Despite many stock market indexes reaching new all-time highs this week, there is much to be concerned about in the short-term and the long-term. Some worrying trends:
- The global bond market is crashing. Since the Trump election, the world has experienced the biggest two-week loss for the global bond index in 25 years!
- Long-term interest rates are rising. The one thing that the world financial system can’t handle is rising interest rates, given the size of the global debt bubble. This will also put pressure on asset prices, including stocks.
- The US dollar is climbing. Sounds good for us, but for the most part it’s not because it could trigger the next global recession. How much higher can the dollar go before triggering an emerging market debt-crisis? It’s hard to know where to draw the line, but there is certainly a line, and it might not be that far away.
- The Chinese Yuan is falling. This is the big story to watch. China’s epic bubble is at the whim of capital outflows. Should Beijing lose control of their currency, either by choice or by market force, this seven-year-and-counting economic “expansion” will come to an abrupt end.
- The Economy is still weak. Let us not forget that the US economy, and indeed most of the world, is one shock away from recession. Given all of the trends above, the Trump election may very well have been that shock.
There is a shocking connection between elections and recessions. Raoul Pal, one of the best macro analysts around, made this startling discovery.
“Since 1910, the US economy is either in recession or enters a recession within twelve months in every single instance at the end of a two-term presidency… effecting a 100% chance of recession for the new President…..
“In the last 100 years, the recession of 1979 is the only recession not to occur around an election date.
“Every single US recession bar one occurred around an election. Only two Presidents in history did not see a recession and they were inaugurated after single-term Presidents.”
It is hard to say exactly why this is the case. (It could be somewhat coincidental, but 100% accuracy since 1910 means that there is a large enough sample size to infer causation). Maybe it is because governments have more influence on the economy that we tend to recognize. Whatever the case may be, this is an important pattern to consider.
Trump is not just facing the election-recession connection, but he is also facing rising long-term interest rates. That has a connection of its own.
30-Year Yield and Crises; China on Deck
There is no question that rising long-term interest rates cause problems, especially with the existence of a debt bubble. Businesses have a more difficult time making money with new projects due to higher interest expenses, and forgo expansion. Struggling businesses have trouble rolling over unpayable debt. Consumers cut back on major purchases for similar reasons, particularly houses and cars. All of this is bad for economic growth and the financial system.
Even more worrisome, rising long-term interest rates have a way of reversing capital flows, an all-important trigger for currency crises. In this case, rising interest rates in the US make investments here more attractive, causing the US dollar to rise. What we are witnessing now is perhaps the beginning of the end of the China bubble, which will almost certainly be triggered by capital outflows and a Yuan devaluation.
While I have never seen this chart before, it is not surprising. In a world drowning in debt, there is not a more important number than interest rates. It is the deciding factor in most financial decisions. Most importantly, it becomes the decider of what country to store one’s capital in.
It is hard to overstate the importance of international capital flows and carry trade dynamics. Capital inflows cause debt bubbles. When money comes flooding into a country, that money ends up on banks’ balance sheets as “high-powered money”, leading to excess debt expansion and the boom/bust cycle that debt creates. There are many past examples of this, two of which are on the chart above (1994 Tequilla Crisis, and 1996 Asia Financial Crisis). And I have a strong feeling what is going to be next on this chart: The China Crisis.
China has built perhaps the largest private sector debt bubble in modern history. And it has been built like all the rest: with capital inflows. While the Yuan was rising, investing in China via a carry-trade has been like free money. The carry-trade goes like this: borrow money in US dollars for nearly nothing; sell those dollars and buy Yuan and invest at much higher interest rates; make even more money as the Yuan increases in value. Some estimates put the nominal value of this carry-trade strategy at $3 trillion, all of which has fueled the China bubble.
Now the carry-trade has reversed and is perhaps set to accelerate. The dynamics have changed. First, the Yuan is no longer appreciating, but has been depreciating over the last two years. Second, interest rates are rising in the US, narrowing the gap on this yield arbitrage strategy. And third, Beijing has begun allowing corporate defaults, which adds risk that previously didn’t exist. When investors start losing money on a carry-trade like this, a crisis erupts due to capital outflows.
When the $3 Trillion begins to leave the country, everything goes in reverse, a self-reinforcing feedback loop of destruction. When carry-traders want to exit the trade, they have to sell Yuan and buy dollars to pay back their debts; that causes the Yuan to fall versus the dollar, which forces even more losses on the remaining carry-traders. The reversal of capital flows puts pressure on the Chinese economy and banking system, causing even more defaults that add to the credit risk. If Beijing is to defend the currency, they have to sell US treasuries to buy Yuan, a double whammy in and of itself: it pulls Yuan liquidity out of China, causing deflation; and the selling pressure of US Treasuries causes US dollar interest rates to rise, further eliminating the interest rate arbitrage opportunity. Eventually there is a tipping point at which a rush for the exits ensues, which turns into a full blown crisis. We are nearing that stage for China.
We have seen this movie before. Mexico in 1994; Thailand, Korea, Indonesia in 1996/1997; Japan in the late 1980’s; the entirety of South American in the 1970’s; the US in 2008! All of these bubbles were built on capital inflows. China fits the script perfectly. The Trump election may be the beginning of the final act.