Author : John E. Charalambakis
Date : May 14, 2015
Over the course of the last two weeks, we have been observing a twist in the bond markets. Yields are rising and consequently bond prices dropping. More than $420 billion worth of paper wealth has been wiped out in the bond markets across the globe. The rooster of negative yields and the trajectory of a negative equilibrium we started talking about three weeks ago (see http://stage.blacksummitfg.com/2960 and http://stage.blacksummitfg.com/2987) came crowing home, telling us that the mirage of deflation and secular stagnation may just be a propaganda. On top of this, the reality of supply and demand for Treasuries and bonds in general (given the QE has deprived markets of good collateral) as well as the fact that bond buyers (and especially the primary dealers of the Fed) may be hearing the rooster of even higher deficits to finance an unsustainable situation, create an environment of financial purgatory as explained below.
The speed by which the bond market changed direction not only is rare but also indicative of the volatility that will continue characterizing the markets this year. German yields on two and five year notes were negative, assuring that investors who held those notes until maturity will lose money! This is the epitome of absurdity in an environment where placebo treatments are taken as scientific prescriptions that cure the financial cancer of debt overhang. The graphs below demonstrate the significant turnaround we have been observing in the bond markets and particularly in the German bunds (in terms of dropping prices and higher yields).
The reversal in the yields (especially in European bonds) may not last. We would not be surprised if we test similar lows (in terms of yields) in the next few months, which will again reflect an environment of volatility, possibly destined to become an environment of instability as the ephemeral order established by the QEs around the world disintegrates into a joyful disorder (joyful for some since money can still be made, and disorder since the law of financial entropy cannot be avoided).
The peculiarity of the recent reversal is not due to a pickup in economic activity. If economic activity and the outlook had improved then projected earnings would have brightened and thus the equity markets would have experienced gains. It is a reversal from the irrationality of paying the government to hold the investors’ money. In addition, the rising oil prices have placed a put option on the deflationary fears and some investments done with leverage trying to exploit a carry trade (by shorting the Euro and investing in higher yielding securities) may have been called.
When growth stagnates due to unaffordable and unsustainable debt levels then financial manipulations could be used to generate paper wealth. Unfortunately, such manipulations may become impediments to real wealth creation that advances innovation and job creation, since the focus is not on the structural problems (debt, regulations, overspending, waste, inability to control costs, demographics, unfunded liabilities, lack of funding for entrepreneurs, etc.) but only on what we see on the surface.
The projected “joyful” disorder is reminiscent of the Dioskouri brothers (Castor and Pollux a.k.a. Polydeuces) whose activities set in motion the Trojan War (the war that killed Achilles, devastated the Mycenaean Kingdom and took Odysseus away from his home for a long period of time). That awful expedition was crowned with deception from the very start, and thus was destined to bring destruction to all those involved. The Dioskouri brothers ended up spending their lives between Mt. Olympus and Hades, becoming the emblems of immortality and death, and may well reflect the destiny of our global economy in the foreseeable future since the pendulum seems to be swinging from immortality (Japanese bonds are still kicking despite offering almost zero returns) to death (the bursting of the bond bubble). At least we can hope that we can name another star in the constellation of bubbles. Castor got his (Alpha Geminorum) and Pollux his own (Beta Geminorum). What does the bond bubble have to fear after all? It too can shine in the constellation of bubble stars.