Today’s debt is tomorrow’s claim on future production, the unbreakable nexus between debt and production. If debt is incurred for a productive purpose and the return is higher than the interest rate charged, it adds to economic growth. If debt funds present consumption or uneconomic investment, then in the future that debt will necessarily mean that economic growth is less than it would have been in the absence of that debt, regardless of whether it or not it is repaid or refinanced. Repayment reduces the debtor’s future consumption or investment. Default reduces the creditor’s future consumption or investment. Either the debtor or the creditor has fewer funds with which to fund future investment, the basis of future production. Refinancing—replacing old debt with new—merely postpones the eventual outcome.
The world now has about $200 trillion in debt, or almost three times the world’s annual production of about $70 trillion (see “A World Overflowing With Debt,” SLL, 2/5/15). Most of that debt has been for consumption, transfer payments, or politically driven “investments,” which, unlike productive private-sector investments, will not generate economic returns sufficient to pay the debt. Mounting debt service costs, despite generational-low interest rates, are retarding or reversing economic growth in virtually all developed-country economies. Global debt continues to grow, which means repayment of interest, not principle, is imposing this burden on current production. While we all await the fateful snowflake that triggers the avalanche, those who want to know down which slope it will roll are advised to look to the link between debt and production.
If production shrinks at all, some debt will not be repaid. The oil market is first illustration of that point: its precipitous price decline made some production uneconomic, reducing producers’ ability to service debt. There have already been defaults and there will be more, in turn reducing consumption, investment, and eventually production, in ever-widening waves that are rippling and will continue to rippled out beyond the oil sector. Oil is in fact the snowflake, as SLL said back in December (“Oil Ushers in the Depression,” SLL, 12/1/14), just as housing was in 2007.
Europe is frantically trying to postpone its rendezvous with welfare-state destiny in Greece, but the debt has already been incurred and somebody will bear the burden of either its repayment or repudiation. For purposes of this analysis the eventual outcome matters not at all, only that it will inevitably arrive and will entail reductions in consumption, investment, and production, leading to economic contraction. Markets are anticipating all this, steadily marking down the prices of Greek debt and equities.
One facet of the current market adjustment process bears close attention: adjustments are sudden, large, and have far-reaching consequences. European governmental institutions and their financial adjuncts have lost control of the value of Greek debt. In less than five months, from last September to late January, the rate on Greece’s 10-year bond doubled, much as the price of oil more than halved over a period of a few months. When the Swiss central bank decided to unpeg the Swiss franc from the euro, the franc appreciated against the euro over 40 percent in a few hours. There was no bid for euros until the market established a much lower exchange rate (less francs per euro).
The oil, Greek debt, and Swiss franc markets, and their associated derivative markets, have one thing in common with virtually every other financial market around the world: they are heavily leveraged. If speculators are 20 times leveraged (not at all unusual), a 5 percent contra move in the underlying asset wipes them out, so they sell first and ask questions later. Bids and market liquidity evaporate, usually only reestablished at dramatically lower levels later on. The gap in price inflicts huge and often solvency-threatening losses, with substantial secondary effects. Yesterday, a capital hole of up to $8.51 billion in an Austrian bank set up to resolve bad loans was reported, in large part because of deteriorating eastern European Swiss franc mortgages. The mortgagees were essentially short the Swiss franc (see “‘Spectacular Developments’ in Austria: Bail-In Arrives after €7.6 Bad Bank Capital Hole “Discovered’,” from Zero Hedge, SLL, 3/2/15).
The world’s central banks have staked their all on monetizing debt to promote rising equity markets. There is much blather about new equity “wealth” promoting economic growth and rising incomes, but even governments’ statistics, manipulated and biased as they are, give the lie to that one. However, unless the link between equity markets and economic growth has been completely severed, two variables the central banks have sought to control are now in direct conflict. Debt monetization and interest rate suppression promote debt expansion as well as rising equity markets, but debt has become economically counterproductive (David Stockman calls it “peak debt). It now demonstrably retards rather than promotes growth, eventually leading to contraction and—barring that complete severance between equity markets and economies—falling equity markets.
Faltering, on-the-verge-of-contracting economies decrease the debt-servicing capabilities of those economies, and debt levels are rising. SLL has long hypothesized that there will come a day when over-indebted governments face the rising interest rates the government of Greece has already faced. That may be happening now, at least in the US and Japan, where rates have been rising, under the radar (it’s the last thing to which Washington, Wall Street, or Tokyo want to draw attention).
It may be just a blip, and as a trading vehicle only the most intrepid should jump aboard, but it bears close attention. Interest rates are a crucial variable that governments and central banks must control. Keep in mind that governments (including their central banking arms) have historically been “dumb money.” (Who can forget the British Treasury’s sale of gold from 1999 to 2002, at the bottom of the gold market?) A general rise in interest rates, and concomitant fall in bond prices, after years in which central banks have been buying huge amounts of bonds, would fit the “dumb money” historical pattern perfectly, and would inflict grievous losses on the central banks.
Remember the phrase from above concerning market adjustments: they are “sudden, large, and have far-reaching consequences.” Equity markets are just as leveraged as most other markets. Central banks are attempting to manipulate them upwards while at the same time promoting economic growth and suppressing interest rates. The Command and Control Futility Principle (governments and central banks can control one or more, but not all variables in a multi-variable system) and its corollary (due to the impossibility of controlling all variables, they will usually lose control of even the variable or variables they have attempted to control) imply that when they lose control of one of these variables, they will lose control of all them. There is virtually no chance that this loss of control will lead to anything but a gargantuan crash that wipes out a significant, by which is meant 50 to 75 percent, chunk of nominal equity wealth in a hurry. There is no chance that such a crash will not lead to a depression.
There are two classes of participants in today’s equity markets: those who know the game is rigged but think they can get out, perhaps even profit, when the music stops, and those who haven’t a clue. There were corresponding classes who were short the Swiss franc—everybody knew the Swiss central bank “had their backs.” Both classes were scorched when it stopped suppressing the franc’s price against the euro. The only investors who won’t get scorched when equity markets collapse are those who aren’t in them, or those who are fortunate enough to short them at the top. SLL recommends its readers join the former, with the latter being reserved for those with substantial trading experience using a fraction of their risk capital. It’s tough trying to time an avalanche.
AMERICA AT ITS GREATEST