Trumped! A Nation on the Brink of Ruin... And How to Bring It Back

by David Stockman

  Would not the bombastic crooks that run the Spanish government send a few legions of crusaders into Greece before they made good on the $42 billion they are on the hook for? Would the bond speculators basking in the Riviera not hit the sell button at the sound of the Spanish hoofs?

  So, yes, the euro and the Eurozone do not have a prayer of surviving. It is only a question of when the bluff of the German leadership and a handful of bureaucrats in Brussels and Frankfurt is called.

  They have fed their electorates the delusion that Greece is fixed, financial markets have been stabilized and the rest of the Eurozone has benefited from the survival of the single currency.

  In fact, worldwide bond managers and speculators are tickled pink because nearly all of Greece’s $350 billion of unpayable debt—on which they would have suffered grievous losses—has been transferred to the taxpayers of the EU-18. Whatever the precise scenario and timing, therefore, this big lie will be exposed when the Greek economy and democracy finally buckles under the weight of the absurd obligations that have been imposed upon them by Merkel and the Brussels apparatchiks.

  In a word, Greece is finished, the bailout commitments will be called, and all hell will break loose in a $20 trillion bond market that is in thrall to a raging central bank–induced mania.

  THE LUNATIC CHASE FOR YIELD IS GLOBAL

  The destruction of honest pricing in the European bond market is only the tip of the iceberg. Our lunatic central bankers have unleashed a worldwide pincer movement among market participants that is flat-out suicidal. To wit, the leveraged fast-money gamblers everywhere on the planet are chasing prices ever higher as the sovereign bonds of “open to buy” central banks become increasingly scarce.

  At the same time, desperate bond-fund managers, who will lose their jobs for just sitting on cash, are chasing yields rapidly lower on any bond issued anywhere that still has a positive current return.

  This is the reason, for example, that they are chasing yield out the duration curve to 30-year and even 50-year paper. Accordingly, the 30-year U.S. Treasury bond has produced a 22% return during the last six months. To say the least, that’s not shabby at all considering that its current yield is just 2.25%.

  All the rest, of course, is capital gains—meaning that the whole scenario is nuts. A recent Wall Street Journal piece entitled “35-Year-Old Bond Bull on Its Last Legs” quotes a European fund manager who explains why everything is going haywire:

  Neil Dwayne, global strategist at Allianz Global Investors, is still buying. “Every piece of analysis we do on the bond market tells us they are structurally overvalued,” he said. But he is buying US Treasurys anyway. “That’s what you have to do when you have the ludicrous valuations in Europe and Japan.”

  Exactly. The poor man is buying a bond he hates because Draghi and Kuroda have driven him out of what amounts to a $15 trillion corner of the sovereign-debt market.

  So in addition to front-runners on repo, we now have institutional fund managers from all over the world piling into the U.S. bond market in a frantic chase after the last positive yield standing. Thus, when the 10-year U.S. Treasury note hit a low yield of 1.34% in July, it literally made history. There has never been a lower yield since 1790.

  Needless to say, this planetary scramble for yield puts Janet Yellen right in the financial dunce chair where she belongs.

  She and the rest of her posse keep insisting that 93 months of ZIRP and $3.5 trillion of bond buying (QE) have so far produced no serious signs of overvaluation or bubbles. But, pray tell, what does she think is happening in the U.S. Treasury market at this very moment?

  Over the last seven years, the Fed has done its level best to drive U.S. Treasury yields into the sub-basement of economic plausibility. Now the other major central banks are helping it to finish the job.

  Needless to say, with the other major 10-year government bonds actually in sub-zero land, this can’t go on much longer. The weighted average yield in the entire developed world government-bond market skidded to just 40 bps in early July. At the current rate of decline, the entire global market could be in the subzero zone by the end of the year.

  You could call this central bank–driven yield stripping. And the latter would be bad enough if its effects were limited to just the vast moral hazard it poses to governments and politicians all over the world.

  After all, we are now entering the zone in which government debt is tantamount to free money. In fact, Germany issued new 10-year bunds recently that actually bear a negative coupon.

  But as we suggested above, it is not just politicians who are being lulled into the delusion of free money. The central bank–driven stampede for yield has spilled over into every nook and cranny of the fixed-income and equity markets around the world.

  Anything that prices on a spread basis against sovereign debt, or that is impacted by the endless destructive arbitrages that falsification of bond prices inherently generate, has been drastically overvalued.

  THE DESTRUCTIVE FRENZY IN THE U.S. CORPORATE-BOND MARKET

  It now appears that U.S. corporate-bond issuance will hit a record $1.7 trillion this year—or 55% more than the last blow-off in 2007. And that is due to one reason alone—bond managers are desperate for yield and are moving out the risk spectrum exactly as our monetary central planners have ordained.

  And that’s not the half of it. The other side of the coin is that the massive proceeds from this orgy of bond issuance are not going into productive investments in plant, equipment, technology and other forms of business-efficiency and capacity enhancement. As we demonstrated in earlier chapters, real net business investment in the United States is still 20% below its turn-of-the-century level.

  Instead, this corporate fundraising spree is being cycled right back into the stock market in the form of share buybacks, M&A deals and other financial-engineering maneuvers. Since the financial crisis, in fact, upward of $7 trillion has gone into stock buybacks and M&A deals.

  This massive purchasing power, in turn, has driven the stock market to the perilous heights described in Chapter 12. It has effectively turned America’s C-suites into stock-trading rooms. Our stock-option-crazed CEOs and boards are doing nothing less than de-equitizing their balance sheets and eating their seed corn.

  Someday the due bill will arrive. But in the interim, corporate finances are being ransacked owing to the scramble for yield set in motion by central banks and the $13 trillion of subzero sovereign debt that has been generated during the last two years.

  But this monumental deformation is so recent that there is very little negative-coupon debt that has yet been issued in the marketplace. Subzero land is overwhelmingly a phenomenon of the secondary market, meaning $13 trillion of bonds are trading at significant premiums to par—and, in some Japanese and German issues, massively so.

  THE GIANT VOLCANO OF UNCOLLECTIBLE CAPITAL GAINS IN GLOBAL BOND MARKETS

  In short, the global bond market has become a giant volcano of uncollectible capital gains. For example, long-term German bunds issued four years ago are now trading at 200% of par.

  Yet even if the financial system of the world somehow survives the current mayhem, the German government will never pay back more than 100 cents on the dollar.

  What that means is there will eventually be a multi-trillion-dollar bond implosion as speculators and bond-fund managers alike scramble to cash in their capital gains at the first sign that the global bond markets are breaking and heading back to par or below. And it is not just the “winners” who will be stampeding for the exits.

  There will also be an even larger and sorrier band of “losers” in an even greater state of panicked flight. We refer here to all the Johnny-come-lately bond managers on the planet who are today buying trillions of bonds at a premium to par. For example, the price of the 4% coupon Italian bonds that have traded up to a 1.2% yield owing to Mario Draghi’s $90-billion-per-month buying spree will get absolutely monkey hammered when the ECB’s big fat bid finally ends.<
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  To be sure, these befuddled money managers claim to have no choice or that these premium bonds still have a slightly better yield than subzero. Yet what they are actually doing is strapping on a financial suicide vest. These premiums absolutely must disappear before maturity, and most probably suddenly, violently and all at once when the great global bond bubble finally implodes.

  Likewise, there are nearly $3 trillion of junk bonds and loans outstanding in the United States alone, and that is double the level extant on the eve of the great financial crisis. But double the money embodies far more than double the risk.

  That’s partially because the drastic, central bank–induced compression of benchmark bond yields has been transmitted into ultralow absolute levels of junk-bond yields via spread pricing. Compared to all of modern history, current junk-bond yields in the 5–6% range are just plain ridiculous.

  After all, long-term junk-bond losses have been in the 3–4% range, inflation is still running close to 2% on a trend basis and taxes have not yet been abolished. So the sheer math of it is that the average single-B junk bond today has negative value—and that’s before the next default cycle really kicks into gear.

  And junk-bond defaults like never before in history are coming with a vengeance. That’s because a very substantial portion of current junk-credit outstandings went into speculations that even leveraged-buyout shops wouldn’t have entertained 15 years ago.

  To wit, it was used to fund radical commodity-price speculations in the shale-patch, mining and other commodity plays, subprime auto-lending schemes and financing for stock buybacks and dividend recaps by highly leveraged companies. Accordingly, the embedded business and credit risk in the $3 trillion of outstanding U.S. junk bonds and loans is off the charts.

  Already by midyear 2016, defaults in the shale patch had taken down 40% of outstandings. Even cautious rating agencies like Fitch now project high-yield bond defaults will hit nearly $100 billion in 2016, or double last year’s already-elevated levels.

  But as usual the rating agencies are far behind the curve. Standard and Poor’s, for example, projects that by June 2017 today’s rapidly rising defaults will only hit the 4–7% range. But they are smoking the same thing they were in 1989, 1999, and 2007!

  In fact, the junk-bond sector will soon be hit by a double whammy that will push loss rates to unprecedented levels. That’s because there is already a deeply embedded loss due to the distortions of ZIRP/NIRP on benchmark bond pricing. When the central banks of the world are eventually forced to shut down their printing presses and permit rates to normalize, these losses will be transmitted across the entire credit spectrum.

  On top of that, the massive global deflation/recession currently unfolding means defaults will easily soar far above the prior 11–12% peaks shown below. And the next peak default cycle will last far longer than the historic results shown in the chart because this time the central banks will not be in a position to reflate the bond and other financial markets.

  The prior default peaks shown below are part of the two-decade-long supercycle of global credit and investment growth. Each junk-bond market break was quickly reversed by successive rounds of central bank money printing.

  But the world economy is now stranded at Peak Debt, and the central banks are out of dry powder. The latter have reached the limits of subzero rates, the credibility of QE is fading fast and Bernanke’s fleet of helicopter-money drops will never get off the ground in the United States or Germany, and that’s mainly what matters.

  So this time recessionary conditions will persist, and the implied revenue growth in most junk-bond deals will never happen. The resulting cumulative buildup of cash-flow shortfalls, therefore, will be immense. This means that a far larger share of issuers will eventually default—especially given the elevated credit risk already embedded among commodity-oriented issuers.

  Moreover, as the junk-bond default rate continues to rise, the “extend and pretend” market, which has forestalled defaults in the last few cycles, will also dry up. Consequently, hidden defaults will finally come to the surface, and issuers will resolve their inability to pay in the bankruptcy courts, not in the junk-refinancing markets.

  FINANCIAL EXPLOSIVE DEVICES (FEDS) AND THE COMING FINANCIAL CARNAGE

  Yet the junk-bond sector is only a small section of the coming bond-market carnage. The scramble for yield generated by central bank financial repression, in fact, has systematically impregnated the global markets with FEDs (financial explosive devices).

  Even as approximately 200 principal central bankers and senior staff have spent the last seven years pushing interest rates toward the zero bound or below, there have been millions of financial operators and capital users scouring the earth for ways to escape it.

  Recently, one of these zero-bound escape routes blew sky high when the 9.5% contingent convertible bond of 2049 issued by an obscure German bank, Bremer Landesbank, plunged by 40% from 120 to 73 in just minutes—a move that has, in turn, spooked broader global markets.

  It turns out that Bremen LB is a $29 billion German state-owned bank heavily invested in shipping loans that is now facing massive write-downs and the need to raise capital from its principal owners—German Landesbank NordLB, the city of Bremen and the savings-banks association in North Rhine-Westphalia.

  Here’s the thing. All the parties involved had stumbled into risk that extended way over the end of their financial skis. Indeed, the cliff-diving bonds were at the very end of a long chain of mispricings emanating from today’s central banking regime.

  It originated a while back when central banks made cheap debt available to households in the United States and Europe. That caused a consumption boom there and an oversized export boom in China and the Far East.

  Next, more cheap capital enabled by the Asian central banks funded an artificially large investment boom in China and in its emerging-markets supply chain, which, in turn, caused demand for bulk, crude oil and container-ship capacity to surge.

  Needless to say, still-more cheap capital generated a massive excess of highly leveraged ship-building capacity that needs cash flow to service its debt. So the huge state-enabled ship-building industries of China and South Korea built new ships like there was no tomorrow and, to move the iron, priced them near marginal cost.

  Then, even-more-yield-hungry capital hooked up with the growing surplus of these “new builds,” funding on high leverage what is ultimately a day rate commodity (that is, shipping capacity).

  Even then, the daisy chain was not done. The bank arrangers and other intermediaries who bought and financed the surplus ships that the central bankers indirectly built needed to enhance their own returns. So they funded their newly acquired “assets” with yield bait like the Bremen LB contingent bonds that blew sky high on a moment’s notice.

  The one thing that is absolutely true in a $300 trillion global financial market is that Bremen LB is not a one-off. After a $20 trillion central bank printing spree and 93 months on the zero bound, these kinds of FEDs exist in the tens of thousands.

  Soon we will know their names.

  After all, creating this kind of fiery demise is what central banks ultimately do.

  CHAPTER 15

  Revolt of the Rubes—Bravo, Brexit!

  AT LONG LAST THE TYRANNY OF THE GLOBAL FINANCIAL ELITES HAS BEEN slammed good and hard. You can count on them to attempt another central bank–based shock-and-awe campaign, but it won’t be credible, sustainable or maybe even possible.

  The central bankers and their compatriots at the EU, IMF, White House, U.S. Treasury, OECD, G-7 and the rest of the Bubble Finance apparatus have well and truly overplayed their hand. They have created a tissue of financial lies—an affront to the very laws of markets, sound money and capitalist prosperity.

  After all, what predicate of sober economics could possibly justify $13 trillion of sovereign debt trading at negative yields?

  Or a stock market trading at 25X reported earnings in the face of a fa
ltering global economy and a tepid domestic U.S. business cycle expansion that at 87 months is already long in the tooth and showing signs of recession everywhere?

  And that’s to say nothing of the endless ranks of insanely overvalued “story” stocks like Valeant was and the megalomaniacal visions of Elon Musk still are. Or the coming proof that Facebook’s digital billboard is subject to cyclical slump and that its ballyhooed 1.7 billion monthly users are today’s equivalent of dot-com-era “eyeballs.”

  So there will be payback, claw back and traumatic deflation of the bubbles—plenty of it, as far as the eye can see.

  On the immediate matter of Brexit, the British people have rejected the arrogant rule of the EU superstate and the tyranny of its unelected courts, commissions and bureaucratic overlords.

  As Donald Trump was quick to point out, they have taken back their country. He urges that Americans do the same, and he might just persuade them.

  But whether Trumpism captures the White House or not, it is virtually certain that Brexit is a contagious political disease. In response to June’s history-shaking event, determined campaigns for Frexit, Spexit, Nexit, Grexit, Italxit, Hungexit and more centrifugal political emissions will next surely follow.

  And if Trump loses, there may even be a small uproar from the Lone Star state on behalf of Texit!

  Smaller government—at least in geography—is being given another chance. And that’s a very good thing because more localized democracy everywhere and always is inimical to the rule of centralized financial elites.