March 27, 2015
By Steve Blumenthal
“When you are inspired by some great purpose, some extraordinary project, all of your thoughts break their bonds. Your mind transcends limitations, your consciousness expands in every direction, and you find yourself in a new, great, wonderful world.”
“When you are inspired, dormant forces, faculties, and talents come alive and you discover yourself to be a greater person, by far, than you’ve ever dreamt yourself to be.”
– Patañjali
The Fed tried to talk down the dollar last Wednesday. Essentially firing a warning shot (downgrading estimates for growth, inflation and short-term interest rates). The ultra-low rates in Germany and Japan vs. the U.S. favor the dollar. Anything that points to the Fed raising rates enhances the attractiveness of U.S. bonds and attracts further capital flows.
The McKensey report on debt has received a lot of press (and rightfully so). The problem is debt and deflation has the lead in the inflation deflation race. It is the foe we do not wish to win. This from The Telegraph in a piece titled, “From bust to boom: How the world became addicted to debt”.
Not one developed economy (and only five emerging markets) has managed to reduce debt-to-GDP ratios which include both household and government debt. When taken together, this total debt mountain has grown by $57 trillion since 2007, far outpacing global growth.
This explosion in public debt levels has come about as countries have been unable to “inflate away” their liabilities. Instead, a global deflationary spiral has amplified the amount that countries owe and the interest they pay to service these debts.
Each country is playing from the same playbook. Thinking, if only we can grow our way out of this mess. Debase currency, become more competitive currency wise – grow the economy and inflate away the debt. The opposite is happening.
When debt becomes too big, growth slows. Evidence of this is everywhere. Devaluation by China is the next great risk for a deflationary world.
“China is trapped. The Communist authorities have discovered, like the Japanese in the early 1990s and the US in the inter-war years, that they cannot deflate a credit bubble safely.” Ambrose Evans-Pritchard. Source
Think of a currency’s value as a share price tied to the performance of a nation. When confidence is strong in a particular country, capital will flow to that currency. We are seeing this right now in Europe. Who wants to lose money? No one does. As fear rises that the Euro will collapse, European capital is moving to Germany driving the bunds to historic highs and the DAX to highs.
With relatively higher yields in the U.S. and a more favorable financial position over say Japan and Europe, we are seeing capital flow to the U.S. and the Fed’s warning shot points to the enormity of their concern.
We are in a global debt bubble of unimaginable proportion. Some countries are better positioned than others. As deflation spreads and beggar-thy-neighbor currency wars become the norm, the question becomes simply one of confidence. Capital will flow to where it is treated best. Say that even louder a second time.
Ultimately, I believe it is higher rates in the U.S. that will help to set in motion a sovereign debt crisis both in Europe and in the balance of the world who financed their debt in dollars since 2007. Here is the skinny on this: if you borrowed in dollars and the dollar goes up vs. your home currency, you have to pay back more in real terms. Dollar up 30%, you effectively owe 30% more.
Let’s try to get our arms around this risk and more importantly the opportunity it might present.
Included in this week’s On My Radar:
- Global Finance Faces $9 Trillion Stress Test as Dollar Soars
- Profound Shift in Liquidity Risk
- Trade Signals – Zweig Bond Model Signals Longer-Term Bond Exposure Favored
Global Finance Faces $9 Trillion Stress Test as Dollar Soars
The world is more dollarized today that any time in history and, therefore, at the mercy of the U.S. Federal Reserve as rates rise. Evans-Pritchard does a great job at making sense of this complicated concept, he writes:
Sitting on the desks of central bank governors and regulators across the world is a scholarly report that spells out the vertiginous scale of global debt in U.S. dollars and gently hints at the horrors in store as the U.S. Federal Reserve turns off the liquidity spigot.
This dry paper is the talk of the hedge fund village in Mayfair and the stuff of nightmares for those in Singapore or Hong Kong already caught on the wrong side of the biggest currency margin call in financial history. “Everybody is reading it,” said one ex-veteran from the New York Fed.
The report – “Global dollar credit: links to U.S. monetary policy and leverage” – was first published by the Bank for International Settlements in January, but its biting relevance is growing by the day.
It shows how the Fed’s zero rates and quantitative easing flooded the emerging world with dollar liquidity in the boom years, overwhelming all defences.
This abundance enticed Asian and Latin American companies to borrow like never before in dollars – at real rates near 1 percent – storing up a reckoning for the day when the U.S. monetary cycle should turn, as it is now doing with a vengeance.
Contrary to popular belief, the world today is more dollarized than ever before. Foreigners have borrowed $9 trillion in U.S. currency outside American jurisdiction and, therefore, without the protection of a lender-of-last-resort able to issue unlimited dollars in extremis. This is up from $2 trillion in 2000.
The emerging market share – mostly Asian – has doubled to $4.5 trillion since the Lehman crisis, including camouflaged lending through banks registered in London, Zurich or the Cayman Islands.
Here is the meat of the article:
The result is that the world credit system is acutely sensitive to any shift by the Fed. “Changes in the short-term policy rate are promptly reflected in the cost of $5 trillion in U.S. dollar bank loans,” said the BIS.
Find the full article here
Oh, how globally intertwined we are with each other. Let’s next take a look at some of the unintended consequences of QE and regulation. In a word, “liquidity” or lack thereof.
Profound Shift in Liquidity Risk
Oliver Wyman at Morgan Stanley is out with a new report that takes an in depth look at the issue. From the report:
Combine the impact of higher interest and a rising dollar with lack of liquidity and you begin to see the opportunity that will present. Stay nimble, alert and prepared.
Trade Signals – Zweig Bond Model Signals Longer-Term Bond Exposure Favored
The Zweig Bond Model and our CMG Managed High Yield Bond Program have both switched back to “buy” signals. The overall equity market trend remains positive as measured by Big Mo (Momentum) and the 13/34- Week EMA. Sentiment is neutral.
Included in this week’s Trade Signals:
- Cyclical Equity Market Trend: The Primary Trend Remains Bullish for Stocks
- Volume Demand Continues to Better Volume Supply: Bullish for Stocks
- Weekly Investor Sentiment Indicator:
- NDR Crowd Sentiment Poll: Neutral Signal from Optimism (short-term Neutral for stocks)
- Daily Trading Sentiment Composite: Neutral Signal from Pessimism (short-term Bullish for stocks)
- The Zweig Bond Model: The Cyclical Trend for Bonds is Bullish
Click here for the full piece.
Several Concluding Thoughts
The debt needs to be written down. This means default and then recovery. Ultimately, I believe it has to happen. We’ll have to figure it out.
I also believe it is important to keep in mind that, like other periods of crisis, such movement creates opportunity for the ones who are prepared.
A 60/40 mix with historical low equity return probabilities and ultra-low bond yields just won’t cut it. It is for this reason that I favor a 30/30/40 mix. Equities, fixed income and liquid alternatives (tactical, long/short, managed futures, gold, etc). Continue to seek growth but do it in a way that can better protect against inevitable bear market declines.
With so much debt and the desperation, country by country, to game the system, collectively the system is more fragile than it was in 2008. The Fed is stuck in what my father used to say, “between a rock and a hard place”.
The goal then is to grow your money but do it in a way that can better mitigate downside risk. Become tactically strategic with asset weights and prepared to overweight equities when stocks are better priced. We go through cycles. That day will come.
Personal note
“When you are inspired by some great purpose, some extraordinary project, all of your thoughts break their bonds. Your mind transcends limitations, your consciousness expands in every direction, and you find yourself in a new, great, wonderful world.”
Ten years ago no one knew what a smart phone was or thought about cloud computing. Look at us all today. Now we need a few inspired economic rock stars to help fix this mess. Sadly, it likely takes crisis to help move us forward. Perhaps there is another way. We’ll see.
I thought about my mom and dad when I came across the Patañjali quote. It reminded me of how they help lead me forward. Go forward with great purpose. I shared the quote with my kids during breakfast this morning. They liked it. I was expecting far less enthusiasm. Along the lines of “right dad, thanks”.
“… talents come alive and you discover yourself to be a greater person, by far, than you’ve ever dreamt yourself to be.”
Here’s to Going Forward with Great Purpose!
Speaking of joy, I’m writing from Snowbird, Utah (here with my family). My father loved this place and passed that love down to me 36 years ago when I was just 18 and now I share this love with my children. Pretty cool. Ahead of us this week is a private family tribute to my old man. Atop 11,000 feet with beer in hand for the adults, we’ll again say a prayer of joy for Marv. I hope he doesn’t mind that it won’t be his favorite Michelob Ultra.
Have a great weekend!
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
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