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Musings Report 2017-47 11-25-17 Why the Global Financial Bubbles Will Break
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Welcome to November's MUS (Margins of the Unfiltered Swamp)
The last Musings of the month is a free-form exploration of the reaches of the fecund swamp that is the source of the blog, Musings and my books.
Why the Global Financial Bubbles Will Break
At the risk of putting those who aren't particularly interested in financial matters to sleep, I'd like to take a stab at explaining a dynamic that will prove fatal to the global financial markets, sooner rather than later, i.e. in 2018.
I'll do my best to keep this as straightfoward as possible.
1. One of the ways that central banks have kept interest rates low and pushed private investors into stocks and real estate is by buying government bonds--in the U.S., Treasury bonds that are used to fund federal deficits and replace existing bonds which have reached maturity.
This is largely a matter of supply and demand: if the Treasury offers bonds paying 1%, and there are more buyers than there are bonds available for purchase, then the bonds paying 1% are quickly snapped up. If the Treasury offers the next batch at 0.9%, and they're also bought, then over time the yield declines, as buyers--in this case, the Federal Reserve-- are ready to buy bonds at any yield, no matter how low.
The Federal Reserve can do this because it creates money out of thin air in whatever quantity it deems necessary to buy as many bonds as it needs to suppress interest rates.
Other central banks have pursued the same strategy of "printing" new money and using it to buy bonds at very low or even negative yields.
2. In an open market that isn't dominated by central banks, bond yields are set by supply and demand: if investors don't buy the bonds at 1% yield, the Treasury has to offer higher yields.
3. What drives the decision to buy or not buy bonds at a particular yield? Investment decisions weigh the trade-off between risk and return (yield): the safer investments such as Treasury bonds will have lower yields, while high-risk assets (such as stocks) must offer higher yields to entice investors to accept the higher risk.
The gap between low-risk Treasury and AAA corporate bonds and higher-risk investments such as BBB corporate bonds, stocks, etc., can't get too wide, or investors will abandon the low-yield safe investments for higher-risk assets.
If low-risk bonds yield 1% and stock dividends yield 4% plus the potential for appreciation, money managers whose jobs depend on earning high yields will sell bonds and buy stocks.
Alternatively, if the stock market is plummeting and bond yields have risen to 3%, money managers will sell stocks and buy bonds, as the risk of losing capital in a stock market sell-off isn't worth the extra 1% earned by stocks.
4. By buying trillions of dollars of assets (bonds) to drive down yields and interest rates, central banks have manipulated the risk premium to favor higher-risk assets such as stocks and real estate.
If bonds are paying 1%, and there is not much appreciation upside left (bonds gain in value as yields drop), how can a money manager justify accepting such poor returns when stocks and real estate offer higher yields plus upside in appreciation?
5. In effect, central banks have pushed investors and money managers into higher-risk assets, inflating asset bubbles that increase the damage that will be done when the bubbles pop.
6. By suppressing interest rates to unprecedented lows, central banks have also created enormous incentives to borrow cheap money to speculate in high yielding risk-assets.
For example: if a financier can borrow $1 billion at 1.5% interest, and buy a bond paying 3.5%, the financier skims $20 million a year in pure profit for doing nothing but executing a few digital transactions.
7. Central banks have now begun buying stocks and even housing to keep the stock and real estate bubbles inflated. The Bank of Japan now owns a major chunk of the Japanese stock market, and local governments in China are buying empty flats with central-bank funds to keep property values elevated.
8. Having pushed everyone into high-risk assets to earn a decent yield, central banks have inflated asset bubbles in these risker assets (stocks and real estate). Now the danger of a reversal is much higher than it would have been if central banks hadn't pumped trillions into the financial markets and pushed investors into risky assets.
9. To keep these central-bank iflated bubbles aloft, central banks are now buying stocks and empty flats to keep these markets elevated.
10. But this creates another dynamic: with central banks buying risk assets at ever-higher prices, they've forced private investors to overpay for stocks and housing.
11. By pushing the value of stocks higher, the central banks have effectively reduced the yield available to private investors.
Let's say Company A pays a $1 dividend and its stock is $20 per share. The stock yields 5% per share.
As investors pile in, the stock goes up to $40 a share, reducing the yield to 2.5%. Then central banks start buying shares of the company, and the price per share rises to $60.
Now the stock only yields 1.67%, not much above longer-maturity Treasury bonds.
12. In effect, central banks have not just driven private investors into risky assets; by buying these risk assets, central banks have reduced the yield, pushing private investors into ever more risky assets as they have been forced to "chase yield," i.e. seek a return above near-zero.
This has inflated all major asset classes into bubbles--bubbles that are so over-valued that there is very little upside left but plenty of downside.
13. Now central banks are trying to reduce their purchases of assets, but they have to do so without popping the bubbles they've inflated.
14. What happens when central banks reduce their buying? The odds of a bubble popping increase, as a major buyer (the central bank) will no longer be buying regardless of the price.
15. What happens to insurance companies, pension funds and millions of IRA and 401K accounts when owners of risk assets suddenly get exposed to risk, i.e. these overvalued bubbles pop?
16. Selling stocks and real estate to buy low-risk bonds doesn't solve the core problem, which is bond yields are so low that pension funds, etc. are unable to meet their obligations by owning low-risk assets.
17. Central banks have painted the financial markets into a corner: buying overvalued assets lowers the yield and exposes the owners of the risk assets to high risks, but selling risk assets and buying bonds paying next to nothing insures the investments won't even keep up with inflation, much less actually earn a real return.
18. There is no way out: if central banks allow yields to rise, speculative borrowing dries up, removing a key support of the asset bubbles. Higher yields on safe bonds will make low-risk bonds more attractive than high-risk stocks, triggering a sell-off of stocks.
Even if central banks go all in and buy trillions of dollars of stocks to keep the bubble expanding, they haven't solved the low-yield conundrum they created; all they'll do in buying stocks/lowering the yield is push private investment into even riskier assets as everyone is forced to seek yield.
One way or another, the bubbles inflated by central banks will pop, and the myriad risks and unintended consequences will come home to roost. Buying more stocks won't increase the yields private investment funds need to remain solvent, while letting the bubbles pop will wipe out trillions in gains booked since the Great Financial Crisis of 2008-09.
No matter what the central banks do, private investors have no way to earn a safe return and no way to escape the risk of overvalued bubbles reversing to historical valuations.
From Left Field
A Record Share of Men Are “Marrying Up” Educationally (via Maoxian) -- smart move... every household needs two incomes nowadays...
For The First Time Ever, The Richest 1% Own More Than Half Of The World's Wealth, Or $140 Trillion
I worked as a prosecutor. Then I was arrested.
Walmart Nation: Mapping the Largest Employers in the U.S. -- amazed by how many are state university systems...
Harvey Weinstein had a secret hit list of names to quash sex scandal
The Party's Over For Australia's $5.6 Trillion Housing Frenzy -- as I was saying about bubbles...
A growing number of young Americans are leaving desk jobs to farm (via Steve M.)
Lessons from the Rise of Women’s Labor Force Participation in Japan -- academic, but of interest to those who know something about the traditional gender limitations of Japan's labor markets...
Citi's Shocking Admission: "There Is A Growing Fear Among Central Bankers They've Lost Control"
Americans Are Retiring Later, Dying Sooner and Sicker In-Between --yikes...
The Swiss Way of Health -- will check with my brother to see if this is accurate...
An anthropology of happiness -- from 2001, but still valid and important...
The 15 Most Beautiful Main Streets Across America -- you probably know of more charming main streets...
"If you would know who controls you, see who you may not criticise." Tacitus
Thanks for reading--
charles |
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