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World on Knife Edge of Debt Crisis

Monday, December 16, 2019 20:57

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“World on Knife Edge of Debt Crisis”

by Jim Rickards

“Herbert Stein, a prominent economist and adviser to presidents Richard Nixon and Gerald Ford, once remarked, “If something cannot go on forever, it will stop.” The fact that his remark is obvious makes it no less profound. Simple denial or wishful thinking tends to dominate economic debate.

Stein’s remark is like a bucket of ice water in the face of those denying the reality of non-sustainability. Stein was testifying about international trade deficits when he made his statement, but it applies broadly. Current global debt levels are simply not sustainable. Debt actually is sustainable if the debt is used for projects with positive returns and if the economy supporting the debt is growing faster than the debt itself. But neither of those conditions applies today.

Debt is being incurred just to keep pace with existing requirements in the form of benefits, interest and discretionary spending. It’s not being used for projects with long-term positive returns such as interstate highways, bridges and tunnels; 5G telecommunications; and improved educational outcomes (meaning improved student performance, not teacher pensions).

And developed economies are piling on debt faster than they are growing, so debt-to-GDP ratios are moving to levels where more debt stunts growth rather than helps. It’s a catastrophic global debt crisis (worse than 2008) waiting to happen. What will trigger the crisis? In a word – rates. Low interest rates facilitate unsustainable debt levels, at least in the short run. But with so much debt on the books, even modest rate increases will cause debt levels and deficits to explode as new borrowing is sought just to cover interest payments.

Real rates can skyrocket even as nominal rates fall if deflation takes hold. Real rates are nominal rates minus the inflation rate. If the inflation rate is negative, real rates can be significantly higher than the nominal rate. (A nominal rate of 1% with 2% deflation equals a real rate of 3%.) The world is on the knife edge of a debt crisis not seen since the 1930s. It won’t take much to trigger the crisis.

Meanwhile, the stock market is set up for a sharp decline in the days and weeks ahead. Here’s why… Stock market behavior has become remarkably easy to predict lately. Stocks go up when the Fed cuts rates or indicates that rate cuts are coming. Stocks also go up when there’s good news on the trade war front, especially involving a “phase one” mini-deal with China. Stocks go down when the trade war talks look like they’re breaking down. Stocks also go down when the Fed indicates it may stop raising rates or actually goes on “pause.”

Good news (rate cuts in July, September and October and good prospects on the trade wars) has outweighed bad news, so stocks have been trending higher. You don’t have to be a superstar analyst to figure this out. The key is to understand that markets are driven by computerized trading, not humans. Computers are dumb and can really only make sense of a few factors at a time, like rates and trade.

Just scan the headlines (that’s what computers do), weigh the factors and make the call. It’s easy! What’s not so easy is understanding where markets go when these factors are no longer in play. Stocks are in bubble territory, based on weak earnings, and have been propped up by expected good news on trade.

The other driver is FOMO – “fear of missing out” – that can turn to simple fear in a heartbeat. If the phase one trade deal and a successor to NAFTA (USMCA) are both approved by late December and the Fed pauses rate cuts indefinitely, which are both likely, what’s left to drive stock prices higher?

It won’t be earnings or GDP, which are both weak. Once the good news is fully priced in, there’s nothing left but bad news. And we’re at the point right now. That leaves stocks vulnerable to a sharp decline around year-end or early 2020. To understand the Fed, don’t just look at the nominal interest rate. It’s the “real” interest rate that counts…

This summer I was in Bretton Woods, New Hampshire, along with a host of monetary elites, to commemorate the 75th anniversary of the Bretton Woods conference that established the post-WWII international monetary system. But I wasn’t just there to commemorate the past – I was there to seek insight into the future of the monetary system.

One day I was part of a select group in a closed-door “off the record” meeting with top Federal Reserve and European Central Bank (ECB) officials who announced exactly what you can expect with interest rates going forward – and why. They included a senior official from a regional Federal Reserve bank, a senior official from the Fed’s Board of Governors and a member of the ECB’s Board of Governors.

Chatham House rules apply, so I can’t reveal the names of anyone present at this particular meeting or quote them directly. But I can discuss the main points. They essentially came out and announced that rates are heading lower, and not by just 25 or 50 basis points. They said they have to cut interest rates by a lot going forward. They didn’t officially announce that interest rates will go negative. But they said that when rates are back to zero, they’ll have to take a hard look at negative rates. Reading between the lines, they will likely resort to negative rates when the time comes.

Normally forecasting interest rate policy can be tricky, and I use a number of sophisticated models to try to determine where it’s heading. But these guys made my job incredibly easy. It’s almost like cheating! The most interesting part of the meeting was the reason they gave for the coming rate cuts. They were very relaxed about it, almost as if it was too obvious to even point out. The reason has to do with real interest rates.

The real interest rate is the nominal interest rate minus the inflation rate. You might look at today’s interest rates and think they’re already extremely low. But when you consider real interest rates, you’ll see that they’re substantially higher than the nominal rate. That’s why the real rate is so important. If you’re an economist or analyst trying to forecast markets based on the impact of rates on the economy, then you need to focus on real rates.

Assume the nominal rate on a bond is 4%; what you see is what you get. But the real rate is the nominal rate minus inflation. If the nominal rate is 4% and inflation is 2%, then the real rate is 2% (4 – 2 = 2). That difference between nominal and real rates seems simple until you get into a strange situation where inflation is higher than the nominal rate. Then the real rate is negative. For example, if the nominal rate is 4% and inflation is 5%, then the real rate of interest is negative 1% (4 – 5 = -1). The U.S. has never had negative nominal rates (Japan, the eurozone and Switzerland have), but it has had negative real rates.

By the early 1980s, nominal interest rates on long-term Treasury securities hit 13%. But inflation at the time was 15%, so the real rate was negative 2%. The real cost of money was cheap even as nominal rates hit all-time highs. Nominal rates of 13% when inflation is 15% are actually stimulative. Rates of 3% when inflation is 1% aren’t. In these examples, nominal 2% is a “high” rate and 13% is a “low” rate once inflation is factored in.

The situation today is much closer to the latter example. The yield to maturity on 10-year Treasury notes is currently around 1.8%, which is extremely low by traditional standards. Meanwhile, inflation as measured by the PCE core deflator (the Fed’s preferred measure) is currently about 1.6% year over year, below the Fed’s 2% target. Using those metrics, real interest rates are above zero. But more interestingly, they’re higher than the early ’80s when real rates were -2%.

That’s why it’s critical to understand the significance of real interest rates. And real rates are important because the central banks want to drive real rates meaningfully negative. That’s why they have to lower the nominal rate substantially, which is what these central bank officials said at Bretton Woods. So you can expect rates to go to zero, probably sooner or later. Then, nominal negative rates are probably close behind.

The Fed is very concerned about recession, for which it’s presently unprepared. It usually takes five percentage points of rate cuts to pull the U.S. out of a recession. During its hiking cycle that ended last December, the Fed was trying to get rates closer to 5% so they could cut them as much as needed in a new recession. But, they failed.

Interest rates only topped out at 2.5%. The market reaction and a slowing economy caused the Fed to reverse course and engage in easing. That was good for markets, but terrible in terms of getting ready for the next recession. The Fed also reduced its balance sheet from $4.5 trillion to $3.8 trillion, but that’s still well above the $800 billion level that existed before QE1 (“QE-lite” has since taken the balance sheet up above $4 trillion, but the Fed has done its best to downplay it).

In short, the Fed (and other central banks) only partly normalized and are far from being able to cure a new recession or panic if one were to arise tomorrow. The Fed is therefore trapped in a conundrum that it can’t escape. It needs to rate hikes to prepare for recession, but lower rates to avoid recession. It’s obviously chosen the latter option.

If a recession hit now, the Fed would cut rates by another 1.50% to 1.75% in stages, but then they would be at the zero bound and out of bullets. Beyond that, the Fed’s only tools are negative rates, more QE, a higher inflation target, or forward guidance guaranteeing no rate hikes without further notice.

Of course, negative nominal interest rates have never worked where they’ve been tried. They only fuel asset bubbles, not economic growth. There’s no reason to believe they’ll work next time. But the central banks really have no other tools to choose from. When your only tool is a hammer, every problem looks like a nail. Get ready. Now’s the time to stock up on gold and other hard assets to protect your wealth.”

- dailyreckoning.com

Source: http://coyoteprime-runningcauseicantfly.blogspot.com/2019/12/world-on-knife-edge-of-debt-crisis.html

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