Stress Levels Building Up

I am suspicious of the idea of a new paradigm, to use that word, an entirely new structure of the economy.”

~ Paul A. Volcker

Dear Mountaineers,

On December 16th, Janet Yellen raised the federal-funds rate. Is this the beginning of rising interest rates? Possibly. Will they increase radically? Hardly.

We may actually still have a few more years of low, if not negative, rates ahead. The actual data for the economy – for example the PMI – actually tells a different story than Ms. Yellen. They point toward recession, as the US and global economies do not look all that bright.

Even with funds-rates possibly rising further, you can expect monetary policies to remain highly accommodative. The US and the global economies are not strong enough for anything else. Other central banks who tried hiking over the past few years had to short-stop the exercise. In Sweden, Canada, Korea, Israel or Australia, just to name some examples, they were forced to bail out in view of “soft economic indicators”.

At first nothing…then a splash and a stain on your shirt!

Monetary policies in Europe and Japan are diverging from US policies. While Ms. Yellen is making a show of putting on her hiking boots, the ECB under Draghi’s command and the BOJ under Kuroda’s lead are staying committed to the slippery slope of quantitative easing. In fact, Draghi seems quite enamored with Abenomics – diverging policies in America and Europe.

So far, expansionary monetary policies have not yet raised inflation expectations. The problem is that the risks of sudden changes in the system – for example, an inflationary boost – often do not become visible until it is too late.

To understand the basic problems, or the moral and economic issues of continuous “money printing”, one might compare central bank policies visually with a ketchup bottle that you shake and shake. Nothing comes out at first; it is in essence risk-free. So you shake harder, hitting the bottom of the bottle with your palm, when suddenly the ketchup splashes out, across your plate and all over your dress shirt.

Volatility in the markets has increased. The prospect of US “hiking” is making them nervous. They understand that we have come to a crossroads.

There is no such thing as a free lunch!

What do rising rates mean for financial markets in 2016? The honest answer? We don’t know. Just as we did not know what exactly to expect when we entered a sequence of QE policies on a global scale in 2008, we are now again entering “terra incognita” as the US Federal Reserve has started navigating into “normalization territory”. We don’t know where and when the shift will lead to cracks in the global financial system. However, this paradigm shift will not go by without friction; there will certainly be some uncomfortable surprises.

Central bankers are not telling the truth about the risks their policies entail. Moreover, those who are benefitting from lax monetary policies and who are enriched by their ‘quasi-risk-free’ financial maneuvers will not be punished for the risk-taking if things go wrong. It will be the savers, the retirees, and future generations shackled by excessive debt and financial waste.

There is no such thing as a free lunch!

Stress levels in financial markets are building up

The stress levels in the financial system are building up. This can be seen, for example, in the US high yield bond sector where rates have risen considerably. As the yields rise, as is the nature of bonds, the prices plummet.

Oil has recently dropped to US$ 35 per barrel, a price that puts considerable fiscal stress on oil producers. A growing number of oil firms in the US are suffering and the foreclosure numbers are picking up. Starting in the fall of 2014, the risk premiums on bonds of oil producers started rising. Soon after that, bonds in the commodity sector in general made investors nervous.

At this point, the fire is spreading across the entire junk bonds market…and fast. The following chart, courtesy of Deutsche Bank and Thomson Reuters, illustrates the portion of bonds in distress, i.e. close to default.

Figure 1: Sector distress rations in US high yield bonds

Source: Deutsche Bank, Thomson Reuters

The threat of defaults is spreading across other sectors too, particularly those that are closely related to the commodities sector, such as Transportation, Materials or Commercial services. The problem is not isolated, however. As the Figure 1 shows, it has started to spread across other sectors like Retail, Gaming, Media or Technology. These are sectors which should actually be able to benefit from low oil prices.

Obviously, the Fed’s rate increase did not help. Bond guru and CIO of the investment firm DoubleLine, Jeff Gundlach, recently called this “a blood bath in the junk bond market”.

If you’re not invested in junk bonds, you might think that this does not concern you. However, from experience we know that problems in the junk bond market are frequently a precursor to corrections in the stock market, where a lot of stocks are toppish.

Hopefully, Ms. Yellen has different or better information than us. She will hopefully know exactly what she’s doing. Central bankers have dictated the markets for several years now. Maybe, they can carry their “successes” into the New Year, so that we don’t all get that ketchup stain on our shirt.

I hope you have taken precautions to protect yourself and your wealth.

BFI offices closed on December 24th and December 31st

At BFI, our offices will be closed on both Christmas and New Year’s Eve. Although there is always much to do at the end of the year, we want to keep in our tradition of taking some extra time with our families and friends to properly honor and cherish this special time of the year. I hope that you can do the same.

In any case, in the name of the entire BFI and Mountain Vision Team, I wish you and your family a blessed and joyful Christmas, and all the very best for 2016!


Your “Swiss Mountain Guide”

Frank Suess

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