This special guest commentary was written by Daniel Lacalle
The biggest bubble in financial history is about to end.
With rate hikes, a stronger dollar and the return of inflation, bond inflows are normalizing, sell-off in negative yield fixed incme continues, and real rates increase despite central planners’ financial repression. High-yield bond funds saw their biggest outflows since December 2014 last week, as investors withdrew $5.7bn, according to EPFR Global.
Meanwhile, the total value of negative-yielding sovereign bonds fell to $8.6 trillion as of March 1 from $9.1 trillion at the end of 2016.
Three factors are helping the burst of the bond bubble:
- The price of oil falling to three-month lows on the evidence of the ineffectiveness of OPEC cuts, a record increase in inventories and a stronger dollar is helping to reduce the thirst for high-yield.
- A strong “America First” policy needs a stronger US dollar. The US economy benefits from a strong dollar and rising rates, not the other way around. Believing that the US needs to weaken its currency is a fallacy repeated by mainstream economists. The US exports are relatively small, about 13% of its GDP, and its citizens have 80% of their wealth in deposits. The new administration knows it. They are their voters. The only ones that benefit from a weak dollar and low rates are bubbles, indebted and inefficient sectors. If a rise in rates of 0.25% negatively impacts a part of the economy, after more than 600 rate cuts, it means that such part of the economy is unsustainable. Increasing rates is essential to limit the exponential growth of bubbles and excesses.
- The European Central Bank. The placebo effect of ECB policy has already passed. With more than € 1.3 trillion in excess liquidity and a dangerous environment where economic agents have become “used” to unsustainable rates to perpetuate low productivity sectors, it is inevitable that the central bank will begin to unwind its Monetary laughing gas sooner rather than later.
That dollar strength and US rate hikes, reinforced by the Trump administration’s capital repatriation policy, is exactly what the country needs if it really wants to “make America great again.” If you destroy the middle class with financial repression, you will not only lose its political support, but the policy will not work either.
Strong dollar, normalized rates and repatriation of capital create the vacuum effect. Higher demand for dollars is triggered and the attractiveness of low yield bonds outside the US is reduced.
… In Europe, we are not prepared for the bond bubble to deflate.
The vacuum effect can mean a loss of up to a $100 billion just from repatriations. If the top five technology companies repatriated half of their cash back to the US, it would mean more than $240 billion leaving the rest of the world and returning to the US.
But, moreover, rate hikes make it less attractive for investors to buy bonds from European and emerging countries.
At the moment, growth prospects in the Eurozone, and the US-European inflation differential keep the flow of investment in the European Union because in real terms it still offers a decent mix of risk and profitability. But the Eurozone has a problem when governments have to refinance more than a trillion euros and have become used to spending elsewhere the “savings” in interest expenses achieved due to artificially low rates.
Those savings have already been spent, and when rates rise, and it will happen, many countries do not seem to be sufficiently prepared. Same with many companies. The rise in inflation and rates, which has given some breathing air to banks, holds another side of the coin. Non-performing loans have not been adequately cleaned, and remain above 900 billion euro in the European financial system. Banks do not have enough capital cushion to undertake the deep provisions that would entail cleaning up such a hole and have relied on the recovery to try to sell these loans. The improvement in NIM (net income margin) coming from inflation and a rate increase does not compensate for the increase in NPLs and their provisions. A rate hike of 0.25% means an increase in NIMs of 17% for Eurozone banks, but the clean-up of NPLs would completely wipe out that benefit.
The European Central Bank should analyze the risk of fragility. Because it has not been reduced.
Europe continues to suffer from three factors: Industrial overcapacity, high indebtedness and excessive weight in the economy of low productivity sectors.
These sectors -industrial conglomerates, construction- have absorbed most of the new credit. The ECB and governments were too obsessed with increasing credit to the economy to worry about where that credit was going to. When Eurozone economies and companies are afraid of the impact of a hike of just 0.25%, it means we have a problem – really big.
Do you have a business? Are you prepared to pay 1-2% more for your financing in the next five years? Yes? Congratulations. You have nothing to worry about.
Do you have a variable rate mortgage? Are you prepared to pay a few hundred euros more per year in the next few years? Yes? You have no problem.
Do you have a country where net financing needs are going to continue to fall as rates rise? Yes? Congratulations, you are fine.
Do you think that the ECB will have to keep or lower rates because everyone is so entrapped that it needs to be more dovish? I wish you luck.
The big mistake of central banks has been to create bubbles, then deny them, and afterward try to perpetuate them with the same policy that created the initial problem. Lowering rates and increasing liquidity has been the only policy.
Now central banks face a new US administration that sees currency wars and beggar-thy-neighbor policies as what they are, assaults on the middle class. Financial repression did not work in the past, and failing to adapt economies to normalized rates is dangerous.
Investors should really pay attention because real and nominal losses are more than evident in bond portfolios.
This is a Hedgeye Guest Contributor note written by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the forthcoming Escape from the Central Bank Trap.