I was interviewed by Jorge Nascimento Rodrigues for Janela na web (a Portuguese site) and the printed edition of Expresso. After what I said, he might never interview me again :-]
1- Sovereign bond yields of some Eurozone peripherals are at historical lows, in certain cases even below yields for US Treasuries and UK Gilts. So the three-year austerity adjustments worked?
Central banks have performed a miracle: separating financial assets from reality. The crassest example is the Bank of Japan. Not far behind are the Fed and the ECB. Japan’s fiscal situation is far worse than Greece’s. Gross national debt is over 220% of GDP. About half of every yen the government spends is borrowed. There is no solution in sight to bring down the deficit. Hence, the debt will continue to balloon. Standard & Poor’s rates Japan’s debt AA-, four notches from the top. Inflation in April was 3.4% for all items from a year earlier, with goods prices up 5.2%. And yet, 10-year JGBs yield below 0.6%. Whoever holds this dodgy paper is getting creamed. But by purchasing every JGB that isn’t nailed down, the BOJ has effectively imposed a peg on yields. “Financial repression” is the result.
Draghi’s promise to do “whatever it takes” has had a similar effect, but less pronounced. To investors, it no longer matters what the classic risks of holding debt are. The only risk that matters is what the ECB will do. With its whatever-it-takes promise, the ECB has effectively given investors the idea that sovereign bonds are a one-way bet.
So the austerity adjustments have had little impact on yields. But they’ve had a huge impact on the real economy in the affected countries – and rarely for the better. Bailing out bank bondholders, stockholders, and counterparties and then making workers give up wages and benefits – the lucky ones who got to keep their jobs – and imposing numerous other cuts to fund these bailouts isn’t exactly a prescription for economic success. But it benefited investors!
2- Are these historical lows sustainable? For Portugal the historical “average” for 10-year sovereigns is 6.8%, based on data from Global Financial Data. Since 1997, yields were below 4% for only 28 months. Now they’ve dropped to 3.3% and might go a little lower. Does this mean that Portuguese “fundamentals” have changed?
My example – and every central banker’s role model – is the Bank of Japan. Portugal’s fiscal situation is far better than Japan’s, and Japan’s 10-year yield is currently below 0.6%. So by that standard, Portugal’s is still high. Portugal’s economic and fiscal fundamentals are a different story. But if the ECB decided tomorrow to very vocally abandon its “whatever-it-takes” pledge, and to pronounce that it would never ever again engage in any form of bond purchases, guarantees, or special loans, not even through the back door, and that all countries in the Eurozone would have to deal with their debt and the financial markets on their own, Portuguese yields would soar to crisis levels. Portugal could borrow even under these conditions, but at much higher rates – rates that it could not afford. Hence a debt crisis.
3- Jeremy Stein, Harvard professor and former US Fed Board member, proposed we focus the attention on risk premiums in the sovereign bond market. Risk premiums for certain Eurozone peripherals are declining with respect to German Bunds or Nordics’ bonds. Are investors in the Eurozone bond market taking on excessive risk?
The only risk investors are currently paying attention to is what the ECB will do in the future. As the ECB has backed all Eurozone sovereign bonds, it has taken credit risk essentially off the table, as far as investors are concerned. They cannot imagine that the ECB would let Portugal default. The risk of inflation remains, though inflation is low at this point. But look at Japan: inflation jumped and yields haven’t budged. Investors see that. Bondholders used to fear inflation. Now they take it lying down. When a central bank with its unlimited power to manipulate sovereign debt markets gets involved, the overbearing risk is the central bank itself – and what it will or will not do in the future.
With their policies, central banks have pushed all investors who want to earn any kind of yield way out to the thin end of the classic risk limb. At the next major storm, these investors will fall off and get hurt.
4- You recently wrote that the Financial Stress Index dropped to the lowest level on record, going back to December 1998. But instead of three cheers, you are worried about it. Why?
The Financial Stress Index, issued by the St. Louis Fed, is based on 18 components, such as interest rates (Fed Funds, Treasuries, corporate bonds, and asset backed securities), yield spreads, and “Other Indicators” that include the VIX volatility index, expected inflation rate, and the S&P 500 Financials index.
The prior record low of “financial stress” was achieved in February 2007 when the financial system in the US was already cracking under mountains of toxic securities and iffy overleveraged mega-bets cobbled together and sold at peak valuations to funds held by unsuspecting investors in their retirement nest eggs. And banks stuffed this paper into their basements and into off-balance-sheet vehicles, while their financial statements showed values and profits that didn’t exist. No one cared. Greed and obfuscation ruled the day. That’s what “low financial stress” means.
In bubble times, when exuberance takes over, when nothing can go wrong, when risk has been banished from the system, and when interest rates are low, perceived financial stress simply disappears. At that point, decision makers – from homebuyers to bank CEOs – make reckless decisions that can only be funded when there is nearly free money for everything, and when this crap can be unloaded no questions asked. It happened in 2007, and it’s happening now again. These decisions always come to haunt the markets. It’s just a question of when.
5- Another index under the spot is the Euro High Yield Index from BofA Merrill Lynch. It is also at historical lows, going back to 1997. What does that mean?
Junk bonds have benefitted particularly from the ECB’s interest rate repression. As desperate investors are searching for yield, any kind of yield at any risk anywhere, they come upon junk bonds, and they hold their noses and close their eyes and pick up this stuff, and it drives up demand and represses yields further. With plenty of liquidity sloshing through the system, the risk of default is perceived as minimal since everyone knows that even junk-rated companies that are losing money can usually refinance their debt and sell new debt to yield-desperate investors. Everyone knows that the day of reckoning is being delayed, and hopefully for long enough. But this debt is explosive, and it sits on the shelf everywhere, waiting to go off. It has to be refinanced – which may be difficult or impossible in an era of higher rates and tighter liquidity. Hence, once again, all eyes are on the ECB, instead of on the junk-rated, overleveraged, money-losing companies and the crappy paper they’re selling.
6- Is ECB monetary strategy under Draghi fueling the Eurozone sovereign bond market? Are we living in bubble dynamics?
The ECB in conjunction with the Fed, the Bank of Japan, and others have created the greatest credit bubble in history. Financial markets are distorted beyond recognition. Real risks are covered up and cease to figure into the calculus. Related asset bubbles are blooming everywhere, particularly in equities, and in some places in housing, farmland, and other sectors. Bubbles are good: some people get immensely rich, governments collect more taxes, banks are saved as they can write up certain assets on their books…. There are just two problemitas with bubbles: they don’t do much for the real economy; and they invariably implode. Then sit back and watch the magnificent and very destructive fireworks!
7- Fiscal policy in the Eurozone has been driven by austerity marked by disinflation and quasi-economic stagnation. Is ECB easing – and a collateral bubble in sovereigns and stock exchanges – the only way?
Disinflation – that is inflation at a lower rate – is good for most people as the prices of goods and services rise only slowly, rather than quickly. In many countries, wages have lagged behind inflation; hence, real wages have dropped. It is widely claimed that lower real wages make a country more “competitive.” But with what? The competitor down the street? Not that many industries have to compete with Bangladesh. But it does increase corporate profits. It’s a devastating experience for workers, and it reduces domestic consumption. Inflation is a tax on wages (except where wages are indexed to inflation). On the other hand, low or no inflation or even slight deflation is good for workers, savers, and many investors.
But low inflation or deflation is toxic for over-indebted governments, companies, and other debt sinners because they can no longer rely on inflation to mitigate their debt. In a land of low or no inflation, corporations have trouble showing paper growth in revenues and profits. And it’s terrible for politicians who rely on inflation to take care of their promises.
We now know that, these days, central bank easing is creating asset bubbles, which, when they implode, are devastating for the real economy. Easing may or may not create consumer price inflation. It doesn’t seem to stimulate the real economy, as we have seen in the US where economic growth has been tepid despite enormous amounts of easing over the past five years.
Solution? Let the markets sort this out on their own, let decrepit overleveraged companies and banks fail and restructure, let even big investors lose their shirts, and let the real economy take priority. People are smart. They can figure out how to make this work once central bank manipulators get out of the way.
8- Recently you remarked that we are seeing since H1 of 2011, and particularly more recently, a clear divergence between the exuberance in the Eurostoxx 600 index and the declining EPS of the companies listed. What does this divergent dynamic mean?
The Stoxx 600 index is up 6.6% year-to-date, 26% from a year ago, and 43% from May 2012, just before Draghi’s magic promise to do “whatever it takes.” That’s a phenomenal performance.
Yet, since July 2011, earnings per share of the companies in the index, according to data provided by FactSet, are down 11.2% from July 2011. These miraculous European companies that make up this gravity-defying index and that have been trumpeted by Wall Street with such conviction are making less now than they did three years ago during the depth of the Eurozone debt crisis!
That was just me pointing it out a few days ago. But now the Centre for Economic Policy Research, which dates official recessions for the Eurozone released a report that supports what deteriorating corporate earnings have been clamoring about: the Eurozone recovery, which peaked in Q3 of 2011, has been in recession ever since! In other words, the recession in the Eurozone still isn’t over.
The Committee observed “a prolonged episode of extremely weak growth” in 2013 and so far this year with “little change over that period” in the labor markets. Instead of the recovery since early 2013 that politicians and Eurocrats have been prematurely taking credit for, the Eurozone has been experiencing “a prolonged pause in the recession.”
The declining earnings of the companies in the Stoxx 600 have been a harbinger of that. So why have stocks skyrocketed in face of this sour picture of the economy? It always comes back to the greatest achievement of the ECB (and other central banks): using extreme monetary policies and financial repression to surgically separate economic realities on the ground from the financial markets. Wolf Richter interviewed by Jorge Nascimento Rodrigues, Janela na web.
Speaking of Japan, a terrible corporate hangover from the consumption-tax hike has set in. Read….Japan Inc.’s Worst Quarterly Outlook Since The 2011 Earthquake