In 1997 two distinguished scholars, Myron Scholes and Robert Merton, shared the Nobel Prize in Economics for their work on methods to valuate financial instruments called derivatives. Subsequently they teamed up with a veteran Wall Street banker named John Meriwetherin a company called Long Term Capital Management.
The fund blew up spectacularly in 1998 almost taking the Western financial system down with it. Which is hilarious, or it would be if not for all the money lost and damage to the economy. It took a consortium of 14 major banks led under the gun by Federal Reserve to restore liquidity in the markets.
Perhaps the problem with university professors is that they live in their heads, with little interest and understanding how the life works in the trenches.
If they did, they would realize that common sense is the most misleading tool one can use to forecast events.
I wouldn’t call it hubris, just a disconnect from reality.
What is hubris, however, is the practice of governments to manipulate interest rates (price of money in time) in an attempt to combat the old and true business cycle by making funding artificially cheap. I’ll be kind and say that the results are mixed.
And the counter argument to this logic is really simple:
Low interest rates force people to savemore, not spendmore. If the rate of return is low, one needs to save more for retirement, for the house, for children’s education. This fact flies in the face of European Central Bank’s QE policy.
Obviously they have a different goal in mind – keep the debt of member states artificially cheap, so they don’t blow up like the LTCM.
The Greek 10 year bond now pays 2.7% a year. How disconnected from reality is that? Add a zero to that number for a sanity check. Greece is not even a real country – it was always a proxy for somebody else.
So, for this sweet arrangement to work somebody has to suffer because the economy is zero sum game, so here it is.
The pension funds need 7 – 8% return to meet their obligations. Where are the investment grade instruments that pay that? Out of necessity they’re chasing risky debt (like Turkish bonds, which add currency risk as their lira is in a free fall).
Note that in a global economy every investment needs to filtered through currency risk.
I am of the opinion that the system will reset itself at some point, it could be in a few months or in a few years, but it will, and it could be the biggest trade of our lives.
Take the United States, the strongest economy in the world. They’re claiming almost full employment and at the same time forecasting trillion dollars budget deficits as far as the eye can see. This doesn’t make any sense any way you look at it.
So how can the reset look like? There are a few elements that are clear already.
First, the value of all sovereign debt out there and the value of all currencies is purely based on people’s confidence in governments. There is nothing else backing it up since Nixon took the dollar off the gold standard in 1971.
This confidence is still running pretty high, as indicated by the price of gold, which is trading sideways for the last few years. Gold is not a hedge against inflation, is a hedge against governments loosing control over their economies.
When the stats go up, watch down below.
Granted, gold is not what it used to be – with all these metal detectors at the airports and elsewhere it is hard to move, almost like a real estate. Which may explain the ultra high prices paid for paintings – it’s way easier to cut them out from the frame, roll them up and move to wherever you want to be next.
That’s playing it safe, not being confident about knowing how things will work out.
Second thing is, the bondholders will eventually take a haircut. Notice that in a liquidation mode, any listed firm has tangible assets that will give some money back. Government bonds are backed by nothing.
It looks to me that the big money is getting ready for something. Don’t underestimate them.
Tom Kubiak is the author of The Traveler