The Biggest Short, by Robert Gore

Some reversals of financial trends prove so momentous they define the generation in which they occur. The stock market crash in 1929 kicked off the Great Depression, which ushered in the welfare and then the warfare state and redefined the relationship between government and citizens.

Bonds and stocks began their bull market runs in the early 1980s. Now, those markets are fonts of optimism increasingly unhinged from reality. The US has come full circle. The New Deal and World War II marked a massive shift of resources and power to the federal government. Conversely, financial reversal will fuel a virulent backlash against the government and its central bank.

Such epochal reversals are usually foreseeable. However, they are long in the making and involve such a confluence of powerful forces that usually only a handful get the timing right. Calling the end of the current bull markets has been difficult because governments and central banks are desperate to keep them alive. Central bankers prattle on about the wealth effects of elevated stock markets and how low interest rates promote debt and consumption, supposedly the fountainhead of economic progress. Those emissions are noxious nonsense. Central banks promote rising markets because they are under the thumbs of their governments; independent central banker is an oxymoron. High stock prices are a popular barometer of social mood, while high bond prices keep interest rates low, benefitting the largest borrowers, governments.

Consider the absurdity of loaning money to any of today’s welfare state governments, including the most indebted of them all, the US government. Most of them haven’t run an honest, GAAP budget surplus in decades. They have compiled staggering amounts of debt relative to their economies’ GDPs. Unfunded pension and medical liabilities are many times the amount of the stated, on-the-books debts. Those programs could be cut, but a compilation of such cuts the last thirty years would fill a book slightly thicker than Hillary Clinton’s Integrity. The debt cavalcade will stop only when creditors say “Enough!” or start charging usurious interest rates.

Yet, that is the opposite of what creditors are doing now: they are paying governments for the privilege of lending them money! Governments are assumed to have a call on every last dollar, euro, yen, and yuan their economies generate, but there are flaws in that assumption. To the limited extent today’s economies function, they do so because vestigial capitalism still offers incentives, markets, and the price mechanism. The foundation of production is brains and brains are quite sensitive to incentives and the political and legal framework in which they operate. Nobody designs the newest generation semiconductor, app, or robot when virtually everything they produce is expropriated by the state. Tax rates have probably gone as high as they can go in terms of extracting revenue, and even if they haven’t, any revenue increase from higher rates will be nowhere near enough to repay governments’ debts and unfunded liabilities.

So rational investors must question governments’ ability to pay their debts, which leaves irrational investors—central banks—as the buyers. The Bank of Japan is the market for Japanese government debt. While the situation is not quite as bad in Europe and the US, the ECB and the Federal Reserve have amassed huge portfolios of their own sovereigns’ debt, purchased from private banks in exchange for central bank reserves that they conjure at will in unlimited amounts. Speculators buy debt with negative yields from governments that are poor credit risks because central banks will pay them an even higher price at an even more negative yield. The stated goal of the central banks is to increase economic activity and inflation rates, which would increase interest rates and reduce bond prices, inflicting losses on bondholders, including, perversely, central banks.

This is the very definition of a market awaiting a crash: a long running bull trend that has pushed prices to absurd prices (you can get no more absurd bond pricing than that which yields, so to speak, negative yields); an extreme divergence between the government bonds prices and their underlying value as a claim against issuers that are de facto bankrupt; a commitment by governments and central banks to inflict losses on those who buy government debt; a long historical dishonor roll of instances where governments and central banks have done just that; a class of dumb money, short-term, price insensitive buyers (speculators and central banks), and a degree of complacency and obtuseness so extreme that market participants make a mad dash for these putrid instruments at every appearance of financial and economic turmoil. So why not rush right out and short sovereign debt markets, either directly or indirectly through any number of exchange traded funds?

Markets often take seemingly forever to do what rational people think they should have done long ago. They can, as John Maynard Keynes noted, stay irrational far longer than those who bet against them can stay solvent. Japanese finances are in far worse shape than the US government’s or most European government’s, and its aging population is a demographic and actuarial nightmare. Roughly half the government’s deficit is monetized by the sole buyer, the Bank of Japan, and if it stepped out of the way yields would skyrocket. Yet, speculators have been shorting Japanese government bonds and losing money for decades. The Japanese government’s 10-year bond trades at an all-time high price and with a negative yield.

In the US, the majority of Wall Street sharpies have recommended shorting bonds for several years running, based on an imminent, central-bank inspired economic lift off that has never arrived. Anyone who has taken their advice has suffered the same fate as those shorting Japanese debt. Nobody ever suggests shorting sovereign debt because of deteriorating credit quality. Long before their longest maturity bonds mature, sovereigns will have insufficient revenues to pay all their obligations. In the US by 2025, Social Security, Medicare, Medicaid, and interest on the government’s debt will consume all tax revenues and taxes would have to double to pay for the rest of the budget. That’s if doubling the top rate to 80-plus percent actually doubled tax revenues, which it won’t; revenues would undoubtedly shrink.

Shorting sovereign debt has been a widow maker, although on fundamentals sovereign debt is the biggest short of them all. Bonds now trading at high premiums with negative yields will go to zero as governments go bankrupt. Sovereign debt is the foundation for the $225 trillion global pyramid of debt. When it goes so will the rest of the pyramid, and so too will debt-supported equity, commodity, and derivatives markets. The time to catch those trades will be when government bond yields persistently climb in the face of clear, impossible-to-deny economic weakness and financial turmoil: market recognition that governments are not safe havens, they’re insolvent. The economic production that supposedly supported their debt holdings gone, all creditors will have is a promise from governments to redeem unsupported debt with more unsupported debt. It will be the worst of times and the best of times. The financial system will crater. However, that may usher in a replacement based on sanity rather than political promises, flimsy pieces of paper, quack economics, and debt, conjured with a computer keystroke, masquerading as money.

A TIME OF REALISTIC OPTIMISM AND RATIONAL EXUBERANCE

ROBERT GORE’S EPIC NOVEL OF THE INDUSTRIAL REVOLUTION

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