Macro Brief: Interest Outlook - Voltaire: 'A sovereign state that owes money only to itself could not become poorer'

 

Voltaire, 1738: "A sovereign state that owes money only to itself could not become poorer" (Source: Gilles Bransbourg, NYU & Bloomberg Briefs)

 

To say the last four year since the financial crisis broke out for real in 2008 has been slightly atypical would be the understatement of the century. The central banks across the globe have been deep into their toolbox to find what they call "unconventional measures" – which is really short for cutting interest as low as possible for as long as possible – when rates hit the floor (zero interest rate) in the short-end (0-2 year),  they moved their effort further out on the yield curve buying most of the bonds issued by their own governments Treasuries. Decades ago that would have been called a Ponzi scheme, but in today's world it is sold as the "only alternative".  Voltaire saw it coming.

 

Traditionally the central banks have only controlled the interest rate curve from Overnight to one year through their policy setting rates, but the severe drop in equities in 2008/2009 and the huge fiscal imbalances created from biggest fiscal stimulus in history created a need for securing "orderly business" through ample liquidity at low rates. That was followed up with a PR blitz from central bank and policy makers telling us: It's all ok – we got everything under control! Sure you do! We then migrated from one bubble to another, and ended up in a debt trap, where governments and banks remains thinly capitalized and often without access to further credit.

 

The world government and commercial banks now takes so much of "credit cake" – that the private sector is only left with  crumbles. The private sector which is traditionally the risk taking and profitable side of the economy has been cut off from its oxygen : Credit. The macro side of the economy have taken over the micro. Trust me you want the micro economy, you as a person and individual companies, to have the maximum flexibility and access to capital and risk, instead they are cut off, overtaxed and overregulated.

 

In 2012 so far we have a gradual normalization of interest rates. The move this month has been dramatic and lead to talks of changing fundamentals and a potential for mainly the US for having turned a corner. We were constructive on the US back in Q4-2011 as we saw the expected future growth by consensus economist being too low (Remember the talk of double dip?) – now fast forward to Q1-2012 and the market is, in our view, too busy to project recent "stabilization" into long-term growth. It's too early, if anything our forward looking indicators remains constructive but showing signs of a slow down , hence we believe the US will still be the star of 2012 but only because everyone else will do much worse.

 

This leaves the recent interest hike as almost a counundrum: Have the interest cycled bottomed – are this the new normal or is it back to mean-reversion? The world needs low interest rates to carry the gigantic debt in front of it, so the outcome to this question will a large impact on future growth and investment climate.

 

Chart: US 30 year Yield since 1993 – Source: Stockchart.com

 

 

We presently see three potential scenarios:  (the percentage probability is consensus expectations)

 

-          Much lower interest rates going forward(60%) – based on infinite monetary expansion. The reflation trade. This is the one option favored by politicians as it is of balance sheet and off accountability for them (Stealth crisis help from central banks). These facts makes this the most likely scenario and if you look at charts also very appealing. Ever lower interest rates in downward channel as seen above.

-          Lower in a channel but all-time low in place(30%) – rates have seen the low overall. The "unconventional measures" needs to exited. The biggest policy mistake historically has always been staying too low for too long. The politicians are clearly getting "hand shy" for continuing the "unconventional measures". Another game stopper could the law of stock versus flow. The policy makers have printed in excess of 3 trillion US dollar globally to keep the financial market and government afloat. This means to have additional impact the net new issuance of money needs to be much bigger in nominal terms(10% of 1.000 is 100. – 10% of 7.000 is 700 – so to get 10% impact in this examples you need to print 600 more for same impact). This is our preferred outlook path now

-          Crisis 2.0(10%). Our old theme which is really the loss of faith in government and its ability to repay its debt. To some extent we have had Crisis 2.0 in Club Med, but it is yet to pass on to major economies like Germany, France, US, Japan and the US. This is the least probable scenario, but IF… we break the higher channel in the above chart if would signal a start to a whole new paradigm where FIAT money no longer is sustainable.

 

If we are right and the market is wrong, then the move away from "unconventional measures" is a major game changer. The banks- and government are dependent on the false sense of security low interest rates creates. Even a historic normal expected move in interest rates from the bottom- to the high-end of the present long-term trading range 3.0% to 4.75% would have dramatic impact on debt crisis.

 

Across Europe and the US house owners remains under pressure – any move – small or large would put 100.000s further under water in equity value. That is the negative impact of a debt trap, the inability to create any economic environment where you can exit from the pain of the debt service – look at Japan. The stock- and house market topped in 1980 – now 32 years later the stock market is 75% below its peak. Too negative? Probably, but a long life in trading has taught me a few long-term facts: 1. Everything mean-reverts – What comes up must come down. (Think stock market, house prices, excess, state intervention) and more importantly 2.  We never lean any from history

 

Safe travels,

 

Steen

 

 

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