Blain’s Morning Porridge 14th May 2024 – Will the Bonds Become the Nightmare Markets fear?

“I would like to come back as the bond market – you can intimidate everybody.”

Markets fear instability above all else. Financial crashes happen. Spectacular gains are followed by dramatic losses. Market foundations are strong, based on the truth of bond markets. What might happen if investors lose their confidence in bonds?

 Woe, woe and thrice woe….. Last night I had a nightmare. I was climbing up a ladder, a very tall ladder towards an overhanging roof, but just as got near the top of this very, very tall ladder I realised it was slipping, and was about to tumble.. I made a grab for the roof, and woke up with a start… Scary… but what did it mean? The Romans – great interpreters of dream, would no doubt tell me something about portents of failure and missing the moment.. Or perhaps it was a warning not to invest any time in my project to fix the garage living-roof this weekend…?

I’ve been pondering what the ladder dream might mean… I started by considering random headlines from markets this morning:

And my favourite was “GameStop Stock Jumps After Meme-Stock Guru “Roaring Kitty” returns”… fill yer boots as they say…

I could scribble multiple comments on these stories, or the many other market tales percolating through markets this fine May morning… But each show markets are simply getting on with the business of being markets. Investors are buying and selling. Companies are planning and bidding. Analysts are digging through the data to back-up/demolish investment theses. All is well and normal… Markets go up and they go down.

It’s a different story among the commentariat and economists, those acolytes of the science of human misery and fear. There seems to be an absolute surfeit of doom and gloom out there.. as they prognosticate more earnestly than usual about the imminent end of the world as we know it… I’ve got a pile of newish books sitting on the desk, each with their own angle on how markets, the global economy, and everything else is all about to collapse in sudden implosion of logic and stranded consequences… maybe triggered by a bad inflation print tomorrow?

At which point I should remind everyone, yet again, of Blain’s Mantra No 2: “Things are never as bad as you fear, but seldom as good as you hope.”

(Mantra no 1 is: “Markets have but one objective: to inflict the maximum amount of pain on the maximum number of participants.”  The two are not incompatible. There is always an element of instability to markets – that’s what makes them function.)

Financial crashes are part of the fabric of well-functioning markets, useful Darwinian reminders of our mortality and the dangers of irrational speculation. Markets tumble and get up again.. and we learn a little bit more. The consequences of the last big crash, the Global Financial Crisis of 2008, are still with us today. Markets are now worth a multiple of what they were back then. We fall, we pick up ourselves up, and we climb back up the ladder…

Perhaps the deepest fear in markets is stability. (Maybe that’s what my ladder dream was about – ladders are highly unstable.) And, the foundation of market stability is to be found in Bond markets.

If a major US bank or leading tech firm was to implode it might create a tidal wave of contagion, triggering consequences for lenders, suppliers and customers, maybe even an economic row-back.. but if the Treasury market was to collapse… that would be a financial cataclysm the like of which global markets have never experienced… Could it happen?

After 15 years of QE ultra-low interest rates, and Government financial profligacy to fund recovery and pandemic, many bond watchers fear Government bond markets may be close to saturation point. They fear huge debt quantums impose impossible debt service costs on economies, and that investors will strike and stop buying when they finally figure out how unsustainable they are. Fine in theory, never happened in practice because bond markets are dynamic and respond to currency flows – what do you do with surplus dollars?

One theme is how vulnerable Japan would be if Japanese rates were to rise to address the weakness in Yen? It could immediately destroy the valuations the JGB market – but since there are primarily held by the Bank of Japan (which pretty much owns them all and most of the stock market) – does that matter? And if so.. how?

Much of the fear about debt markets being unsustainable in themselves is misplaced. There may be the Reinhart-Rogoff rule that above 70% debt/gdp squeezes out private investment – show me the proof! Whatever the bond vigilantes say, investors seldom strike – we have seen that repeatedly: as long as they are confident they keep buying. There was a great chart on BBerg yesterday showing how the cover on US treasury bond auctions has remained steady over time.

Many years ago a famous banker, Walter Wriston of Citibank, said “Countries don’t go bankrupt.” How wrong he was as a host of developing nations did exactly that. Their mistake was to borrow in US dollars, and find themselves caught on the wrong side of the strengthening US currency. What Wriston should have said is “Financially Sovereign countries don’t go bust.” That is nations that control their own currencies.

At which point it becomes caveat emptor. Global buyers of sovereign bonds have the choice of multiple sovereign bond markets: Treasuries, Gilts, JGBs… but all have their own issues. In times of crisis the Americans, Brits and Japanese can all print money to repay their debt – although there may be consequences.

European government bonds don’t quality as financial sovereign. Marcus Ashworth (together with his editor Mark Gilbert) of Bloomberg are among the best financial writers today. Marcus wrote y’day about: The European Union Should Burnish its Bond for Prime Time, pointing out the need for a primary dealer network, repo facilities and futures to back the European Union bonds the EU is now selling. However, the nations of the EU are no longer financially sovereign, they gave control of their currency up to the ECB and the Euro.

The question to ask is, is the EU a sovereign nation that can print money to repay investors? I doubt it qualifies. I am not one hundred percent sure the EU could order the ECB to print money to repay its debts at a time of financial stress if some Euro members were to object. It would depend on the granting of that power by the nations of the EU – which is currently not a given.

The key issue for Government Bond market investors is the degree of confidence they have in Sovereign Governments to repay them interest and principal. I look at the components of confidence as three legs of the Virtuous Sovereign Trinity:

  • The Stability of the currency
  • The Sustainability of the bond market
  • The Strength of political competence

When all three legs are in place, nothing to worry about. Investors will keep buying bonds confident they will be repaid interest and principal in a stable currency. It’s when something breaks that confidence goes awry.

The political competency of the West is the key issue – how well are the mechanisms of power and leaders responding to the multiple challenges and crises their economies are under. The answer has got to be “not great”. That is set to become a bigger problem as voters demand change but are confronted by same as, same as choices, in national economies that feel to be in decline, causing them to vote for populism.

So when Donald Trump says he’s going to take control of the Federal Reserve to set rates, fund new and ongoing tax cuts with higher borrowing, declare a trade war against China, and break global alliances that don’t suit America.. that may generate waves of ecstatic cheering from his supporters, but leaves global investors distinctly concerned about what they are investing in when political competency is out the window..

However, if Trump is going to cut rates, that’s probably great news for their Treasury bond portfolios. It only becomes a problem when Trump or his successors then try to refinance US debt and the market says… No. Rates will need to rise. One day The Fed might hold an auction and no one turns up… And that is when the wolf might blow down the house of straw..

Out of time, and back to the day job..

Bill Blain

Author of The Morning Porridge

Wind Shift Capital

www.windshift.capital

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