Crisis Progress Report (7): Carry On! by Robert Gore

Last Friday offered confirmation of the proposition: the only thing the world’s equity markets have going for them is central bank debt monetization and interest rate suppression. The Bureau of Labor Statistics (BLS) reported that April payrolls had increased 223,000, but revised down March’s reported increase of 126,000 to 85,000. Stocks surged because the revised March number took the three-month moving average below 200,000, and market participants’ concluded that the long-delayed Federal Reserve twenty-five basis point (1/4 of one percent) increase in the federal funds rate will be pushed off from June to at least September.

Whether or not the federal funds rate is twenty-five basis points higher is irrelevant to Main Street America. What does make a difference is that global ZIRPs (Zero Interest Rate Policies) have destroyed the incentive to save, driven the rate of return on productive investment to zero, promoted both public and private debt expansion that burden economies with ever increasing debt service costs, and kept alive zombie businesses that should have met the “destruction” part of “creative destruction.” The ripples of the bust in the oil patch, after the easy money boom, are spreading out over the global economy. US GDP in the first quarter was initially reported as .2 percent, annualized, and a subsequently reported big increase in March’s trade deficit will take subsequent revisions into negative territory. The Chinese economy is slowing; two years of “Abenomics” has done nothing for Japan’s, and European growth is undetectable, but high unemployment, especially among younger workers, is glaringly detectable. Various shipping indexes have tracked the drop in world trade.

The gaping holes in the unemployment numbers are obvious even from the BLS’s own figures. There are the revisions, like this month’s downward revision of March’s payrolls by 41,000. There is the steady trend of qualitative deterioration: full-time replaced by part-time jobs; well-paying manufacturing jobs replaced by lower paying service sector jobs; flat inflation adjusted wages since the turn of the century. And there is the steady decline of the labor force participation rate, which flatters the headline unemployment rate (you can’t be unemployed if you’re not “officially” in the labor force). The needle the government must thread is to paint a picture of an economy that is showing strength, and will someday arrive in the Promised Land that used to be routine—3 percent real annual growth in the GDP—but not so much strength that the Federal Reserve will have to raise rates anytime soon.

Unlike Main Street, leveraged speculators care a great deal about twenty-five extra basis points; it’s like a manufacturing business that sees the cost increase for its main input. The cheap money input is cycled into any and every “carry” trade which promises a return higher than the pittance of interest required to fund the trade (aka “positive carry”). After six years of equity bull markets, stocks don’t just promise a positive return, central banks have virtually guaranteed it.

They well know that perpetually rising prices, for not just stocks but the gamut of financial instruments and commodities, keeps everyone but short sellers happy. As the gap between the up arrow on the stock market and the down arrow on the actual economy yawns ever wider, the game is to extend the former and pretend the latter doesn’t exist. Friday’s jobs numbers were perfect: good enough to further the “recovery” story; crappy enough to convince the carry traders there will be no disruptive increases in the price of their main input. Viola, a 262-point rally in the Dow!

Central banks can nail down the cost of short-term funding for carry trades, but longer term interest rates are determined by, among other factors, the credit worthiness of the borrower. The Greek government has just repaid a debt to the IMF using its reserves at the IMF, and plans to pay some pensioners later this month with money “borrowed” from pension funds. Having just paid itself, the IMF wants no part in any further bail outs. Here are four of the more salient aspects of the Greek debt situation: Greece has a lot more debt than it can pay; Greece, its creditors or both are going to sustain losses; such losses are economically contractive, and Greece is a preview of coming attractions for many of Europe’s heavily indebted welfare states. SLL hasn’t paid much attention to the day-to-day developments in this long running drama (it’s been going on since 2010) but absent yet another extend and pretend “solution,” there soon may be a resolution.

SLL has advised watching interest rates as a harbinger of impending economic stress. With the world as heavily leveraged as it is, any increase in longer-term interest rates will bring the pathetic “recovery” to an end. Credit markets seem to be waking up to the fact that lending to governments is not risk free. Greece is the poster child for sovereign risk, but the yield on “solid” German 10-year bonds has gone from about 5 basis points (5/100 of a percentage point) to 68 basis points. Along the way, market participants  have discovered the “vanishing bid”; the suckers they counted on being able to sell to aren’t there. Yields have risen across Europe and in the US and Japan. They have gone up in Europe and Japan despite central banks buying sovereign debt, which is supposed to suppress yields.

This may be the long awaited lift off of a bear market in bonds, driven by concerns that heavily indebted governments will be unable to repay their debts with anything other than more debt or fiat currency. Or it may a reaction to absurdly low, in some cases negative, yields. ZIRP is the linchpin for the carry trade and the bubble in financial assets. Low long-term yields have funded consumer, corporate, and governmental borrowing binges. Rising short-term rates would doom financial markets; rising long-term rates would doom the real economy. Doom in either one would doom the other. Don’t get up for popcorn. This movie is just getting to the good part and you wouldn’t want to miss it.

A LONG FORGOTTEN TIME WHEN THERE WAS NO

FEDERAL FUNDS RATE

AMAZON

KINDLE

NOOK