Mario Draghi’s ECB Inflates 5 Eurozone Bubbles

When central banks drench the system with money—with the supposed aim to stimulate the economy and or to ignite headline inflation—the money stream flows to only some of the sectors. 

(Of course, that's the headline justification which shields the real reason: subsidy to debt strained government and politically privileged industries)

And those sectors that experience the initial “pump” will then draw in a bandwagon (performance chasing) effect from the marketplace. 

The misallocation of resources from political intervention of money represents THE bubble. Bubbles signify as “something for nothing” phenomenon or from the religious belief of expectations elixirs (free lunches) from money creation.

So when ECB Draghi declared that the region’s central bank would “do whatever it takes” to save the EU, the ramifications of her policies, like everywhere else has been to blow bubbles.

Marketwatch’s Matthew Lynn identifies 5 bubble areas where ECB balance sheet inflation has diffused to: (bold mine)

Here are five markets that are already benefitting from the tidal wave of money Draghi has created.

First, take a look at Spanish construction. Only a couple of years ago, we were reading about how Spain was littered with empty housing estates and airports with one flight a day, the forlorn legacy of the building boom that was raging all through the middle of the last decade. You might think there was nothing left to build — but, as it turns out, you’d be wrong. The cranes are back in action again. Construction output in Spain is currently growing at 12% year-on-year, by far the fastest sector of the economy. Cement consumption is up by 8% this year. The property market is humming again.

Second, Dublin housing. There were few hotter markets at the height of the last boom than Irish housing — nor many crashes that were quite so bad. Now, the froth is back again, and anyone who snapped up a bargain as the country was bailed out and its banks went into intensive care will be feeling smug by now. Irish houses prices are up by 16% year-on-year, and by 22% in the capital, Dublin. The emerald tiger is catching another wave of hot money, and starting to boom again. Don’t be surprised if prices keep going even higher.

Third, German wages. For a decade, despite having supposedly the strongest economy in Europe, German wages had hardly risen. Now that is starting to change.The metalworkers union just secured a 3.4% rise, a decent hike in a country where deflation is still a threat, and prices are not likely to rise. Other workers want a better deal as well. This week, the train drivers are on strike, for the ninth time in the last year, as they push for a 5% pay rise and a shorter working week (who says the trains in Germany run on time). Already in 2015 Germany has lost twice as many days to industrial action as it did during the whole of 2014, according to the German Economic Institute. By the end of the year, wages in Germany are likely to be racing ahead at record levels.

Fourth, Maltese assets: The tiny Mediterranean island is expected to record the fastest growth in the European Union this year, at 3.6%. Prices are not rising quite as fast as they are in Dublin, but property is up by 10% year-on-year, the second fastest rate in the eurozone. Some of the local banks are reporting that their balance sheets are expanding by 40% a year or more. Has the Maltese economy suddenly had a surge of competitiveness? It seems unlikely. In fact, it is emerging as the new Cyprus — an offshore haven for all the hot money within the eurozone to find a temporary home.

Five, Portuguese stocks: It is hard to think of anything very good to say about the Portuguese economy four years after the country had to be bailed out. The economy is only expected to expand by 1.6% this year, only marginally better than the 0.9% it managed last year. Unemployment is still running at more than 13% and shows little sign of falling significantly. But, hey, you never guess that from the stock market. Lisbon’s PSI Index  is up by 25% this year already, making it one of the strongest markets in the world.

In reality, central banks can print money when they want to . But they can’t control where it washes up. Some of the rising markets might be useful — higher wages in Germany, for example, might help to rebalance that country’s massive trade surplus.

But in the main Draghi’s tidal wave of euros is most likely to simply to blow up another series of asset bubbles. Indeed, in many cases they are exactly the same bubbles that blew up last time around, such as Spanish construction and Dublin property. That may be great for investors who get in on those markets on the way up. But it won’t do much to fix the eurozone economy — and it will inevitably be very painful when they finally pop.

The ECB tsunami money has designed to ease interest rates or debt servicing costs. 

So the crucial question will always be: how will bubbles be funded?

The answer gives us a clue to the mother of all of Europe’s bubbles: DEBT!

The previous bubble implosion resulted to an explosion of Europe government’s debt levels as a result of collapsed tax revenues, as government spending ballooned accentuated by bailouts.

That’s European government’s skyrocketing debt as of 2013 according to ECB data. Hockeystick debt!

This is expected change in government debt as % of GDP based on McKinsey Global estimates

Expect mainstream expectations to be conservative once the bubble pops.

Here is the updated government debt table from the OECD.

In spite of the reemergence of bubbles (which has and may temporarily spruce up statistical G-R-O-W-T-H) government debt for European nations particularly the crisis affected ones, namely, Portugal, Spain and Italy, has increased! (with the exception of Iceland and Ireland). Yet the decrease in Ireland’s debt has been marginal.

The above red box represents Europe’s staggering combined private and public sector debt in % of GDP as per McKinsey approximations. 

Those new bubbles are likely to inflate more systemic leverage (most likely centered at non financial corporates).

Finally early this year, a big symptom of the debt bubble has been negative yields.

Negative yields have mainly been a product of a massive stampede to frontrun the ECB (asset buying) by the banking financial industry (the other major beneficiary of the ECB stimulus). 

Negative yields then meant that borrowers were even being paid (rewarded) to borrow!

But recently treasury markets like yields of 5 year German bunds have seen a forceful pushback.

Whether this has been temporary or has accounted for growing cracks in the bond bubble remains to be seen.

Yet the next bubble implosion will not just apply to asset bubbles but to the entire debt portfolio of the region (and elsewhere). 

The most likely outcome will be a horrific deflation (chain of debt defaults), or if the ECB fights it with money printing, possibly hyperinflation.

Bankrupt governments depend on sustained access on the credit markets for them to survive. This makes them highly sensitive to market confidence. And such has been the real thrust of all the cumulative easing policies implemented by the ECB (and by governments). 

Once market confidence dissipates, the whole bubble edifice crumbles.

 

Greece may likely be the first casualty.

Europe’s Negative Yields on Government Bonds Inflate to $1.9 Trillion!

Water now flows uphill.

From Bloomberg:

The European Central Bank’s imminent bond-buying plan has left $1.9 trillion of the euro region’s government securities with negative yields.

Germany sold five-year notes at an average yield of minus 0.08 percent on Wednesday, a euro-area record, meaning investors buying the securities will get less back than they paid when the debt matures in April 2020.

By the next day, German notes with a maturity out to seven years had sub-zero yields, while rates on seven other euro-area nations’ debt were also negative. While some bonds had such yields as far back as 2012, the phenomenon has gathered pace since the ECB’s decision to cut its deposit rate to below zero last year.

Even when investors extend maturities, and move away from the region’s core markets, returns are becoming increasingly meager. Ireland’s 10-year yield slid below 1 percent for the first time this week, Portugal’s dropped below 2 percent, while Spanish and Italian rates also tumbled to records….

Eighty-eight of the 346 securities in the Bloomberg Eurozone Sovereign Bond Index have negative yields, data compiled by Bloomberg show. Euro-area bonds make up about 80 percent of the $2.35 trillion of negative-yielding assets in the Bloomberg Global Developed Sovereign Bond Index, the data show.

Traditionally borrowers pay creditors and savers interests (positive yields). Negative yields means that this relationship has been overturned, borrowers are now paid by savers and creditors to borrow.

The reason for this; because of the promise to buy government securities, bond punters have been front-running the ECB to drive rates at subzero levels.

This chart is from February 2 when negative yields constituted $1.7 trillion. This means an 11.7% increase of bonds with negative yields since.

With ECB’s promise to monetize a significant number of debt which Zero Hedge estimates as possibly 100%, bond market liquidity will likely shrink and thus risking an upsurge of volatility.

One may have the impression that perhaps immaculate balance sheets may have prompted the public to pay government to borrow. But as shown above, except for Germany, the Bloomberg’s debt chart reveals that debt from European countries has materially been inflating even from a one year basis.

Negative yields implies that credit risks has almost been totally eliminated!

See water flows uphill now.

The ECB has provided colossal subsidies (or resource transfer) to the banking system, bond holders and the government.

Financial analyst David Stockman at his website the Contra Corner has an incisive treatise on this.

Here is an excerpt: (bold mine)

That investors anywhere in this age of fiscal profligacy would pay to own the notes and bonds of sovereign states is a testament to the financial deformations of modern central banking. But the fact that nearly $2 trillion of debt issued by European governments is currently trading at negative yields——now that’s a flat-out derangement.  After all, the aging, sclerotic economies of the EU have been making a bee line toward fiscal insolvency for most of the last decade.

So it goes without saying that this giant agglomeration of pay-to-own government debt is not reflective of an outbreak of fiscal rectitude or any other rational economic development. It’s purely an artificial trading result stemming from central bank destruction of every semblance of honest price discovery. In this case, the impending ECB purchase of $70 billion of government debt and other securities per month for the next two years has transformed the financial casinos of Europe and elsewhere into a front runner’s paradise.

As today’s Bloomberg piece tracking Europe’s $2 trillion of exuberant irrationality makes clear, sovereign bond prices are soaring because traders are accumulating, not selling, in anticipation of the ECB’s big fat bid hitting the market in the weeks ahead:

“It is something that many would not have pictured a year ago,” said Jan von Gerich, chief strategist at Nordea Bank AB in Helsinki. “It sounds very awkward in a sense, but if you look at it more, the central bank has a deposit rate in negative territory, and there’s a huge bond-buying program coming. People are holding on to these bonds and so you don’t have many willing sellers.”

Needless to say, this is the opposite of at-risk price discovery; it amounts to shooting fish in a barrel. Never before have speculators been gifted with such stupendous, easily harvested windfalls. And these adjectives are not excessive. The hedge fund buyers who came to the game early after Draghi’s “anything it takes”ukase have enjoyed massive price appreciation, but have needed to post only tiny slivers of their own capital, financing the balance at essentially zero cost in the repo and other wholesale funding venues.

Indeed, the more risk, the bigger the windfall. German yields have now been driven below the zero bound on all maturities through seven years, emboldening speculators to move out on the risk curve. So doing, they have gorged on peripheral nation debt and have been generously rewarded. In the case of the 10-year bond of Ireland—-a state which was on the edge of bankruptcy only a few years ago—-leveraged speculator gains are now deep into three figures.

Continue with the rest of the article here 

 

The obverse side of every money manipulation stoked financial asset mania is a crash.

In Pictures: Starved Global Investors Reaching for Yields

In his latest outlook, Dr. John Hussman writes

The Federal Reserve’s policy of quantitative easing has starved investors of all sources of safe return, provoking them to reach for yield in more speculative assets, including equities, leveraged loans, covenant-lite debt, and other securities. Having stomped on the pedal for years, all of these asset classes are valued at levels that are strenuously elevated from a historical perspective, and as a result, offer strikingly poor prospective returns for long-term investors.

I’d compliment Mr. Hussman’s observation by showing the updated 1^st quarter 2014 charts from the Institute of International Finance—a global trade group or association (cartel?) with over 450 members comprising world leading banks and financial houses, headquartered in 70 countries (Wikipedia)

From the IIF:

Global bond issuance continues with its record breaking streak led by Euro area bonds. While the Eurozone’s banking system remains broken as manifested by contracting banking loans and falling money supply, most of the Eurozone’s asset chasing dynamic have been financed by the rapidly growing bond markets.

Next global high risk mezzanine financing called “payment in kind” loans are at “a striking record highs”! Again a lot of this growth comes from the Eurozone.

Meanwhile another global high risk loan called “leveraged loans” (loans to highly indebted entities) have been running at growth rates at par with 2013. 

Indeed markets, starved for returns have been desperately chasing markets by expanding debt exposure. Yet such exposure has extrapolated to a substantial decline in credit quality

The IIF conveys her worries and noted that 

a rising proportion of corporate issuance has been done  by high-yield issuers, increasingly of lower credit quality such as CCC and rising proportion of corporate issuance has been done by high-yield issuers, increasingly of lower credit quality

Aside from high yield (lower credit rating) loans or what are known as junk bonds, Covenant lite loans are loans with less restrictions on collateral, payment terms and level of income. 

Any impression that emerging markets “reformed” following the latest tremors have been misplaced. While emerging market corporate bond issuance has marginally leveled off, government bond issuance soared to its highest level since 2005, mostly due to Eastern Europe.

In addition, international loan exposure by emerging market corporates led by the banks have materially increased since 2010.

So what we are seeing today has been a confluence of contradictory forces: rising risk asset markets being funded by ballooning debt—whose quality have been in a substantial deterioration—as bond yields suggest rising rates soon.

Such lethal combination inevitably indicates a forthcoming Wile E. Coyote moment.

European Economic Recovery? ECB Cuts Interest Rates

The mainstream has been adamantly insisting about a supposed economic recovery in Europe. 

But if true, then why the need for the European Central Bank (ECB) to cut rates?

ECB President Mario Draghi was quoted by the CNBC at last night’s press conference saying that “risks to the outlook remain weighted to the downside”

In addition, Mr. Draghi raised the issue of the risks of deflation to justify such actions.

From Bloomberg

The European Central Bank unexpectedly cut its benchmark interest rate to a record low in a bid to prevent slowing inflation from taking hold in a still-fragile euro-area economy.

With inflation at the weakest level in four years and less than half the ECB’s target, the Frankfurt-based bank halved its key refinancing rate to 0.25 percent in a shift anticipated by just three of 70 economists in a Bloomberg News survey.

“Our monetary-policy stance will remain accommodative for as long as necessary,” ECB President Mario Draghi told reporters in Frankfurt. “We may experience a prolonged period of low inflation…

Euro-area inflation surprisingly deteriorated in October to 0.7 percent, below the ECB’s goal of “close to but below” 2 percent, sparking fears of a deflationary cycle. Unemployment of 12.2 percent is the highest level since the currency bloc was formed in 1999, while the euro’s almost 4 percent rise against its major peers this year is challenging exporters. The ECB will better detail its economic outlook when it releases forecasts next month.

While it is true that the Euro zone’s CPI has been falling which reflects on the declining monetary aggregate M3, that’s only half of the picture.

The other half of what the mainstream doesn’t tell you when discussing central bank policies: Financial markets in the Eurozone has been booming. 

Europe’s crisis stricken economies (Portugal-PSI 20, Spain’s IBEX and the Irish ISEQ) has produced returns of significantly more than 20% over a one year window. Greece’s Athens Index has generated more than 40%!

Even Europe’s blue chip index the Stoxx 50 has strongly risen year-to-date.

And it’s not just stocks…

European sovereign bonds has had a robust performance. The spread of PIGS relative to the German bond has significantly narrowed* after peaking in early 2012.

In other words, the ECB and the mainstream sees TWO different self-contradicting worlds: risks of “deflation” in the economy—based on CPI inflation measures, while alleged “recovery” in the economy based on rising markets.

Or differently put, the mainstream sees financial markets as seemingly irrelevant or unrelated to the real economy unless it serves as convenient alibi to justify rising asset prices.

Yet zero bound rates function as a one size fits all policy that would have different impact on distinct European economies. 

As one would note, bank credit to core Europe has been in the positive (although stagnant) while crisis stricken periphery remains in negative territory*.

Of course, looking at the aggregates can be deceiving. While it may be true that general bank lending has been falling, in breaking down the details we find the Eurozone’s banking system credit to the government has exploded even as credit to the private sector has weakened.

In short, government borrowing has taken the slack from the private sector.

The complex maneuvering by the troika, the ECB, the banking system and the government to keep rates low has resulted to a massive expansion of debt.

The Eurozone’s debt as % to the GDP has been skyrocketing

Yet banks have not been the only source of lending.

 

Europe’s High Yield corporate bond issuance is at record highs*!

Europe’s corporate debt has also been ballooning*.

Corporate debt in core Europe has modestly increased from 2007…

While corporate debt at the periphery has been robust over the same period

Bottom line: Contra policymakers and the mainstream, the risks of deflation remains a popular bogeyman used to justify the “euthanasia of the rentier” via zero bound rates and QE.

While the Eurozone’s banking system remains clogged or the transmission mechanism broken due to impaired balance sheets, substantial credit growth has been taking place at the bond markets.

And credit growth in the bond markets fired up by ECB and government policies has been redistributing resources or has been benefiting the asset markets (via asset inflation) at the expense of the real economy (revealed by CPI disinflation). 

The real intent of the ECB’s rate cut has been to keep interest payments low for the rapidly swelling the Eurozone’s government debts since the Eurozone government’s refusal to reform, France should serve as an example. 

A second unstated goal has been to boost asset markets in order to keep their 'broken' banking system afloat. 

European politicians, bureaucrats and their mainstream lackeys have been pulling a wool over everyone’s eyes.

And it seems that for the first time this year, the unexpected credit easing by a major central bank has hardly been welcomed warmly by the global equity markets. Europe’s markets appear jaded as US stocks fell considerably. Asian markets are down as of this writing.

Has the global financial markets seen ECB’s actions as insufficient? Or has the positive impact on financial markets from credit easing policies reached a tipping point in terms of diminishing returns?

We surely live in interesting times

* charts from the Institute of International Finance November 2013 Capital Markets Monitor and Teleconference

Phisix: Don’t Ignore the Bond Vigilantes

A human group transforms itself into a crowd when it suddenly responds to a suggestion rather than to reasoning, to an image rather than an idea, to an affirmation rather than to proof, to the repetition of a phrase rather than to arguments, to prestige rather than to competence.” Jean-François Revel French Journalist and Philosopher

This is one chart which every stock market bulls have either ignored or dismissed as irrelevant.

Yields of 10-year US Treasury Notes skyrocketed by 249 basis points or 9.7% this week to reach a TWO year high of 2.829% as of Friday’s close. This represents 803 basis points above the May 22^nd levels at 2.026%, when the perceived “taper” talk by US Federal Reserve chief Ben Bernanke jolted and brought many of global stock markets down on their knees.

While US markets, as embodied by the S&P 500 (SPX), recovered from the early losses to even carve milestone record highs, ASEAN markets (ASEA-FTSE ASEAN 40 ETF) and ASIAN markets ($P1DOW-Dow Jones Asia Pacific) posted unimpressive gains. Such failure to rise along with US stocks has revealed her vulnerability to such transitional phase, see red vertical line. 

Considering what I have been calling as the Wile E. Coyete moment or the incompatibility or the unsustainable relationship between rising stock markets and ascendant bond yields (including $100 oil), it seems that signs of such strains has become evident in US stocks.

As I previously wrote[1],

The stock markets operates on a Wile E. Coyote moment. These forces are incompatible and serves as major headwinds to the stock markets. Such relationship eventually will become unglued. Either bond yields and oil prices will have to fall to sustain rising stocks, or stock markets will have to reflect on the new reality brought about by higher interest rates (and oil prices), or that all three will have to adjust accordingly...hopefully in an 'orderly' fashion. Well, the other possibility from 'orderly' is disorderly or instability.

The S&P fell 2.1% this week adding to last week’s loss as yields of 10 year USTs soared (see green circle).

Rising yields affect credit markets anchored on them. This means higher interest rates for many bond or fixed income markets and fixed mortgages[2]. 

And given a system built on huge debt, viz, $55.3 trillion in total outstanding debt and $179 trillion in credit derivatives, rising interest rates will mean higher cost of debt servicing on $243 trillion of debt related securities[3], thereby putting pressure on profit margins and increasing cost of capital which magnifies credit and counterparty risks. Higher rates also discourage credit based consumption, thereby reducing demand. 

In essence, ascendant yields or higher interest rates will expose on the many misallocated capital brought about by the previous easy money policies.

One example is margin debt on stock markets.

The recent record highs reached by the US stock markets have been bolstered by inflationary credit via record levels of net margin debt (New York Stock Exchange).

Should rising yields translate to higher interest rates and where market returns will be insufficient to finance the rising costs of margin credit, then this will lead to calls by brokerage firms on leveraged clients to raise capital or collateral (margin calls[4]) or be faced with forced liquidations.

And intensification of the offloading of securities due to margin calls may become a horrendous reflexive debt liquidation-falling prices feedback loop.

Since 1950s, record margin debt levels tend to peak ahead of the US stock market according to a study by Deutsche Bank as presented by the Zero Hedge[5]. 

In 2000 and in 2007, the aftermath of record debt levels along with landmark stock market prices has been the dreaded debt-stock market deflation spiral or the stock market bubble bust.

Net margin debt appears to have peaked in April according to the data from New York Stock Exchange[6]. This is about 3 months ahead of the late July highs reached by the S&P 500 echoing the 2007 cycle.

But will this time be different?

Rising Yields Equals Mounting Losses on Global Financial Markets

Rising yields extrapolates to mounting losses on myriad fixed income instruments held by banks, by financial institutions and by governments. 

For instance, bond market losses exhibited by rising yields on various US Treasury instruments has led to record outflows in June, which according to Reuters represents the largest since August 2007[7].

The largest UST holder, the Chinese government and her private financial institutions, who supported the UST last May[8], apparently changed their minds. They sold $21.5 billion in June. 

Meanwhile the second largest UST holder, the Japanese government and her financial institutions unloaded $20.3 billion signifying a third consecutive month of decline.

Combined selling by China and Japan accounted for 74% of overall net foreign selling.

Total foreign holdings of UST fell by $56.5 billion or by 1% to $5.6 trillion in June where about 71% of the total UST foreign holdings represent official creditors[9]

The Philippines joined the bond market exodus by lowering her UST holding by $1.9 billion to $37.1 billion in July.

However, Japanese investors, mostly from the banking sector, reportedly reversed course and bought $16 billion of US treasuries during the first week of August[10].

Instead of investing locally, as expected from the audacious policy program set by PM Shinzo Abe called Abenomics, the result, so far and as predicted[11], has been the opposite: capital flight. The lower than expected GDP in June also exposes on the continuing reluctance by Japanese investors to invest locally (-.1%)[12].

Politicians and their apologists hardly understand that policy or regime uncertainty and price instability obscures the entrepreneurs’ and of business peoples’ economic calculation process thereby deterring incentives to invest. When uncertainty reigns, especially from increased interventions, people opt to hold cash. And when government debases the currency, people will look to preserve their savings via alternative currencies or assets.

This only shows how the average Japanese investors have been caught between the proverbial devil and the deep blue sea.

It’s not just in UST markets. Losses have spread to cover many bond markets

In the US, bond market losses led to redemptions on bond funds as investors yanked $68 billion in June and $8 billion in July. The Wall Street Journal[13] reports that the June outflow signifies as the first monthly net outflow in two years, according to the Morningstar

Again the actions of the bond vigilantes are being reflected by the reflexive feedback loop between falling prices (higher yields) prompting for liquidations and vice versa.

Rising yields will not only translate to higher cost of capital, which reduces investments, and diminished appetite for speculation, the sustained rate of sharp increases in bond yields accentuate the “the uncertainty factor” in the financial and economic environment. Outsized volatility from today’s mercurial bond markets compounds on the uncertainty factor by spurring a bandwagon effect from the reflexive selling action and in the reluctance by investors to increase exposure on risk assets.

As bond yields continue to rise the losses will spread.

The Impact of Rising UST Yields on Asia

US Treasuries have been also used as key benchmark by many foreign markets. Hence, rapid changes in US bond prices or yields will likewise impact foreign markets.

And as explained last week, substantial improvements in the US twin (fiscal and trade) deficits postulates to the Triffin Paradox. This reserve currency dilemma implies that improved trade and fiscal balance means that there will be lesser US dollars available to the global financial system which has been heavily dependent on the US dollar as bank reserve currency and as medium for trading and settlement. 

Such scarcity of the US dollar may undermine trade and the the reserve currency recycling process between the US and her trading partners.

Higher yields and a rise in the US dollar relative to her non-reserve currency major trading partners are likely symptoms from a less liquid or a dollar scarce system

And if rising UST yields have indeed been reflecting on growing scarcity of the quantity of US dollar relative to her non-reserve currency trading partners such as ASEAN, then higher yields would likewise imply pressure on the currencies, and similarly but not contemporaneous, on prices of financial assets.

All four currencies of ASEAN majors are under duress from the bond vigilantes.

The pressure on prices of other financial assets will be a function of accrued internal imbalances that will be amplified by external concerns.

One exception is the Chinese yuan whose currency has yet to be adapted as international currency reserve. The yuan trades at record highs vis-à-vis the US dollar, even as her 10 year yields have been on the rise[14].

In the meantime, fresh reports indicate that despite all the previous regulatory clamps applied by the Chinese government, China’s bubble has been intensifying with new home sales rising in 69 out of 70 cities in July, and with record gains posted by the biggest metropolitan cities[15].

Curiously the report also says that the China’s property markets expect minimal intervention from the Chinese government.

If true then this means that in order for the Chinese economy to register statistical growth, the seemingly desperate Chinese government will further tolerate the inflation of bubbles which has brought public and private debts to already precarious levels. 

Rising yields of Chinese 10 year bonds will serve as a natural barrier to the bubble blowing policies by the Chinese government. The sustained rise of interest rates in China may prick China’s simmering property bubble that would lead to a disorderly unwinding that risks a contagion effect on Asia and the world.

Europe’s Bizarre Divergences 

Yet, rising UST yields has thus far affected Europe and Asia distinctly.

Bond yields of major European nations[16] as Germany, United Kingdom and France have been on the rise, the former two have resonated with the US counterpart. Yields of German and UK bonds have climbed to a two year high as shown in the upper window [GDBR10:IND Germany red, GUKG10:IND United Kingdom yellow and GFRN10:IND France green].

Paradoxically bonds of the crisis stricken PIGS have shown a stark contrast: declining yields [GGGB10YR:IND Greece green, GBTPGR10:IND Italy red-orange, GSPT10YR:IND Portugal red and GSPG10YR:IND Spain orange.]

I do not subscribe to the idea that such divergence has been a function of the German and French economy having pushed the EU out of a statistical recession last quarter[17]. Instead I think that such deviation has partly been due to the yield chasing by German, UK and French investors on debt of PIGS. But this would seem as a temporary episode.

Such divergences may also be due to furtive manipulation by several European governments given the election season. As this Bloomberg article insinuates[18]:

The bond-market calm that has descended on the euro area in the run-up to next month’s German election masks unresolved conflicts that have frustrated the region’s leaders for more than three years.

Greece needs more debt relief, the International Monetary Fund says; Portugal is struggling to exit its support program; Spanish Prime Minister Mariano Rajoy is battling corruption allegations and calls to resign; France faces unrest as Socialist President Francois Hollande follows through on his promise to cut pension-system losses.

But if the bond vigilantes will continue to trample on the bond markets then eventually such whitewashing will be exposed.

The Fed’s Portfolio Balancing Channel via USTs

In my opening statement I said that every stock market bulls have either ignored or dismissed the activities of the bond vigilantes as irrelevant to stock markets pricing.

It seems that the mainstream hardly realize that USTs have been the object of the Fed’s QE policies. In other words, what the mainstream ignores is actually what monetary officials value.

The FED now owns a total of 31.47% of the total outstanding ten year equivalents according to the Zero Hedge[19]. And with the current rate UST accumulation by the FED, or even with a “taper” (marginal reduction in UST buying), eventually what used to be a very liquid asset will become illiquid. This would even heighten the volatility risks of the UST markets.

The FED uses USTs as part of the policy transmission from its “Portfolio Balance Channel” theory which intends to “affect financial conditions by changing the quantity and mix of financial assets held by the public” according to Fed Chairman Bernanke[20]. This will be conducted “so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar asset”

In other words, by influencing yield and duration through the manipulation of the supply side of several asset markets, such policies have been designed to alter or sway the public’s perception of risk and portfolio holdings in accordance to the FED’s views.

Unfortunately the above only shows that markets run in different direction than what has been centrally planned by ivory tower based bureaucrats.

Whether in the US, Europe or Asia, where policymakers have been touting of the perpetuity of accommodative or easy money conditions, markets, as the revealed by bond vigilantes, has been disproving them. Soaring bond yields flies in the face of “do whatever it takes” promises.

Bottom line: Rising UST yields have been affecting global asset markets at a distinct or relative scale. 

Rising yields has been a function of a combination of factors such as the growing scarcity of capital or the shrinking pool of real savings at an international level, the unsustainability of inflationary boom, the Triffin Paradox, growing scepticism over central bank and government policies and of the unsustainability of the current growth rate of debt and of the present debt levels (see chart above[21]).

While so far, Asia and other Emerging Markets appear to be the most vulnerable, should bond yields continue to soar, which implies of amplified volatility on the bond markets and eventually interest rate markets, the impact from such lethal one-two punch will spread and intensify.

This makes global risks assets increasingly vulnerable to black swans (low probability-high impact events) accidents.

Caveat emptor.

---

[1] See Don’t Worry Be Happy Stock Markets Ignores the Bond Vigilantes August 14, 2013

[2] See Emerging Market Rout: Prelude to a Global Crisis? June 27, 2013

[3] See The Wile E. Coyote Moment: US Treasury Yields Spikes! June 11, 2013

[4] Investopedia.com Margin Debt

[5] Zero Hedge Deutsche Bank Hopes "Not All Margin Calls Come At Once In Case Of A Sell-Off" August 13, 2013

[6] New York Stock Exchange Securities market credit ($ in mils.), 2013 www.nyxdata.com

[7] Reuters.com China, Japan lead record outflow from Treasuries in June August 16, 2013

[8] See Mayhem in the US Treasury Markets, No Problem, China to the Rescue! July 18, 2013

[9] US Treasury MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES

[10] Wall Street Journal Japanese Investors Buy Foreign Debt As Domestic Rates Fall August 14, 2013

[11] See Global Equity Markets: Signs of Distribution and Japan’s Capital Flight April 8, 2013

[12] Real Time Economics Blog Japan GDP Clouds Tax Debate Wall Street Journal August 12, 2013

[13] Wall Street Journal Bond Funds Outflows Shouldn't Panic Investors August 16, 2013

[14] Tradingeconomics.com CHINA GOVERNMENT BOND 10Y

[15] Bloomberg.com China July Home Prices Rise as Big Cities Post Record Gains August 18, 2013

[16] Bloomberg.com Rates & Bonds

[17] BBC.co.uk Eurozone edges out of recession

[18] Bloomberg.com Europe Muddles to German Vote as To-Do List Grows August 15, 2013

[19] Zero Hedge Good Luck Unwinding That August 15, 2013

[20] Chairman Ben S. Bernanke The Economic Outlook and Monetary Policy At the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming August 27, 2010

[21] Zero Hedge Dylan Grice On The Intrinsic Value Of Gold, And How Not To Be A Turkey July 31, 2013