bought under its trillion-euro purchase scheme (QE) to be used as security for loans, a precaution against any surge in repo prices that might occur as QE sucks securities out of the market. But traders say that the system does not allow bonds to be leased for long enough, is too restrictive on the amount parties can borrow and is very expensive. Kiss goodbye to liquidity. "We are scared about the market freezing," de Vidts said. Exactly what happened in 2008 with Bear Stearns and Lehmann’s.

In fact in recent weeks, one 10-year Bund became so scarce that market players paid up to 2.5% to lend cash in exchange for the German bond, dealers said.

“The role of government bonds as an asset class is changing”

An article in the Economist of April 21 called “The role of government bonds as an asset class is changing”.  It is possible to explain negative yields in terms of deflationary fears or risk aversion. But Jérôme Teiletche of Unigestion, a Swiss fund-management group, says that such yields are fundamentally changing the risk-reward profile of government bonds (no rewards and a lot of risk!) and thus the role that bonds should play in investors’ portfolios. Now you have to pay in order to be sure you get your money back! How can pension companies and any other companies with long term obligations match these obligations with negative yields of -0.5% whilst they need to generate yields of say 7%-8% to be able to fulfill these commitments? Impossible, it is destroying all pensions going forward. Ask Greenspan and Bernanke if they threw pensioners by the wayside! Paulson, Citadel, Pimco!?

Government bonds are no longer shock absorbers!

Government bonds have typically been used as “shock absorbers” within portfolios. When equities or commodities are plunging, government bonds tend to do very well. Even when bonds do badly, “the pain is not that great”. Since 1925 the biggest annual loss in real terms (including the income from interest payments) in the Barclays US bond index was 15.5% in 2009. In contrast, the biggest real loss in equities was 38.9% in 1930; and there were seven other instances of a real annual loss of more than 20%. Though it should be noted that a bear market in the bond markets has much more adverse consequences than an equity bear market. It takes much longer to recover. And remember we have peak bond and equity markets. A double whammy! The only inverse asset class remaining in my point of view are the precious metals, waiting to take off. The mining shares (GDX ETF) often precede the movement in the underlying bullion. Although gold and silver don’t provide regular annual income like interest or dividends their income will come in the form of the value increase of the gold and silver. It is just a matter of concept, do I get it in the form of recurring income or do I get it in NPV. Next to that the precious metals don’t have counter party risk, a theme that will engulf the next fall-out in the markets.

When yields are zero or negative, government bonds clearly do not give investors an income. The problem is that they may not function as shock absorbers either. It is hard to say precisely how far yields can fall: until recently, many people may have felt that zero was a firm limit. The negative rates are a mismatch between not enough supply and too much demand! This situation will be exacerbated by the mismatch between redemption and issuance at any given time. Even if slightly negative yields are palatable, however, it seems inconceivable that investors would accept an annual loss of 5%, say. Imagine the capital destruction for those investors that can only buy government bonds. And investors that are more flexible vis a vis their investment mandate are forced to buy higher risk in the form of corporate bonds or equities! Any way the point is that this exercise creates bubbles that feed on more bubbles till all these bubbles start to implode.

Reward-free, high-risk bonds! Why because the Government doesn’t pay any interest whilst the potential of a blow up in the market is increasing by the day, as we are kind of witnessing with the bunds. Who was talking about RISK-FREE?

Since prices move in the opposite direction to yields, it is thus difficult to imagine investors buying bonds at current yields making much of a capital gain. It is easy, though, to imagine them making a big loss. If inflation returns, nominal yields would rise sharply and prices would plummet. Government bond returns seem likely to have a negative skew, especially with these historically low or negative rates, the percentage changes are much bigger. Markets tend to rise more slowly than they fall. They may take months to advance by 15-20% but can drop that far in a week or even a day. In statistical jargon, this is known as “negative skew”. Another asset class with negative skew is high-yield, or junk, bonds. At best, investors will be repaid at par on maturity; at worst, the company defaults and investors get back pennies on the dollar.

As evidence, Mr. Teiletche points to Japanese government bonds, which have had very low yields since the turn of the century. Japanese bonds have not been very volatile, till recently, but they have had a negative skew. In this respect, they resemble equities and high-yield bonds (see chart). If government bonds in the rest of the developed world start to behave like Japan’s, then some investors may doubt whether they are worth holding at all. They will simply offer reward-free, high risk bonds because the Government doesn’t pay any interest but the potential of a blow up in the market is increasing by the day, as we are kind of witnessing in the bunds at present. Why would you buy government bonds that don’t give you any return but risk? How much more can interest rates be pushed into negative territory before they start to rebel? In other words what is your upside and your downside risk you have to ask yourself when you hold negative yield bearing bonds. The question is how much room do the authorities have to keep the bonds within a safe margin of error before risk starts to rear its ugly head?

No other investment market can absorb the mass exodus from the US bond bubble, the Godfather of all bubbles

Low yields may still last for a while because many investors—pension funds, insurance companies—are forced holders of government bonds for accounting or regulatory reasons. Central banks also tend to hold other countries’ government bonds as a key component of their reserves. And of course, the European Central Bank and the Bank of Japan are committed to buying tens of billions of government bonds each month.

In the bigger scheme of things don’t forget the US bond bubble is the Godfather of all bubbles because it is so large that no other investment market can absorb the mass exodus which will come from it. It is logical that those who have worked so deliberately to create this debt bubble will fight even harder to prevent its collapse because they don’t have any choice which makes this situation very dangerous and unstable. 

53% of all global government bonds are yielding 1% or less whilst $5.3 trillion of all global government bonds currently have negative yields, of which 60% are European.

The following chart by Blackrock and Reuters/Thompson, widely distributed, says it my point of view all. With the chase for yield, the monetization of debt and the scarcity of supply it will be just a matter of time before the whole chart will be Blue! Unless the tide is already turning as we may be witnessing with the bunds!

The chart here above is the result of 3 never seen facts before:

1. As of this moment 53% of all global government bonds yielding 1% or less.
2. $5.3 trillion of all global government bonds currently have negative yields, of which 60% are European.
3. And Central bank assets now exceed $22trn ($2.2trn in 2000), a figure equivalent to the combined GDP of US & Japan.

As mentioned in the context that central banks will keep on monetizing the debt and trying to prevent currency strength or stimulate their weak economies the lowering of the interest rates and negative interest rates is a trend likely to continue till ……!

Bill Gross: "German 10 year Bunds are the short of a lifetime” and Gundlach considers 100X-leveraged bet against German bunds.

As a result of this extraordinary situation of negative interest rates Bill Gross tweeted on April 21 that "German 10 year Bunds are the short of a lifetime”. And mind you from April 21 to April 22 German 10Y Bund yields rose (on a percentage basis) by the most on record from 0.08 to 0.17 or 112%. (See Bloomberg charts here below). Gundlach said in a Bloomberg interview on April 28: “let’s say you leverage up the German two-year 100 times, that’s a 20% return,” referring to the potential bet against the securities. Gundlach’s comments coincided with a revolt against negative-yielding bonds in Europe, sending yields on 2-year German notes up 0.05 percentage points since his April 28 comments. The rout wiped €142bn ($160 billion) off the value of euro-area government bonds this week, putting the market on course for its biggest selloff since at least October 1993. The risk-reward looks great to short the debt, especially for buyers who hold the debt to maturity, said David Schawel, a money manager at Square 1 Bank, said from Durham, North Carolina.

The above illustrates the damage that these interest rate moves can invoke!

Regular interest payments versus capital gains. Also US Treasuries are showing higher lows. Is this the end of QE?

It clearly looks as if the capital gains (or losses using derivatives) on bonds are starting to outpace the attractiveness of yield income whereby bondholders sell their bonds for their capital gains, which will push interest rates much higher. And especially if suddenly everybody wants to exit the same very narrow gates enforcing the lack of liquidity! Hence why yields on the 10y bund rose 775% in just two weeks! And It is not just German fixed income that is selling off. Below is a chart showing the going rates for the 10-year and 30-year U.S. Treasury bonds. We observe higher lows since we reached the 1.45% low on July 26, 2012! Is this the end of QE?

© Gijsbert Groenewegen

Courtesy of www.groenewegenreport.com