Global monetary system is on life support
Worries growing over the Fed’s efforts to fix funding issues that is all likely to get much worse.
Since the Global Financial Crisis, central banks have been printing easy money in exchange for long term government bonds to stimulate the demand stagnated global economy. The global monetary system is like a complex plumbing system with many pipes, pressure gauges and taps to circulates money and balance debts. The pipe diameters and gauges had been designed by the international monetary system to provide the rules for payments, exchange rates, and movement of capital.
Too much debt in the US and the world
When too much money is pumped into the system, and too much debt is flowing out of the system, it causes imbalance. For example, Argentina is heading towards default on $115 billion on foreign currency bonds and over $44 billion more to the International Monetary Fund. Other countries similar to Argentina that can not pay their debt will follow the same fate..
The US debt to US public and foreign countries ballooned
The US Debt is over $22.6 trillion as of end of Sept 2019 and its supposed be secure because it is backed by trusted US government bonds.
“America’s debt is the largest sovereign debt in the world for a single country. It runs neck and neck with that of the European Union, which is a unified trade body of 28 member countries. The national debt is greater than what America produces in a whole year. This high debt-to-gross domestic product ratio tells investors that the country might have problems repaying the loans. “
The U.S. debt to China is $1.11 trillion as of May 2019. That’s 27% of the $4.1 trillion in Treasury bills, notes, and bonds held by foreign countries. The rest of the $22 trillion national debt is owned by either the American people or by the U.S.
Unpredictable US Treasury Yield causes ripple in repo
Ever since the drop of the yields globally, the imbalance created by the demand for the US bonds had created a choppy market. When markets start to get choppy, commodity traders are forced to unwind their long positions on government bonds, triggering a feedback loop of further selling among other VaR-sensitive traders. The overall effect is a sharp climb in bond yields that may lack a prominent driver.
In September, the financial system ran out of cash and revealed the US Treasuries are not truly “risk-free” assets. Some institutions needed money offered a supposed risk-free US treasury, and the repo rate spiked way above the average lending rate demanding 10% interest rather than 2%.
Worries are growing over the Fed’s efforts to fix funding issues that are all likely to get much worse. The New York Fed just announced it is increasing its temporary overnight repo operations to $120 billion a day from the current $75 billion. In addition to the repo increase, term repo operations are rising to $45 billion, from $35 billion.
Even socialist politicians are alarmed
The Fed and treasury are not providing any detailed explanation other than this is an underfunding issue. Senator Elizabeth Warren is pressing Treasury Secretary Steven Mnuchin for answers on recent events in the overnight lending, or repo, markets.
The monetary system can’t handle it
One possible explanation is that there is too much debt in the system, and the “new easy money” injected in turn adds more debt to the system that is not designed to handle it. It is a matter of the time before the pipeline of monetary system overflow and explodes in a financial crisis like no other.
Montery easing has created asset bubble
After two decades of QE, the natural cycle of the stimulus never arrived. QE had one affect the asset bubble.
“This is the way the world ends
Not with a bang but a whimper.” T.S. Eliot
In 2008; the bubble was confined in housing with an impact on the equity. In contrast, in 2019, the bubbles are everywhere, stocks, bonds, high-end real-estate, emerging markets, and Chinese credit. The next financial crisis does not start with a bang but with a whimper. The amount of government and corporate bonds with negative yields has increased to about $17 trillion as of September 2019
The Bank for International Settlements (BIS) has underlined the extent to which once “unthinkable” financial trends are now “routine”!
The financial crisis a decade ago essentially was a debt crisis. Too much had built up in American real estate and investors across the globe unwittingly were caught up in it. The solution was to throw huge amounts of extra debt at the problem and hope it would all go away. Now, there are debt bubbles everywhere
Moreover, markets expect about one-fifth of government bonds will have negative yields for at least three years. Insurance companies and pension funds have no way to neutralize the negative rates and it becomes impossible to provide the rates of return individuals expect. A global recession is widely considered to be a period of growth in the world GDP less than 2 percent at an annual rate. Currently, world GDP is growing at slightly above 2 percent. However, nine countries (Germany, UK, Italy, Mexico, Brazil, Argentina, Singapore and Russia) are below the 2 percent annual rate already.
Central banks had thrown money at the market since 2000 and being at it for over twenty years. This time, however, Central Banks are running out of powder, and the debt bubble they helped to create is astronomical, over $250 Trillion. ECB, BOJ, and many other major economies have already fired their last shot with no effect.
Twenty years of QE did not leave the high exception of the optimists nor resulted in the worst-case scenario of the pessimist. It did one thing, though; it had created the most significant asset bubble in history. The desired inflation never materialized because the companies that thrived with cheap Money used the Fed money to buy back stocks to push the prices of their shares higher.
Root cause of asset bubble
The Fed fund were kept low for too long
It all started in 2000 when Federal Reserve chairman Alan Greenspan; faced four challenges that caused near deflation.
- Bursting .com bubble in March 2000
- Cyclical recession in March 2001
- 9/11 Attacks that generated 40 billion in insurance losses and 7.5% stock decline in one day and closure of the stock market
- China membership to WTO in Dec 2001 that opened the market to the cheap labor that put downward pressure on prices ever since
The customer CPI in 2001 was 1.5%, the lowest since 1986. The CPI rosed to 2.83% in 2002 but dipped again to 1.88% in 2003. In response, the annualized effective Fed fund rate declined from 6% in Jan 2001 to 1.8%.
Greenspan kept fund rate below 2% till Feb 2004 to stop the deflation. However, the three years stretch of sub 2% Fed funds 2001-2004 was too low too long. Cheap money flowed into the housing market and resulted in the housing bubble and subprime mortgage crises that exploded in 2007.
Bernake QE didn’t work either
Real GDP growth from 2009 till mid-2018 was less than 2.2% materially below the long term trend.
In 2008, and the world saw the near-destruction of the banking system and the international monetary policy. The CPI dropped to 0.09% in 2008, even lower than 1.8% that prompted Greenspan to embark on four years of monetary easing.
In 2008 Ben Bernake responded similarly, taking the Fed fund rate to 0% in Dec 2008 until the next Fed Janet Yellen raised the rate to 0.25% in Dec 2015.
Four years of QE did not work
Bernake started QE in three rounds purchasing long term security form the bank primary dealers. The purchases were paid for with money from thin air that resulted in Base money supply MO to increase from $820 billion to $4.1 Trillion.
Supporters of QE argued this would result in higher inflation. However, inflation never came as it has little to do with the money supply. Inflation is a psychological phenomenon that needs a catalyst. Inflation never came because people were saving and paying debts.
None of the expected results emerged, core CPE or consumption rate remained below 2% for six years till 2017. The Fed fund rate was still at 2.5% till mid-2018 well below the 3% fund rate. Real GDP growth from 2009 till mid-2018 was less than 2.2% materially below the long term trend.
Get used to very low return
If you have a vanilla flavor portfolio, then you need to be worried.
The hunt for yields in the world of negative interest rates has driven investors to buy high-risk equity assets that are prone to price drops. It is like buying an investment property at a very high price to generate low rental income. When the price of underlying assets falls, the elusive yields and your capital disappear.
In the current financial market, the only intelligent way to protect your assets and make a profit is to be selective about the selection of the asset class and construct a fluid portfolio that responds well to shifting economics.
According to historical records, the average annual return of S&P500 since its inception in 1926 through 2018 (in a pure hypothetical 100% allocation) is approximately 8-10%.
However, in any given year, the same index fluctuated, and in some years it went down by 10-50%, and in 2007 it took five years to recover.
In hindsight, it is easy to expect a very high return assuming entry at the lowest value and exit at the highest point. Extended return is not just a measurement of trough-to-peak advances of the market but the consideration of peak to through value as we.
For example, if you invest in the market today with the current margin adjusted leveraged P/E of over 40%, your return for a balanced portfolio for the next ten years would be less than 1%.
Nine Countries already in recession
Aa global recession is widely considered to be a period of growth in the world GDP less than 2 percent at an annual rate. Currently, world GDP is growing at slightly above 2 percent. However, five countries are below the 2 percent annual rate already.
- Germany: The German economy shrank 0.1 percent in the second quarter after anemic 0.4 percent growth at the start of the year.
- United Kingdom: Growth contracted 0.2 percent in the second quarter after a weak 0.5 percent performance in the first quarter.
- Italy: The eurozone’s third-largest economy has struggled for years and entered a recession last year. In 2019, growth in the second quarter was just 0.2 percent.
- Mexico: Mexico’s economy contracted 0.2 percent at the start of the year and barely escaped an official recession in the second quarter by growing just 0.1 percent.
- Brazil: The largest economy in South America shrank 0.2 percent in the first quarter and is widely expected to show negative growth again in the second quarter
- Argentina: Argentina is in crisis. It’s already in a recession, and it appears to be getting worse. On Monday, Argentina’s stock market dropped nearly 50 percent, the second-largest one-day crash any nation has experienced since 1950.
- Singapore: Singapore economy contracted 3.3 percent in the second quarter, a sharp reversal from over 3 percent growth in the first quarter.
- South Korea: South Korea managed to avoid a recession in the first half of the year — barely. The South Korean economy shrank 0.4 percent in the first quarter but rose 1.1 percent in the second quarter.
- Russia: A Russian economic institute warned last week that Russia could be in a recession by the end of the year after growing a modest 0.7 percent in the first half of 2019.