Here’s the news of the week – and how we see it here at McAlvany Wealth Management:
1. Liquidity in Ireland: A weekend of bank bond bailouts and whiskey.
There is never a dull moment in the EU. The project was launched decades ago with cohesion and unity in mind (good selling points, if nothing else). The founders had assumed that national pride and historically ingrained identities could be replaced with a more universal sense of belonging (“many tongues, one voice”). There were even suggestions in the ’90s that crisis might be the very thing to break downs the walls of national identity and bring all European countries into a unified whole. Well, they are getting their wish this year; let’s see if it works like they imagined.
As the monetary union has frayed at the edges, critics now agree you need a deeper basis for connection than money. Any observer of human relationships could have offered that insight before the EU came under acute stress – before they positioned themselves with so much to lose.
This week the focus has been on one of my favorite places in the world: The Emerald Isle. In Ireland, real interest rates averaged less than 1% from 1998 to the present, versus over 7% in previous periods (according to the London Telegraph). Similarly, many southern European countries, upon joining the EU, saw lending rates drop 50-70%; the results were quite impressive. Easy, cheap money leads to asset bubbles.
The property boom and the present bust are directly tied to this mispricing of risk and assumption of massive debts at below-average rates. As mortgages rates fell along with official rates, many fortunes were made as particular assets benefitted. Any latecomers from the lower or middle class got sucked into a credit-driven asset bubble/trap. It was fun, but it didn’t last (not long enough, at least). Governments also joined into the mix, borrowing more and more money, as it seemed they could afford to with lower and lower rates. It was obvious that if rates were lower by 50%, you could take on nearly twice as much debt and it wouldn’t cost an extra euro. That kind of thinking has put the whole EU project in jeopardy.
The misperception has been that because they are connected by a shared currency, all countries share a similar credit rating and therefore default risk. We again reflect on how wrong the market can be at times, and how mispriced (so much for efficient markets). Temporarily, governments P, I, I, G, and S all got the credit rating of Germany. (That’s what they call lipstick.) Now, with much greater debt burdens, rising interest rates, falling revenues from taxation, and a refreshed awareness of country-specific risks/fiscal imbalances, the debts are un-payable. As the music stops, the jig is over.
When the IMF and World Bank start analyzing one’s books (as they are presently doing in Ireland) the game is up, and the next series of questions relate to the costs involved in a restructuring, along with who bears those costs. Let’s hope that defaults are contained, and the credit default swap (CDS) market doesn’t go haywire. Christmas is around the corner, and a derivatives disaster would be catastrophic.
We once again observe that a devaluation of currency has been and is likely to be a primary tool in lightening the burden of European debt. It can’t be done by individual countries, but collectively it will be suffered through as a less severe punishment. That argues for greater volatility in the currency markets, with unexpected twists and turns. That’s not a place to speculate these days, with so many varied political interests involved.
Primary trends remain our primary focus. Stay with patience on the right side of the market trends. Volatility will more and more unsettle the decisions you’ve previously made. Try to remain calm. And every once in a while imagine there is a pot of gold and a smart greenish leprechaun at the end of the rainbow. Enjoy your weekend (and stay away from the Irish whiskey).
2. Bond Market Inflection Point? Let’s face it. Growth in the economy is dependent on progressively lower interest rates. To the Fed, this is an imperative – and the sole purpose of their “stimulus” packages. However, the funding crisis of massive Federal and State budget deficits may be inundating the demand side of the equation, so much so that bond markets are beginning to erode despite history-making Fed efforts to prop them up.
Below is a look at the yield on the 30 year Treasury Index. Rates actually backed up 76 basis points after the markets factored in the expected $600B pledge by the Fed. The current rate holds at 4.26%….
This is a chart of the S&P National AMT-Free Municipal Fund Index, which has fallen 4.1% from its high, completely wiping out the benefit of the 3.1% yield one would expect to earn for the year.
And foreign bond markets are struggling, as well; price action is failing to break into solid bullish territory. This is despite the flight of dollars to these markets in the race for yield. The MSCI World Sovereign Index includes the debt of 21 developed markets.
Corporate bonds are likewise impacted. Shown here is the Moody’s Corporate BAA Index. It is pushing into bearish territory above the 200 day moving average.
Combine higher rates with the commodities inflation and you have a recipe for disaster for all productive assets. Now, whether the “top” (or low in yields) has truly been reached in Treasuries remains to be seen, but what is certain is that the Fed is beginning to lose control over the course of rates.
Ben Bernanke has certainly not admitted his recent failure to manipulate the market. Instead he defends himself and the actions of the Fed on a daily basis. But we feel someone should at least alert the stock market bulls, who continue to charge ahead in blind speculative fashion, that the music is about to stop.
Have a wonderful weekend.
President and CEO
VP Investment Management