CHAPTER 5

Testing the Limits of Credit Markets

The Complacent and Desperate Search for Yield

Faced with low or negative interest rates and yields in “risk-free” government bonds, savers and investors have been incentivized—or rather, forced—to take more duration risk to generate the fixed income required to meet their liabilities. A self-enforced process of lending for longer and longer maturities in exchange of lower and lower yields that in my view is leading to the largest duration bubble in history.

The exact same dynamics are incentivizing—or rather forcing—investors and savers to take more credit risk, lending to weaker and weaker credits for lower and lower yields, inflating a bubble in the credit and equity markets.

The Credit Spread Steamroller

The price action and lower financing costs have had a positive impact on fundamentals, a clear application of George Soros’ reflexivity theory, which argues that “fundamentals impact prices, but prices also drive fundamentals.” A virtuous cycle of price appreciation and ever-improved fundamentals. More on this later.

The virtuous cycle of lower borrowing costs and better fundamentals behaves like a steamroller that crushes credit risk premiums and benefits the weakest players the most. Look at my country, Spain. What’s fundamentally changed since 2012 when the 10-year bond reached a yield of 7.5 percent, and was on the brink of collapse? Fundamentals have not changed that much, and in my view do not justify the swing from one extreme to the other. The basic and simple explanation is we avoided a disaster (thanks Mario!) but the reversal toward current levels and negative yields is equally excessive and can only be justified by the Central Bank buying without limits.

High yield credit markets and emerging markets are clear examples of markets that have seen record levels of issuance, as yet another example of demand from investors looking for yield creates supply from borrowers looking to take advantage of the ultra-low rates.

Fiscal Expansion: The Prudent Imprudence

Demand creates supply. It is true for commodity markets, and true for credit markets.

The initial rounds of QE consisted of Central Bank buying the existing inventory of government bonds from investment banks and institutional clients, hoping they would put the money to work. A form of indirect credit easing, as discussed.

In the case of Japan and Europe, the size of the QE programs is so large that the Central Bank is either monopolizing the demand and/or literally running out of inventory to buy. That’s how imbalanced the market is.

To my surprise, Larry Summers, one of the most respected economists in the world, wrote an article in the Financial Times called “the prudent imprudence” where he argued for the merits of fiscal expansion. An analysis that in my view completely misses the point and encourages a “triple-up” in risk (monetary policy without limits was a “double up” in my view).

A dynamic that reminds me of someone stepping into the bank and asking “how much can I borrow?” instead of asking “what can I afford?” The fact that someone is willing to lend me cheap money does not imply I should borrow it. Financing should be a function of the investment opportunities available. Unfortunately, many countries have a mixed track record putting the money to work. Indeed, fiscal expansions tend to be very short-termist measures designed to win votes and not necessarily long-term growth.

Credit, as any other form of insurance, just because interest rates are at a negative, doesn’t mean life expectancy or car accidents are going to change in terms of an actuarial basis.

Trump coming into office opens a whole new chapter in terms of, once again, pushing the limits of credit markets: “Let’s borrow more! Let’s build more!” In my view, the United States has the stronger case for fiscal expansion and infrastructure spending. The other extreme is possibly China, where the tool has been used and abused to a very large extent.

Structural Reform and Restructuring

The two easy solutions: #1 print more money, and #2 borrow more, prevent governments from tackling the necessary structural reform and restructure.

A good example is China, who despite having clear plans to tackle imbalances, was forced to step back and do “more of the same” (intervene and provide monetary and fiscal stimuli) in order to try to contain the situation. This dynamic also contributes to delay or avoid hard decisions, supporting zombie companies that only survive on subsidies. A short-term patch that make the problem bigger, not smaller.

The Gross Misallocation of Capital

The record level of issuance in the private and public markets translates broadly into a combination of more liquidity (money not at work), more working capital (money at work short term), and more fixed investments (money at work long term).

We know from history that there are three possible outcomes when we put the money to work: Some money will finance valuable projects (NPV > 0). Some money will finance marginal projects (Net Present Value, NPV = 0). And some money will finance bad projects, overcapacity, and speculation (NPV < 0). It is impossible to know with certainty how much money may have been grossly misallocated. Only time will tell.

During the Lehman 1.0 crisis the lending from the acronyms found its way primarily to real estate and infrastructure in the developed world. This time around, the lending from the new acronyms is finding its way to virtually everywhere. A big concern.

Inflating the Capital Structure

The virtuous cycle has a direct impact across the entire capital structure. As a result, there is yet another parallel bubble across equity markets that is benefiting from the exact same dynamics as duration and credit.

Furthermore, Central Banks’ buying spree has not been limited to government bonds. As discussed in the previous chapter, Central Banks have also been buying high-grade credit and even equities. A massive reinforcement of the perception of Central Bank infallibility, as in principle they can print infinite amounts of their own paper to buy anything. Back to the “no free-lunch economics,” I believe this dynamic is unsustainable and will lead to major inflation and currency devaluations.

Second-Order Effects

Inequality, widening the gap between rich and poor, is in my view one of the unintended consequences of monetary policy without limits and globalization. The statistics speak for themselves, with 1 percent of the world’s population holding over 50 percent of the wealth.

Further, neo-protectionism in the United Kingdom (Brexit) and the United States (Trump) have emerged as a response to immigration and globalization. A new dimension and source of uncertainty to the global markets.

In addition, political fragmentation and political paralysis are also emerging as obstacles to some of the structural reforms that Central Banks are asking and hoping for. Both extreme right and extreme left are gaining support across Europe.

Taxation

Fiscal expansion provides a short-term boost to the economy by bringing future consumption forward at the expense of lower growth and higher taxation down the line. A bet designed with the hope that the path dependency will be NPV positive, but more often than not these measures are designed with electoral objectives rather than economic ones.

The Shadow Banking System

There are other more structural factors that are also contributing to a credit bubble. The most dangerous in my view is the shadow banking in China. A process that has emerged from constraints and inefficiencies in the Chinese credit transmission process.

There is extensive literature on this issue, which describes the dangers of the many forms of shadow banking, including off-balance sheet lending via structured products. Explosive leveraged instruments that take enormous carry and credit bets: a time bomb in my view.

The Epicenter

The bubble in duration across the government bond market is the Epicenter of all the other bubbles, but in my view will not be the catalyst of a potential crisis.

For example, I used to believe that the bubble in the JGB market was unsustainable and would eventually blow up. My current view is that the JGB market will remain inflated for the foreseeable future, but something else will give in. As a believer in “no free-lunch economics,” I believe the imbalances will show somewhere else, and in the case of Japan, and other countries following its path, it will happen via the FX channel with major devaluations down the road.

As discussed, I believe that Japan has passed the point of no return and JGBs are already “too big to fall.” The pillar of Central Bank independence has been compromised, and in my view the Japanese Government will rely on the printing press to finance, refinance, and eventually repay their debt via monetary financing and “debt forgiveness,” a highly inflationary scenario that will weaken the yen to levels we have not seen in living memory. A “be careful what you wish for” type of scenario. But time will tell.

The Catalysts

There are many catalysts that could expose the imbalances in the system.

First, related to testing the limits of monetary policy. The catalysts would expose the bubble in duration, which could be triggered by a change in Central Bank leadership and policies.

Second, related to testing the limits of credit markets. The catalysts would expose any of the parallel bubbles across high yield credit, emerging markets, or equities among many candidates. These will fall by their own weight.

Third, related to testing the limits of fiat currencies, as per the example from Japan discussed earlier. The catalysts would likely arise from currency wars and competitive devaluations.

All these represent some of the known unknowns, to which we would need to add geopolitical risks and other unknown unknowns.

Stressing the Stress Tests

In my view, stress tests on investment banks played a key role in the Lehman 1.0 crisis. Until then, the true magnitude of the problem was unknown. The uncertainty created a vicious cycle of distrust that shut down all lending between banks, creating an implosion at the core of the markets, which spread out very quickly to other sectors.

The stress tests told us how big the problem was. They told us how much recapitalization the banks needed. They set the beginning of the end of the crisis, as monetary policy and government intervention brought back some confidence into the system.

Of course, it took a long time to get all the “domino pieces” back in place. But the determination from the Central Banks and the Governments to do “whatever it takes” was founded on some more tangible estimates in the form of stress tests.

This time around it may be different. The shadow banking system is by definition unregulated. Its true size is not known. Many investors take comfort on the large reserves of the Chinese Central Bank, ignoring the fact that many of those assets are subject to netting and may account to a fraction of the problem. A very scary situation that the Chinese Government will fight at all cost.

Return on Capital versus Return of the Capital

The desperate search for yield ignores or downplays the risk of capital losses. As and when the yield-seeking bubble bursts, investors will once again focus on the return of their capital instead of the return on their capital, an extremely bullish scenario for gold, volatility, and selective real assets.

Time will tell if Central Banks and Governments will be able to engineer a smooth solution to the challenges ahead, or if the remedy will be worse than the disease. Monetary policy without limits will lead to very wild and bumpy ride and a larger crisis than the one we have been trying to resolve: a perfect storm for gold.