Epic global bond rout is a QE success story - but it won't last

The sudden surge in bond yields is a victory, a sign that markets are finally starting to believe that central banks have defeated deflation

By Ambrose Evans-Pritchard

9:00PM BST 13 May 2015

One dollar note sheets sit in a stack before receiving a serial number and the US Treasury and US Federal Reserve seals at the US Bureau of Engraving and Printing in Washington, DC, US

Markets ignored known evidence that bond yields rose by 80-120 basis points during the various bouts of QE in America Photo: Bloomberg
Occam's Razor is the sharpest way to cut through tangled explanations for the epic rout in global bond markets.

The simplest explanation is the best. "Frustra fit per plura quod potest fieri per pauciora."
Bond yields are soaring because the world's central banks have demonstrably done enough for now to stop deflation taking hold. The short-term monetary cycle is turning. The reflation trade is on.
The broad M3 money supply has been growing at a 7pc rate in the US over the past six months (annualized), and nearly 8pc in the eurozone. Fiscal austerity has run its course as well. Budget policy is no longer contractionary in either of the world's two biggest economic blocs.
Unless the normal mechanisms of monetary policy have broken down altogether - which is possible, but would you bet your pension on it? - the burgeoning M3 data point to a reflationary revival of some sort later this year.

John Williams, the once dovish head of the San Francisco Fed, told Yahoo! Finance on Tuesday that the US economy is "running a little bit hot". Rightly or wrongly, he chose to dismiss the economic relapse in the first quarter as a weather-blip. The world's monetary superpower is chomping at the bit.
Hedge funds were asking for trouble by driving yields on 10-year German Bunds to a historic low of 0.07pc in mid-April. Trouble is what they got. Three weeks later, Bunds are trading at 0.65pc. The paper losses across the spectrum of global bond markets is roughly half a trillion dollars.

Put another way, Bank of America says the €2.8 trillion of eurozone debt trading at negative yields has just shrunk to €2 trillion. It calls this a "positioning purge".

The mistake was to bet on an acute shortage of sovereign bonds once the European Central Bank launched its €60bn monthly blitz of quantitative easing. Bunds were thought to have a special "scarcity premium" since they are dying out. The German government is running a fiscal surplus of 0.5pc of GDP this year.

Markets ignored known evidence that bond yields rose by 80-120 basis points during the various bouts of QE in America, which is what one would expect as recovery builds and the risk of deflation abates.

Contrary to mythology, QE does not work by lowering bond rates. It works through a different mechanism: by causing banks to "create" money.

ECB president Mario Draghi has accomplished his first goal, even if he might silently be cursing the newfound strength of the euro.

The eurozone is clawing its way out of depression. The growth rate of nominal GDP growth has risen from 1.1pc at the start of the year to 1.5pc, subtly altering long-term debt dynamics for the crisis states of southern Europe. They are no longer quite so close to a debt-deflation t

QE periods in the US from MKM Partners

The one-year "inflation swap rate" - measuring expectations - has jumped by almost 100 basis points since October in the eurozone. The five-year contracts are starting to catch up.

This is a short-term cyclical upswing. It does not in itself narrow Europe's North-South rift in competitiveness, and does not magically turn EMU into an optimal currency area. It does buy time.

Lack of liquidity in the dealing rooms for bonds has amplified the bond shock. Regulators might have displayed more common sense when they imposed tougher rules on market-makers, extinguishing half the business.

The energy rally has added a further electric charge, setting off what amounts to a reflation-panic. "The back-up in bond yields has become horribly correlated with crude prices," said Mark Ostwald from Monument.

This mini-boom in oil may, of course, fizzle as Brent crude nears a powerful technical barrier at around $70 a barrel, up more than 40pc from the lows in January. Barclays, Morgan Stanley and Deutsche Bank all warned this week that paper trades on the derivatives markets have moved far ahead of fundamentals, ignoring a glut of excess cargoes building in the Atlantic.

The International Energy Agency's oil market report warned that over-supply has reached 2.1m barrels-a-day (b/d). Iraq, Libya and Russia are all cranking up output, and Iran is waiting in the wings with an extra 400,000 b/d of quick supply if there is a nuclear deal. While US shale has "blinked", it has not capitulated.

The great question is how long a world economy can withstand a spike in bond yields before this sets off a chain of nasty consequences, and ultimately defeats itself.

"There comes a point when this is too fast and too vicious, and starts to hit growth and earnings. That is when we could get an equity sell off," said Andrew Roberts, head of European credit at RBS.

The world's pain threshold is surely lower than ever. Debt has risen by 30 percentage points of GDP since the last financial crisis, reaching a record 175pc in emerging markets and 275pc in the OECD club.

Rising rates this year have already caused the iTraxx crossover index of European corporate bonds to jump 40 basis points to 280. In the US, higher Treasury yields feed rapidly into the mortgage market through the "convexity trade". Fannie Mae's 30-year mortgage bonds have jumped 36 points to 2.94pc in three weeks.

"We think the next shoe to drop will be US corporate credit. A lot of companies are bringing forward bond issuance this summer in a rush to beat the Fed. This could create a supply glut and a vicious circle," he said.

Jan Loeys, from JP Morgan, advised clients this week to pull some money off the table, warning that "dark clouds are now rising" for global asset markets. The bank said productivity growth turned negative in the US and the world in the first quarter, a stunning development that implies a lower speed limit for economic growth.

It also implies a smaller US output gap than widely supposed, making it harder for the Fed to bide its time before raising rates. It is not a pretty picture for a stock market boom that is already long in the tooth, flattered by record margin debt.

Nor is it pretty for those emerging markets that drank deepest from the pool of cheap dollar liquidity during the QE era, racking up $4.5 trillion of dollar debt. They have enjoyed three reprieves from a hesitant Fed so far, and have not used the time well to build their defences. The International Monetary Fund fears a "super taper tantrum" if and when the Fed actually pulls the trigger.

My own fear is that the reflation trade will prove to be another false dawn, overwhelmed within a year or so by the post-Lehman malaise of excess global savings and chronic lack of demand.
China has hit the rocks. Urban fixed investment has collapsed to near zero. China's factory gate deflation is running at -4.6pc and the country is still transmitting the effects of this to the rest of the world through a flood of manufactured exports.

President Xi Jinping could at any time let rip with a fresh blast of credit. He has chosen not to do so, clearly judging that this would store up even greater trouble. The world will have to learn to live for a lot longer with a different kind of China: a post-bubble invalid nursing its wounds.

Historians may pinpoint April 20, 2015, as the last gasp of a 34-year bull market in global bonds that began under the Volcker Fed in the early 1980s, the final inflexion point after yields had fallen through the floor in this year's QE mania.

But don't bank on it. Albert Edwards, at Societe Generale, coined the term "Ice Age" long ago to describe this era of deflationary ascendancy. He is bracing for one final polar freeze before we all hyper-inflate our way out.

Why Syriza Will Blink
Anatole Kaletsky
MAY 14, 2015

 Greece and EU flags

LONDON – Once again, Greece seems to have slipped the financial noose. By drawing on its holdings in an International Monetary Fund reserve account, it was able to repay €750 million ($851 million) – ironically to the IMF itself – just as the payment was falling due.
This brinkmanship is no accident. Since coming to power in January, the Greek government, led by Prime Minister Alexis Tsipras’s Syriza party, has believed that the threat of default – and thus of a financial crisis that might break up the euro – provides negotiating leverage to offset Greece’s lack of economic and political power. Months later, Tsipras and his finance minister, Yanis Varoufakis, an academic expert in game theory, still seem committed to this view, despite the lack of any evidence to support it.
But their calculation is based on a false premise. Tsipras and Varoufakis assume that a default would force Europe to choose between just two alternatives: expel Greece from the eurozone or offer it unconditional debt relief. But the European authorities have a third option in the event of a Greek default. Instead of forcing a “Grexit,” the EU could trap Greece inside the eurozone and starve it of money, then simply sit back and watch the Tsipras government’s domestic political support collapse.
Such a siege strategy – waiting for Greece to run out of the money it needs to maintain the normal functions of government – now looks like the EU’s most promising technique to break Greek resistance. It is likely to work because the Greek government finds it increasingly difficult to scrape together enough money to pay wages and pensions at the end of each month.
To do so, Varoufakis has been resorting to increasingly desperate measures, such as seizing the cash in municipal and hospital bank accounts. The implication is that tax collections have been so badly hit by the economic chaos since January’s election that government revenues are no longer sufficient to cover day-to-day costs. If this is true – nobody can say for sure because of the unreliability of Greek financial statistics (another of the EU authorities’ complaints) – the Greek government’s negotiating strategy is doomed.
The Tsipras-Varoufakis strategy assumed that Greece could credibly threaten to default, because the government, if forced to follow through, would still have more than enough money to pay for wages, pensions, and public services. That was a reasonable assumption back in January. The government had budgeted for a large primary surplus (which excludes interest payments), which was projected at 4% of GDP.
If Greece had defaulted in January, this primary surplus could (in theory) have been redirected from interest payments to finance the higher wages, pensions, and public spending that Syriza had promised in its election campaign. Given this possibility, Varoufakis may have believed that he was making other EU finance ministers a generous offer by proposing to cut the primary surplus from 4% to 1% of GDP, rather than all the way to zero. If the EU refused, his implied threat was simply to stop paying interest and make the entire primary surplus available for extra public spending.
But what if the primary surplus – the Greek government’s trump card in its confrontational negotiating strategy – has now disappeared? In that case, the threat of default is no longer credible.
With the primary surplus gone, a default would no longer permit Tsipras to fulfill Syriza’s campaign promises; on the contrary, it would imply even bigger cutbacks in wages, pensions, and public spending than the “troika” – the European Commission, the European Central Bank, and the IMF – is now demanding.
For the EU authorities, by contrast, a Greek default would now be much less problematic than previously assumed. They no longer need to deter a default by threatening Greece with expulsion from the euro. Instead, the EU can now rely on the Greek government itself to punish its people by failing to pay wages and pensions and honor bank guarantees.
Tsipras and Varoufakis should have seen this coming, because the same thing happened two years ago, when Cyprus, in the throes of a banking crisis, attempted to defy the EU. The Cyprus experience suggests that, with the credibility of the government’s default threat in tatters, the EU is likely to force Greece to stay in the euro and put it through an American-style municipal bankruptcy, like that of Detroit.
The legal and political mechanisms for treating Greece like a municipal bankruptcy are clear. The European treaties state unequivocally that euro membership is irreversible unless a country decides to exit not just from the single currency but from the entire EU. That is also the political message that EU governments want to instill in their own citizens and financial investors.
If Greece defaults, the EU will be legally justified and politically motivated to insist that the euro remains its only legal tender. Even if the Greek government decides to pay wages and pensions by printing its own IOUs or “new drachmas,” the European Court of Justice will rule that all domestic debts and bank deposits must be repaid in euros. That, in turn, will force a default against Greek citizens, as well as foreign creditors, because the government will be unable to honor the euro value of insured deposits in Greek banks.
So a Greek default within the euro, far from allowing Syriza to honor its election promises, would inflict even greater austerity on Greek voters than they endured under the troika program. At that point, the government’s collapse would become inevitable. Instead of Greece exiting the eurozone, Syriza would exit the Greek government. As soon as Tsipras realizes that the rules of the game between Greece and Europe have changed, his capitulation will be just a matter of time.

Read more at http://www.project-syndicate.org/commentary/syriza-eu-default-negotiation-by-anatole-kaletsky-2015-05#65IOR5Toaxjg4RA3.99

Why Shiite Expansion Will Be Short-Lived

  • That a bloc of Shiite states has coalesced in the Middle East is a significant geopolitical development; that it is led by Iran means it could be short lived.
  • In fact, the bloc's formation and expansion, such as they are, were possible only through the division and weakness of Sunni Arab states.
  • Several factors, most notably the Syrian civil war and ethnic and religious constraints, will prevent Iran from projecting Shiite influence farther than it already has.

The sectarian conflict in the Middle East can neatly be divided into two sides: Sunnis and Shiites. Or so it would seem. The reality, it turns out, is more complicated. Sunni unity is a myth – the countries that constitute the Sunni camp are divided over a variety of issues. And the Shiites, whose power has grown since the early 1990s, nonetheless suffer from the inescapable constraints of being a minority population.

A Demographic Challenge

Indeed, the single most defining characteristic of the Shiite camp is that it comprises only a fraction of the Muslim population. More than three-fourths of all Muslims practice Sunni Islam.

According to a 2011 study by the Pew Research Center, only four countries have a Shiite majority: Iran, Azerbaijan, Bahrain and Iraq. But other countries have notable Shiite minority populations as well, including Yemen, Kuwait, Saudi Arabia, Afghanistan, Pakistan, Turkey, the United Arab Emirates, Qatar and Oman. Shiites also form the largest confessional group in Lebanon and account for as much as 20 percent of the 180 million or so Muslims in India.

Like their Sunni counterparts, the Shiites are internally diverse. Twelvers constitute the largest group, but there are many others, including the Ismailis, also known as the Seveners; the Zaidis, also known as the Fivers; the Alawites; and the Druze. All of these sub-sects differ geographically, linguistically, politically and ideologically.

Historically, the Shiites ruled only intermittently, with some notable exceptions. For example, the Fatimids maintained a caliphate, headquartered in Cairo and stretching from Morocco to the west coast of the Arabian Peninsula, from the early 10th century to the late 12th century.

From 932-1055, the Persian Twelver Buyid Empire ruled much of what is now Iran and Iraq.

Later, the Ilkhanate of the Central Asian Mongols governed over parts of Pakistan, Afghanistan, Iran, Iraq, Syria and Turkey. More recently, the Zaidis boasted an imamate in Yemen that lasted from 897 to 1962.

Several minor medieval Muslim polities were also Shiite dynasties.

For the most part, however, instances of Shiite control were rare. Shiites were dominated by Sunnis until the 16th century, when the Safavid Empire designated Shiite Islam as its official religion. But by this time, much of the Middle East and South Asia had fallen under the control of either the Ottomans or the Mughals, both Sunni empires.

Establishing Footholds

Shiite power has since shifted to Persia. In 1979, the Iranian Revolution officially created a Shiite republic. Iran is now the largest and most militarily powerful Shiite country, and its power has enabled Tehran's clerics to support Shiite communities, and thus enhance its influence, in the Arab world. But expanding its influence was not always easy. Iran tried to leverage its own ethnic Azeris to use the Shiite majority in Azerbaijan to its advantage. However, until 1991, Azerbaijan was part of the Soviet Union and, as such, a secular nation. Its secularism, in turn, made it resilient to Shiite overtures.

Iranian influence has also been stifled in places such as South Asia. Strong states such as India and Pakistan, not to mention the war in Afghanistan, have made eastern expansion very difficult for Tehran. With its northwest and east largely closed off, the only other direction Iran could expand was west toward the Arab world. Despite the vicious fighting that occurred during the Iran-Iraq War in the early 1980s, Tehran was able to establish a foothold in Iraq made possible by the animosity between the regimes in Baghdad and Damascus. Indeed, Syria became an early Iranian ally, thanks in part to the fact that it had an Alawite regime ruling over a majority Sunni population. Syria's rulers also helped Iran develop Hezbollah into a major political and military force.

Two other events were instrumental to the expansion of Iran's regional clout: In 1989, the Iran-Iraq War ended, and, somewhat coincidentally, the Lebanese civil war was resolved. This left Hezbollah, Iran's proxy group, as Lebanon's single largest political entity. A few years later, Iraq invaded Kuwait, bringing forth the first Gulf War. For Iran, the war was incredibly beneficial because it weakened the government in Baghdad, which previously had protected the Gulf Cooperation Council from Iranian encroachment.

Subsequently, Iraq's minority Kurds and Shiites, whom Tehran had supported for years, began to exploit the growing weakness of the Iraq regime. By the time the United States defeated Saddam Hussein in 2003, Iraq was ripe to fall under Iranian control. And fall it did, giving Iran an arc of influence from Tehran to the Mediterranean Sea.

But Iranian expansion soon stopped, even if its aspirations for hegemony did not. Assuming its western flank was secure, Tehran saw an opportunity in the Arab Spring to expand into the Arabian Peninsula – the heartland of Iran's regional rival, Saudi Arabia. Specifically, Tehran hoped to use the Shiite uprisings in Bahrain to its advantage. Saudi Arabia, aided by its allies in the Gulf Cooperation Council, crushed the uprising and, by extension, Iran's hopes for gaining prominence in the island nation.

Soon thereafter, Iranian ambition was dealt another blow in Syria, where Arab Spring protests eventually evolved into full-scale civil war. The Alawite government is still intact, but its dissolution would be disastrous for Iran: It would cut Tehran off from its allies in Hezbollah and leave Iraqi Shiites exposed to a Sunni regime in Syria. It is little surprise, then, that Iran has supported the regime of Syrian President Bashar al Assad so enthusiastically.

Too Many Red Lines

Currently, Iran and the Shiites appear to be in better shape than Saudi Arabia and the Sunnis.

Hezbollah and other militias have helped al Assad remain in power. The fight against extremist groups such as Jabhat al-Nusra and the Islamic State have given Iran time to regroup, as have the nuclear negotiations with the United States. Moreover, the Saudis have been preoccupied with the Houthi rebellion in Yemen.

However, the Shiites' advantages will not last. What gains the Shiites made largely came as a result of Sunni weakness and incoherence, and some recent developments suggest the Sunnis are regaining ground, if only temporarily. Rebels have gained critical territory in Syria, particularly in Idlib province, and Saudi Arabia and Turkey entered into an alliance to oust al Assad from power.

More important, there are simply more Sunnis than Shiites, and there is plenty of evidence to suggest Sunnis will not abide Shiite rule. In Lebanon, Hezbollah has been unable to dominate the government, despite the size and influence of the militant group. In Yemen, the Zaidi movement may emerge as the Yemeni version of Hezbollah, but it cannot impose its will on the country beyond the core Zaidi areas. In Iraq, the Islamic State is still a powerful Sunni group, even in areas dominated by Shiites, despite its barbarity.

Jihadists do, in fact, threaten Iran and its Shiite allies, but they also represent an opportunity.

Jihadism weakens Sunni states and tends to swing international opinion toward Iran. The Iranians are hoping that Saudi Arabia will buckle; from their perspective, the momentum of the Houthi movement in Yemen could help trigger a similar uprising among the Ismailis in the Saudi provinces of Jizan and Najran, both of which abut Yemen. Ideally, the Twelver community in Saudi Arabia's Eastern Province would flourish – a development that, along with Bahrain, could create an important outpost of Iranian influence in Saudi Arabia.

There are simply too many red lines for the region's Sunnis. Even in the unlikely scenario that Saudi Arabia weakens so much that Iran assumes de facto control of the Arabian Peninsula, the Sunni populations would not allow the holy cities of Mecca and Medina to remain under Shiite control. And there are simply not enough Shiites to do anything about it since they are essentially surrounded by Sunnis.

In addition to religious considerations, there are also ethnic considerations that prevent the spread of Shiite rule. Shiite leadership is now in the hands of Persians, not Arabs. And though Arab Shiites have aligned with Tehran, they have done so only out of necessity, maligned as they are in their respective countries. This limits the extent to which Iran can rely on them to serve its purposes.

Though the Shiites of the Arab world have largely united, some of their differences will be very difficult to ignore. Competition still exists between the Iraqi theological centers of the Arab-dominated Najaf school and the school in Qom, and Tehran has tried hard to increase its influence over Najaf. Iranian leaders hope that the power vacuum in Iraq will enable them to spread their doctrine of Velayat-e-Faqih. But with Iran undergoing its own political transformation, tensions between liberal and conservative factions – and between democratic and theocratic factions, considering the rise of Iranian President Hassan Rouhani and the domestic rehabilitation he began – have become more acute. Those tensions could well command Iran's attention, leaving its international aspirations by the wayside.

Thus, as much as Iran would like to further exploit current Sunni weaknesses, changes underway in Tehran could thwart its leaders' regional ambitions – as could internal differences among Shiites and the progression of the Syrian civil war.

The End Is Near, Part 4: Peak Trophy Asset Inflation

By: John Rubino

Wednesday, May 13, 2015


Stories about insane prices being paid for unique (and some not so unique) things are now a daily occurrence. A few examples:

Picasso's Women of Algiers smashes auction record
(BBC) - Picasso's Women of Algiers has become the most expensive painting to sell at auction, going for $160m (£102.6m) at Christie's in New York. Eleven minutes of prolonged bidding from telephone buyers preceded the final sale - for much more than its pre-sale estimate of $140m. 
The previous world record for a painting sold at auction was $142.4m, for British painter Francis Bacon's Three Studies of Lucian Freud in 2013. 
The sale also featured Alberto Giacometti's life-size sculpture Pointing Man, which set its own record. It is now the most expensive sculpture sold at auction, after going for $141.3m (£90.6m). Both buyers chose to remain anonymous.

Sales of $100 Million Homes Rise to Record Worldwide
(Bloomberg) - The ultra-luxury housing market is scaling new heights as a record number of properties around the world command prices topping $100 million. 
Demand for mega-mansions and penthouses has accelerated as wealthy buyers seek havens for their cash and search for alternative investments such as art and collectible real estate, according to a report Thursday by Christie's International Real Estate, owned by auction house Christie's. Five homes sold for more than $100 million last year, with at least 20 more on the market with nine-figure asking prices, the brokerage said. 
Just one home sale exceeded the $100 million mark in 2013, following four such transactions in 2012 and three in 2011, Christie's reported. 
Sales are likely to increase this year with more newly built properties and off-market homes trading for at least $100 million, Conn said. Demand is growing among affluent Americans and Europeans; billionaires from unstable economies, such as Russia and Middle Eastern countries; and buyers from mainland China, who were barred from investing overseas before 2012 and since have snapped up houses in cities including Hong Kong, Los Angeles, New York and London, he said. 
Residences currently on the market with asking prices at that level include a $400 million Monaco penthouse, a $365 million London manor and a $195 million estate in Beverly Hills, California, according to Christie's. France's Cote d'Azur, a getaway for jet-setters, has homes with asking prices of $425 million and $215 million.

The median cost of a house in San Jose is $900,000
(MarketWatch) - The median price for a previously owned single-family home in the San Jose, Calif., metropolitan area just hit a whopping $900,000, according report released Monday. 
That first-quarter price was up 11.4% from a year earlier, and more than four times the U.S. median of $205,200, the National Association of Realtors reported. It's important to note that these price figures are for the median, not the mean, meaning that there are as many homes that cost more as those that cost less than these levels, whereas a mean price could be skewed upward by a number of high-value transactions.

The 16 Tech Startups that Joined the Unicorn Club in 2015
(CB Insights) - The worries about a bubble haven't hurt private companies in their pursuit of getting a billion dollar valuation. In fact, through April 13, 2015, 14 new private companies raised financing at a billion dollar or greater valuation. To give you a sense for how crazy things are, our data set was pulled yesterday. Today, two more were added to the club. So now, we're at 16 unicorns (Docker and Zomato were added today). 
By the time you finish reading this research brief, 2-3 more will likely be added to the club. Yes - things are just that nuts.

Yep, things are indeed just that nuts. But they're not surprising. When the world's central banks create trillions of dollars of new currency every year and hand it to 1% of the population, of course the latter will start indulging their inner Marie Antoinettes.

It's also not historically unusual. Trophy asset prices always soar at the peak of financial bubbles. In the late 1990s tech stocks were trading for 100 times sales. In the mid-2000s lots in California trailer parks were going for $1 million+. And in both cases penthouses and fine art set records. So in one sense this is familiar territory.

But in another sense it's unique. Where previous bubbles were localized in one or two asset classes and the amount of irrational wealth thrown off was as a result comparatively modest, this bubble is global, with every major central bank flooding its economy with new currency.

New billionaires are everywhere, and their search for trophy properties on which to spend their mountains of excess cash is getting desperate.