There we were under a London Plane tree watching the sun set into a smoky sky while having a Mexican beer with some mates. Coming up Fitzroy Street on the footpath to left was a rag-tag band of people banging drums and wearing orange robes. On the right, stuck in traffic and puffing on cigarettes was a van full of tired looking men wearing Ferrari shirts and staring at the scene. See below for what happened next…
What happened overnight in the market was just as interesting as the goings on in St. Kilda on the eve of Melbourne’s Formula One race. For one, bond yields are moving on up in the United States. The ten-year bond yield jumped again after putting on 17 basis points the day before.
Equity strategist Peter Boockvar at Millar Tabak told Bloomberg that “The U.S. Treasury market has gotten slammed over the past two days. This is the last thing a fragile economy needs because yields aren’t spiking because all of a sudden the U.S. economy is great again.”
Good point. So why are they spiking? Bonds have been a 30-year bull market. Is that topping out? We thought it was a few years ago. But when the Fed slashed interest rates beginning in 2003 to reflate the dot.com bubble (and unintentionally cause a housing bubble) bonds went on a tear again. Now, though, it may all be ending.
For one, as we pointed out earlier in the week, some corporate bonds are yielding more than sovereign government bonds of the same duration. Maybe that’s anomalous. As David Goldman of Bank of America pointed out in a Barron’s article, if the government needs more money to pay higher interest rates, it can just raise taxes. Corporations, on the other hand, do not collect their revenue at gun point.
We think Mr. Goldman may have a bit too much faith in the ability of governments to keep raising taxes without seriously undermining business investment. What’s more, people are getting tired of paying higher taxes to bail out financial companies and/or to pay for public pensions. And that’s before a huge increase in government spending on the boomers as they get older. You’ll have fewer and fewer workers supporting more and more retirees.
That leaves already damaged public sector finances in an even bigger lurch. They’d face rising interest payments on debt outstanding as well as rising payments to the elderly and the retired. It doesn’t leave room for much else in the way of spending, does it?
“The sharp uptick in Treasury yields may indicate something more fundamental – that the bond market cannot absorb an infinite amount of even U.S. debt without a price concession,” writes Randall Forsyth. Rising U.S. bond yields will trigger a lot of global consequences, including right here in Australia.
Keep in mind that governments in the U.S., U.K. and Japan will have to refinance trillions in debt in the coming years. And that’s not including new borrowing. In other words, they’re going to gobble up a lot of capital. Australia’s banks (and its government) have to compete in that global capital market.
This prospect makes the rosy conclusions of yesterday’s Financial Stability Report from the Reserve Bank of Australia a bit premature, in our opinion. In its summary, the RBA wrote that, “The Australian financial system remained resilient through the crisis period and, in aggregate, banks experienced only a relatively shallow downturn in underlying profits. ” This all sounds positive, so far. But what about the loan portfolios?
“The quality of banks’ housing loan portfolios has proven to be very high by international standards, notwithstanding a modest increase in loan arrears. There has been a more significant deterioration in the quality of banks’ business loan portfolios, particularly for commercial property, and this remains an area to watch closely in the period ahead. Nonetheless, recent indications are that banks’ overall loan losses may have peaked and that profits have again begun to increase.”
Yes, banks profits are just fine, thank you very much. But we’re not entirely convinced that the banks are out of the woods on their commercial property loans OR their housing loans. The fact that Australia’s residential housing market is the only one in the Western world not to see a major decline tells us that it’s overdue, not that it’s impossible.
But that’s an old debate and we won’t rehash it here. One interesting note was the RBA breakdown on bank assets held overseas, especially in Europe. You can see from the table below that Aussie banks have $56.4 billion in assets held in various European investments.
We’re not saying a euro crisis would render all those assets worthless, or that $56.4 billion is a balance sheet killer (especially since that amount is spread out across all the banks). But between Europe, New Zealand, and the U.S., Aussie banks have an awful lot of foreign assets. How are those going to hold up in a global currency/credit crisis?
And speaking of Europe, is it reaching a tipping point? The Continent is at war with itself (verbally for now) over how to bail out Greece. Should the IMF be involved? Overnight, European Central Bank President Jean Claude Richet came out against it. It’s now clear that nothing is clear.
On CNBC, via Zero Hedge, we learn that Phillip Mancuda, head of investment at the ECU Group, puts the Greek situation even more directly: the only thing that can save the euro now is a dollar crisis. “Trichet said the Greeks are crooks, and they’ve been lying about the numbers. There is a deeply embedded corruption within the Eurozone,” he said.
“Combined with the endemic European socialism and there is just no way you are going to get spending cuts and tax raises and maintain a GDP that makes any sense of the percentage aspect of debt to GDP. So the whole show is wrong. This is an intractable situation. This is going to continue on and on. The only hope for the Eurozone, and the Euro as a currency, is that someone takes the spotlight soon, and that may be the United States.”
Hmm. So which will go first? The dollar or the euro? The financial markets are telling us the Euro. But really, the question is not entirely financial. The question is this: will bad fiscal and monetary policy lead to a social crisis and civil instability in the US or Europe first? In Europe, the Greeks in the streets could be joined by others.
In the States, we’ve been saying privately for the last year that this year’s mid-term elections in the United States could see the first non-peaceful transfer of Federal power in a long, long time. The healthcare debate has gone beyond the ins and outs of good policy to ignite a kind of anti-Federal distrust that we think has always been part of the American political character.
And of course, the United States was formally a union of separate States, rather than a large homogeneous Federalised entity. It’s entirely possible that this voluntary union is coming under the kind of strain that won’t leave it unchanged. After all, if other large institutions (made possible by cheap money, cheap energy, and cheap labour) are having trouble adapting to this new world, why would America be left unchanged?
None of this was probably on the minds of the Hare Krishnas chanting their way up Fitzroy Street at sunset. They looked pretty happy singing their song. And most people smiled as they passed.
Hare Krishna Hare Krishna
Krishna Krishna Hare Hare
Hare Rama Hare Rama
Rama Rama Hare Hare
“Hey what does that mean anyway?” our friend asked. “What are those guys all about?”
“I don’t know. Krishna is a Hindu god right? Or is it Vishnu. Or Ganesh? I don’t know much about it.”
“You’d probably better learn.”
But just then, on the right, a car full of Italians pulled up and stared sullenly at the Hare Krishnas. They had a Ferrari logo on their van and were wearing the red shirts of the Ferrari F1 team. They looked exhausted and expressionless watching the world pass by.
“They know the Red Bull car is faster,” our friend said. “But they don’t look very happy do they? Maybe they should hook up with the Hare Krishnas. That’s it! It would be a great team. Ferrari Krishna!”
“What are you talking about? Those Italians probably know the euro’s made a ten-month low against the dollar. They’re probably wondering what their country is going to be like when they get home, and if their money will still be good…and maybe if they should buy some gold while they’re here in Australia.”
“Not that again! I’m going for another beer. And so are you.”
By the way, after some study this morning, we learn that the Hare Krishnas pursue “a higher consciousness taking the form of pure love.” And their god Vishnu is, “He who removes illusion.”
The world could use a little more Vishnu right now. And more cowbell.
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