Unfunded Promises

By John Mauldin


In describing the global debt train wreck these last few weeks, I’ve discovered a common problem. Many of us define “debt” way too narrowly.
A debt occurs when you receive something now in exchange for a promise to give something back later. It doesn’t have to be cash. If you borrow your neighbor’s lawn mower and promise to return it next Tuesday, that’s a kind of debt. You receive something (use of the lawn mower) and agree to repayment terms – in this case, your promise to return it on time and in working order.
One reason you try to get that lawnmower back on time and in the proper condition is that you might want to borrow it again in the future. In the same way that not paying your bank debt will make it difficult to get a bank loan in the future, not returning that lawnmower may make your neighbor a tad bit reluctant to lend it again.
Debt can be less specific, too. Maybe, while taking your family on a beach vacation, you notice a wedding taking place. Your 12-year-old daughter goes crazy about how romantic it is. In a moment of whimsy, you tell her you will pay for her tropical island beach wedding when she finds the right guy. That “debt,” made as a loving father to delight your daughter, gets seared into her brain. A decade later, she does find Mr. Right, and reminds you of your offer. Is it a legally enforceable debt?

Probably not, but it’s at least a (now) moral obligation. You’ll either pay up or face unpleasant consequences. What is that, if not a debt?
These are small examples of “unfunded liabilities.” They’re non-specific and the other party may never demand payment… but they might. And if you haven’t prepared for that possibility, you may be in the same kind of trouble the US government will face in a few years.
Uncle Sam has made too many promises to too many people, with little regard for its future ability to fulfill them. These are debt. Worse, some of them are additional debt on top of the obligations we already see on the national balance sheet.
Even worse, entire generations have planned their retirement lives around the government fulfilling those promises. If those promises aren’t met, their lifestyles will indeed become a potential train wreck.
That will be our topic today as we continue my Train Wreck series. This will be chapter 8. If you’re just joining us, here are links to prior installments.
In the coming weeks we’ll summarize the train wreck series and then shift the discussion to how you can prepare. But first, I want to leave no doubt about how big this problem is.

Let’s start with what we know. The official, on-the-books federal debt is currently about $21.2 trillion, according to the US National Debt Clock. I say “about” cautiously because decimal points really matter when the numbers are this large. The difference between $21.1T and $21.2T is $100 billion. That used to be a lot. Now it’s a rounding error.
Anyway, $21.2T is the face amount of all outstanding Treasury paper, including so-called “internal” debt. This is about 105% of GDP and it’s only the federal government. If you add in state and local debt, that adds another $3.1 trillion to bring total government debt in the US to $24.3 trillion or more than 120% of GDP. Then there’s corporate debt, home mortgages, credit cards, student loans, and more. Add it all together and total debt is about 330% of GDP, according to the IIF data I cited in Debt Clock Ticking. We are in hock up to our ears.
But it’s actually worse than that, due to the kind of promises I mentioned above. Prime among them are Social Security and Medicare. Strictly speaking, these aren’t “unfunded” because they have dedicated revenue streams: payroll taxes. Most Medicare recipients also pay premiums. To date, these revenue sources have covered current expenditures and more, allowing the programs to build up reserves. But that’s about to change.
As of this year, both programs are in negative cash flow, meaning Congress must provide additional cash to pay the promised benefits. It will get worse, too. The so-called “trust funds” are going to run dry sooner or later, and it may be sooner. This month’s annual trustee report estimated Social Security will run out of reserves in 2034, and the hospitalization part of Medicare will go dry in 2026.
Just for the record, those “trust funds” don’t exist except as an accounting fiction. It is like you saving $100,000 for your child’s education and then borrowing all the money from your children’s education fund. You can pretend in your mind that you have set aside $100,000 for your child’s future education, but when it comes time to make those payments, you’ll have to pull it out of current income or liquidate other assets.
The US government has borrowed (or used or whatever euphemism you want to apply) all the money in those trust funds. So, talking about running out of reserves in 2034 or 2026 is rather meaningless. We’ve already run out of reserves. I was talking with Scott Burns about this and other facts over the unfunded liability (he wrote a book on it with Professor Larry Kotlikoff) and he gave me the great line, “The only truly bipartisan cooperation in Congress is that both sides lie.” Any time a politician talks about putting a “lock box” around Social Security or Medicare trust funds, he or she is either staggeringly ignorant or lying.
But, going with their terminology, these estimates of when the trust funds run out depend on a slew of assumptions. To estimate revenue, they must know how many workers the US has, their wages, and at what rates those wages will be taxed. To estimate expenses, they must know how many retirees will be drawing benefits, the amount of those benefits, and how long the retirees will live to receive them. They also have to assume an inflation rate on which the cost-of-living adjustment is based.

A small deviation in any of those can have huge long-term consequences.
For what it’s worth, then, Social Security says it has a $13.2 trillion unfunded liability over the next 75 years. That’s the benefits they expect to pay minus the revenue they expect to receive.
Medicare projections require even more assumptions: what kind of treatments the program will cover, how much treatment senior citizens will need, and what those treatments will cost. All these could vary wildly but the “official” assumptions put Medicare’s 75-year unfunded liability at $37 trillion. It could be vastly more or, if we all get healthier and healthcare costs drop, could be less.

This being the government, I think the safe course is to assume their numbers are the best case, resembling reality only if everything goes exactly right. And of course, it won’t.
My friend Professor Larry Kotlikoff estimates the unfunded liabilities to be closer to $210 trillion. (Click on that sentence for a link to his Forbes column.) That’s a far cry from the $50 trillion official estimate.
So, at a minimum, we can probably assume Social Security and Medicare are at least another $50 trillion in debt on top of the $21.2 trillion (and growing) on-budget federal debt. And then you come to the scary part.

This doesn’t include civil service or military retirement obligations, or federal backing for some private pensions via the Pension Benefit Guaranty Corporation, or open-ended guarantees like FDIC, Fannie Mae, and on and on.

Negative Cash Flow

Think back to my example of promising your daughter the beach wedding.

That is sort of what is happening with Social Security, if you had accompanied the promise by asking your daughter to save a nickel a week toward paying for it. The resulting $28 after ten years would not begin to cover the cost, but your daughter will rightly argue she did her part. You will be on the hook for the rest, just as Congress will be on the hook with angry retirees who think they “paid” for their benefits.
That means benefits will continue once the trust funds run dry. Maybe they’ll make some minor cuts here and there, but voters won’t allow much, at least until enough Boomers leave the scene to let younger generations outnumber them. But as I continue to argue, Boomers are going to live a lot longer than the younger generations think. The deal each generation makes with previous generations is to die on schedule. The Boomer generation is going to break that deal. We will not go willingly into that good night.
But in reality, arguing over whether it’s $50 trillion or $200 trillion is pretty pointless. Long before we get to testing that hypothesis, we will have to cut spending or raise taxes or some combination of both.
This week, the Congressional Budget Office released its 2018 Long-Term Budget Outlook. Like the Social Security and Medicare trustees, the CBO makes assumptions, so it’s fair to be skeptical of its estimates. In fact, we had all better hope they are too pessimistic because we’re in deep trouble otherwise.
Because the CBO thinks federal spending will grow significantly faster than federal revenue, CBO foresees debt as a percentage of GDP will likely be 200% of GDP by 2048. But we will hit the wall long before then.  

Consider this table from the Committee for a Responsible Federal Budget.

CBO numbers show that by 2041, Social Security, health care, and interest expenditures will consume all federal tax revenue. All of it. Everything else the government does (including defense) will require going into more debt.
Yes, making that projection requires an assumption about tax revenue, which requires another assumption about GDP. It could be wrong. But if so, I think it will be wrong in the non-helpful direction because CBO projections don’t include recessions. (You think we’ll get to 2048 without some years of negative GDP growth? I’ll take that bet.)
Note also that the amounts CBO projects for Social Security and healthcare spending may well be low. I think they are very low. They assume some payment cuts to doctors and hospitals that Congress routinely overrules each year, as well as a different inflation benchmark to govern cost-of-living adjustments. And I have little hope Congress and presidents, now or future, will ever gain control over “discretionary” spending.
Of course, the interest expense depends on interest rates. CBO assumes the 10-year Treasury will go from today’s below-2% yield to 3.7% in 2028 and 4.8% by 2048. That might be too high, too low, or just right. Your guess is as good as mine (or CBO’s).
The CBO also assumes a fairly robust employment picture throughout that time. However, we are entering a period in which automation will replace mass numbers of human jobs. It might also result in new industries and new jobs, but history shows the transition to create new jobs will take time. Bain & Company’s Karen Harris estimates automation could eliminate 40 million US jobs by 2030 and depress wages for the jobs that remain. That will reduce payroll tax revenue and drive safety-net spending higher, neither of which will help reduce the debt.
It’s not just Bain, either. McKinsey, Boston Consulting, and other think tanks all expect similar job losses, which CBO does not consider. Yet, it will mean more people not paying Social Security and taxes, hence large revenue losses and even bigger deficits, and more unemployed people looking for the social safety net to help them.
Note: The bulk of those job losses will come in the latter half of the 2020s as new technologies kick in. And new technologies always bring about new jobs, but unfortunately not in the places where the old jobs were lost nor in the industries for which people are trained. To paraphrase Jerry Lee Lewis, there is going to be a whole lot of retraining going on.
So, take whatever estimates are made about future deficits and debt, and realize they are going to be worse. There will be fewer people working and paying taxes and more people living longer and using benefits. Kiss your assumptions goodbye.

The Threats Go On
So, the on-budget picture looks terrible, and even more so when you add the unfunded liabilities on top of it. What else could go wrong? Plenty. I’ll mention just four more possibilities.
First, at least some of the state and local pension debt I described two weeks ago could easily wind up on the federal government’s plate. Enough states are in a pickle to probably get some kind of bailout through Congress. Maybe not this Congress, but when it’s a Democratic Congress? It may be a whole other ballgame. This would add trillions to federal spending.
Second, CBO and pretty much everyone else assumes the world will avoid major wars. Aside from the death, destruction, and resource diversion, wars are expensive. Our relatively minor (in the historical scheme of things) Iraq and Afghanistan involvements added trillions in debt. Will we get through the next two decades without more such actions, whether large or small? I fervently hope so, obviously, but I would not bet on it.
Third, the life extension technologies I think are coming soon will raise Social Security spending because people will live longer. They may also raise payroll tax revenue if people keep working longer, but it’s not clear which way the scale will tip. It will likely be a net drain on the budget, at least initially. And by the mid-2030s when true rejuvenation is widely available, kiss your actuarial assumptions goodbye.
Fourth, all this presumes that those with capital to lend will stay interested in lending it to the US government. They may not, as the government’s financial condition becomes increasingly precarious. Yes, we’ve heard this before and it proved groundless. Things change. The fact that people cried wolf doesn’t mean no wolves are out there.

The Venus Flytrap of Western Civilization: Entitlements

My friend Dr. Woody Brock, one of the best economists and social commentators that I know, wrote a marvelous essay this last week about part of the entitlement issues. I’m going to close with a few lines from his letter. You can see some of his other work at www.SEDinc.com. His more exclusive quarterly Profiles are a treasure trove of economic insight. (Occasionally he lets me share them in Over My Shoulder, by the way.)

Now to the beginning of his latest Profile:
The death of the extended family throughout the G-7 nations during 1850-1950 will go down as one of the most momentous developments of past centuries. For it is this development that gave rise to the modern welfare state with its crippling retirement and medical promises made to all citizens. How did today’s entitlements crisis begin, why does it get ever larger, and what can be done about it?
President Trump’s tax reform bill has rightly been criticized for inflating the US fiscal deficit. To many, this was unconscionable at a point when US federal debt is already 100% of GDP. Yet like everyone else, these critics have been mum on the far greater growth of debt that will accrue from ever-exploding entitlements expenditures. This latter prospect was identified a decade ago by the bi-partisan Simpson-Bowles committee as by far the gravest threat to the future of the US.
CBO projections show that within 18 years, entitlements spending will absorb all US federal tax revenues—leaving no revenues even for interest expense on the debt and for the military. In Germany, which proudly pays annually for its expenditures without incurring debt, Deutche Bank has estimated that by 2045, income tax rates of 80% (total, not marginal rates) would be needed for its PAYGO system. The entire workforce of the nation would be in bondage to the elderly. Other nations face even worse prospects.
Those spending projections and massive deficits are going to happen in the 2020s. Here is a graph that we used last year showing what is likely to happen during the next recession (which I now think we will likely avoid this year, but it is coming), if tax revenue falls to the same degree it did in the last one.

We will have at least a $2 trillion deficit in the next recession, plus a bear market that leaves pensions even more underfunded, and a slower recovery because high debt crowds out future growth. Numerous academic studies back up that statement.
I think a future Democratic Congress and president, or maybe a split Congress that is desperate for funding, will enact a Value-Added Tax (VAT) in response to this. At least that is what I hope. Woody is a little more pessimistic than I am and thinks, quoting at the end of his analysis, that politics and not demographics is the problem:
Furthermore, why need benefits be trimmed much less slashed when the staggering new wealth of the top 10% can be taxed to pay for all promised benefits? Today’s obsession with the growth of inequality will significantly impact how the US will resolve the entitlements issue. The nation will not cut benefits because doing so will prove politically impossible, as President Clinton has long stressed.
Rather, the nation will fund its promised Social Security and Medicare benefits via the only kind of tax that can raise the staggering sums needed to fund them: a net-worth tax on, say, the top 15% of the population. Raising income tax rates on the rich will not raise anywhere near the amount needed for the next 40 years. Only a net-worth tax can do so.
Here are the relevant mathematics. As already stated, the net worth of US households has now reached $100 trillion. The top 15% wealthiest families own 90% of this wealth, or about $90 trillion.

When push comes to shove, resistance by the rich against a wealth tax will be swamped by the political reality that a good 60% of Americans will be obsessed with funding their old age. Thus, rich as they are, the very wealthy will have little political leverage with which to fend off an annual net-worth tax.
The political logic will be: “Look, you rich people have had a return on your wealth of over 6% during the past hundred years. Why should this change very much? But if this is so, then it is time for you to pay your fair share, that is, to part with 2.5% of your total net worth annually. Your wealth will still continue to grow. With increased annual tax revenue of some $2.5 trillion, it will be possible for Americans to receive their promised benefits.”

We would expect the same logic to translate into additional net-worth taxes at the state and municipal level.
The fallout from such a policy will of course be disastrous.
Oh, dear gods, I hope he is wrong. It would be beyond disastrous.
Next week, I will try to close this series by summing up all the debt we have to deal with globally, recognizing that we are all in it together. And we will begin looking at strategies we can take to protect ourselves. The good news is none of this is going to happen within the next few years, so we have time to make plans. I’m in the same situation as you and already implementing some changes.

LA, Maine, Beaver Creek and Boston
I am flying to Los Angeles in mid- July to talk about the future of social organization with Bob Lefsetz, whom I have long wanted to meet. Then I have the annual Camp Kotok economics/fishing trip to Maine, then a board meeting with Ashford Inc. at the Beaver Creek Park Hyatt, where Shane and I will take an extended vacation, and then a trip to Boston to visit with friends in the area, among them the above-quoted Woody Brock at his family’s Gloucester compound.
My twins and their husbands are coming down this weekend to be with dad on their birthday, and they are getting the entire family together for sushi one night. I’m really looking forward to that.
This week I had a meeting with someone quite inspirational to me and was going to tell you about it here. However, I want to tell the story carefully and we couldn’t get it edited by our deadline. I’ll work on it and share next time.
Meanwhile, I hope your summer is going well (or winter if you’re Down Under). Happy Fourth of July to all my US friends. Amid the celebration, take a moment to cherish the freedoms we have and remember that not everyone has them.
Your working on our plans for prospering during The Great Reset analyst,

John Mauldin

Bond markets send signals of a looming recession

Fears of Fed over-tightening add to growing concern about a potential trade war

Raghuram Rajan

A trade war between China and the US will be costly © Bloomberg

The US bond markets are telling us something, but it is not clear exactly what.

Interest rates on two-year Treasury bills, known as the yield, have been climbing since late 2016. But the yield on the 10-year has increased far less. As a result, the difference between the two, known as the term spread, has compressed to less than 40 basis points. In trader parlance, that means “the yield curve has been flattening”, which has previously been a strong predictor of recessions. Is that the case today?

The rise in the two-year yield is probably being driven by growing conviction that the US Federal Reserve will continue to raise rates by about 25 basis points each quarter, till the end of 2019.

US inflation is running at around the Fed’s 2 per cent target, labour shortages are emerging, some fiscal stimulus is still in the pipeline, and Fed policymakers have been quite clear that market volatility will not divert them from their plans. The Fed chairman Jay Powell has also indicated that he believes that most emerging markets should be able to weather the rate rises.

Given the strong Fed signals, why aren’t long-term rates rising as well?

One obvious explanation is that the European Central Bank and the Bank of Japan are continuing their quantitative easing. The sheer flow of money still pouring into the long end may be keeping yields down — after all, the five-year German Bund is at -0.3 per cent and 10-year Japanese bonds yield zero.

However, if market prices are based on impending changes, long yields should be rising in the US; the shrinkage of the Fed’s balance sheet is gaining momentum, US government deficits are expanding, the ECB will end quantitative easing by the end of the year, and so on.

Perhaps it is just a matter of time before yields start moving up. This certainly is my preferred explanation. The competing view is that Fed policymakers are mistaken about how much they should tighten, and that slowing growth will eventually cause them to pause, if not cut. The term spread is then low because it is pricing in recession.

What then are the possible sources of an adverse hit to growth? The most obvious, of course, is Fed over-tightening. Years of low rates and easy credit have led companies and some sovereigns to borrow lots of money. In the US, covenant-lite loans, which put very few conditions on borrowers, are significantly above their pre-crisis levels. While rising rates will increase interest costs for new debt, tightening liquidity may be the greater concern, as it will make it harder for borrowers to roll over their loans. McKinsey estimates $10tn of corporate debt will come due in the next five years. If investors believe that looming corporate or sovereign debt difficulties will slow growth and prompt a flight to safe assets, it would help explain low Treasury yields.

The talk of a full blown trade war might be another reason investors fear a recession. The timing is off, though. The term spread began narrowing before the US and China began to talk of slapping tariffs on each other’s goods. Also econometric estimates of the effects of one or two rounds of tariff rises are small. But the models do not capture the intertwined nature of global supply chains. Moreover, the effect on business sentiment, as well as the pall of uncertainty cast over investment, will be considerable. A trade war will be costly.

It is possible that negotiations will prevent conflict. Unfortunately, the US’s objectives are not clear. It may be seeking to counter the perceived unfair elements of China’s Made in China 2025 plan to build strength in areas like artificial intelligence, robotics and chip manufacture. American grievances include state aid to Chinese companies, pressure by the state on overseas companies to share technology if they want access to Chinese markets, and the state condoning, if not aiding, intellectual property theft. These issues might best be addressed by joining with other industrial countries that have similar apprehensions and negotiating with China, with penalties as a last option.

However, a second possible objective of the US administration is to shore up its political base before the November midterm elections with a broader attack on the “unfair” practices of all trading partners. This makes the first objective harder to achieve. Also, no country, especially in a world where strong leaders increasingly dominate, wants to be seen giving in to threats, making trade conflict more likely.

That leads to a final reason for concern. China is cleaning up its financial system, an immensely complicated task given the debt that has built up. Growth has slowed, the cost of riskier loans has been rising as have defaults. The Chinese authorities are working to spread losses across the system, but this needs to be managed carefully to avoid panic. If China is caught in a trade war while it is still restructuring its financial system, its difficulties could spread abroad.

The world economy has finally managed to recover from the financial crisis, without much help from the politicians. Let us hope they do not send it back to the emergency room again.

The writer is a professor of finance at the University of Chicago’s Booth School

Are We in a Corporate-Debt Bubble?

Susan Lund

Pedestrians walk past the skyline of the financial district

WASHINGTON, DC – Is growing corporate debt a bubble waiting to burst? In the ten years since the global financial crisis, the debt held by nonfinancial corporations has grown by $29 trillion – almost as must as government debt – according to new research by the McKinsey Global Institute. A market correction is likely in store. Yet the growth of corporate debt is not as ominous as it first appears – and, indeed, in some ways even points to a positive economic outcome.

Over the past decade, the corporate-bond market has surged as banks have restructured and repaired their balance sheets. Since 2007, the value of corporate bonds outstanding from nonfinancial companies has nearly tripled – to $11.7 trillion – and their share of global GDP has doubled. Traditionally, the corporate-bond market was centered in the United States, but now companies from around the world have joined in.

The broad shift to bond financing is a welcome development. Debt capital markets provide an important asset class for institutional investors, and give large corporations an alternative to bank loans. Yet it is also clear that many higher-risk borrowers have tapped the bond market in the years of ultra-cheap credit. Over the next five years, a record $1.5 trillion worth of nonfinancial corporate bonds will mature each year; as some companies struggle to repay, defaults will most likely rise.

The average quality of borrowers has declined. In the US, 22% of nonfinancial corporate debt outstanding comprises “junk” bonds from speculative-grade issuers, and another 40% are rated BBB, just one notch above junk. In other words, nearly two-thirds of bonds are from companies at a higher risk of default, including many US retailers. These businesses have a lot of speculative-grade debt coming due over the next five years, and for many the math simply will not add up, owing to declining sales as shoppers go online.

Another potential source of vulnerability is soaring corporate debt in developing countries, which have accounted for two-thirds of overall corporate-debt growth since 2007. In the past, advanced-economy firms were the largest borrowers. But much has changed with the rise of China, which is now one of the largest corporate-bond markets in the world. Between 2007 and the end of 2017, the value of Chinese nonfinancial corporate bonds outstanding increased from just $69 billion to $2 trillion.

One final source of risk is the fragile finances of some bond-issuing companies. To be sure, MGI finds that in advanced economies, less than 10% of bonds would be at higher risk of default if interest rates were to rise by 200 basis points. Similarly, in Europe, the share of bonds issued by at-risk companies is currently less than 5% in most countries, indicating that only the largest blue-chip companies have issued bonds so far.

The problem is that there are pockets of vulnerability. Even at historically low interest rates (before the US Federal Reserve raised its benchmark rate to 1.75-2% on June 14), 18% of bonds (worth roughly $104 billion) outstanding in the US energy sector were at higher risk of default.

Still, the biggest risks appear to be in emerging markets such as China, India, and Brazil.

Already, 25-30% of bonds in these markets have been issued by companies at a higher risk of default (defined as having an interest-coverage ratio of less than 1.5). And that share could increase to 40% if interest rates were to rise by 200 basis points.

Within these emerging markets, some sectors are more vulnerable than others. In China, one-third of bonds issued by industrial companies, and 28% of those issued by real-estate companies, are at a higher risk of default. Corporate defaults are already creeping upward in China; and in Brazil, one-quarter of all corporate bonds at a higher risk of default are in the industrial sector.

With the global corporate default rate already above its 30-year average and likely to rise further as more bonds come due, is the next global financial crisis at hand? The short answer is no. While individual investors in bonds may face losses, defaults in the corporate-bond market are unlikely to have significant ripple effects across the system, as the securitized subprime mortgages that sparked the last financial crisis did.

Beyond the near-term bumps in the road, the shift to bond financing by companies is a positive development. There is plenty of room for further sustainable growth. But as the market grows, banks will need to rethink their strategies focusing more on other customer segments, such as small and medium-size businesses and households. Investors and individual savers, for their part, will have new opportunities for portfolio diversification.

But if the financial crisis ten years ago taught us anything, it is that risks often emerge where they are least expected. That is why regulators and policymakers should continue to monitor existing and potential risks, such as those arising from credit default swaps on corporate borrowers or complex securitization of bonds. They should also welcome the establishment of electronic platforms for selling and trading corporate bonds, to create more transparency and efficiency in the marketplace.

That way, today’s debt would be less likely to become tomorrow’s debt overhang.

Susan Lund is a partner of McKinsey & Company and a leader at the McKinsey Global Institute.

Sorry OPEC, Oil’s Surge Is Made in America

Oil is up a lot, but the reason is not OPEC’s decision to boost production

By Spencer Jakab

          Oil equipment near Bakersfield, Calif. Photo: lucy nicholson/Reuters 

Your perception of how the world is moving depends a lot on where you are standing—especially when it comes to the world oil market.

Energy-related headlines in the U.S., the world’s largest crude consumer and soon to be its largest producer, have been almost unremittingly bullish in the past several days. The main reason is that crude prices surged to a three-and-a-half year high in the wake of last week’s meeting of the Organization of the Petroleum Exporting Countries, despite that group’s decision to raise output quotas.

But it is the U.S. benchmark, West Texas Intermediate, that has surged, not the globally important Brent that tends to be more sensitive to OPEC’s decisions. As of Friday morning, the former had rallied by 12.5% in three weeks while Brent was a mere 1.7% higher over the same time.

Oil futures prices in June

Source: FactSet

Much has to do with North American rather than global conditions. Surprisingly strong drops in inventories at Cushing Okla., the delivery point for the WTI futures contract, are the biggest reason. Most recently at 29.89 million barrels, inventories have dropped 4.7 million barrels in three weeks and are now half their level this time last year.

Another reason is a major outage in western Canada affecting 360,000 barrels a day. While those barrels don’t necessarily flow to Cushing, refiners may source replacement barrels from U.S. producers. The problem could last several weeks. A one-month outage would create a 10-million-barrel deficit.

WTI’s surge also comes from an extreme and unsustainable discount relative to Brent. By late May, the discount had reached its highest since 2015 at over $10 a barrel. That reflects surging U.S. production temporarily swamping local shipping capacity. Before the surge in shale production, WTI often traded at a small premium to Brent.

Countries Face the Tricky Task of Undoing Negative Interest Rates

The longer countries wait to raise rates, the more damage it may do

By Brian Blackstone

Central banks in Europe and Japan are reluctant to reverse negative deposit rates for fear of derailing economic recoveries. Photo: Ralph Orlowski/Bloomberg News 

Europe has finally emerged from its debt crisis with healthy economic growth, but it can’t shake one relic of its troubled times: negative interest rates.

The policy was tried by Sweden briefly in 2009 and 2010 but eventually was implemented by Denmark, the eurozone, Switzerland and Sweden again over the subsequent five years before landing in Japan two years ago. Negative rates—where the central bank charges commercial banks for money held at the central bank—helped safeguard economic recoveries by lowering borrowing costs across fixed-income markets and, in some cases, boosting exports via weaker exchange rates.

None of these economies seems willing to be the first to lift rates above zero for fear of derailing their recoveries. The European Central Bank said on Thursday that it probably won’t touch its rates until at least summer 2019.

But the longer the banks wait, the greater the risk that damaging side effects—such as squeezing bank profits or fueling housing bubbles—may materialize.

‘An effective instrument’

When central banks want to stimulate growth and inflation, they typically set official interest rates below inflation, which in turn favors borrowing over saving. When inflation is superlow, as has been the case for the past decade, then policy rates might have to go below zero.

The U.S. never went down the negative-interest-rate path, in part because deflation—a dangerous decline in the overall price level—never emerged as the serious threat that it was in Europe. And Europe’s economies are heavily intertwined, so when the European Central Bank eases policy, its neighbors in Switzerland and Scandinavia often follow suit.

Another reason is that Europe relies more on banks for private-sector loans than the U.S., which depends more on capital markets, and negative rates work primarily through banks.

The policy has had mostly positive results in Europe, though they appear more mixed in Japan. Since 2014, countries deploying negative interest rates have avoided recession and, recently, have generally shown signs of healthy growth.

“I think they have been an effective instrument” by depressing long-term yields that spurred growth and inflation, says Stefan Gerlach, chief economist at EFG Bank and Ireland’s deputy central-bank governor when the ECB cut its deposit rate below zero in June 2014.

Meanwhile, the darker scenarios of negative rates—such as cash hoarding and evaporating bank profits—didn’t materialize. Banks haven’t passed negative rates on to retail depositors, instead eating the cost themselves or charging higher fees in other areas, such as mortgages.

“As much as we worried about Y2K, and that wasn’t a problem, it’s the same with negative interest rates,” says Karsten Junius, chief economist at Bank J. Safra Sarasin.

The eurozone’s deposit rate has been minus 0.4% since early 2016, but European countries outside the zone have made the most aggressive use of negative rates. Switzerland’s deposit rate has been minus 0.75% since early 2015, for instance, while Sweden’s is minus 1.25%, and its repo rate is negative too. Japan’s, meanwhile, is minus 0.1%. 
But each tool was designed to fit different economies. In export-sensitive Switzerland and Denmark, where exchange rates are paramount, banks were exempted from the negative rates up to a certain amount of deposits. That centered their effects on currencies and blunted the effect on the banking system somewhat.

In the eurozone and Japan, negative rates are used alongside large-scale bond purchases and commitments to keep rates low for a long time, giving the policies’ broader economic impact. “You have to think about the whole package,” says Mr. Gerlach.

No cure-all

Yet negative rates are far from a cure-all, and the longer they last, the greater damage they might do. European banks weren’t crippled by negative interest rates, but they have underperformed their U.S. peers since the policy became widespread. Swiss financial institutions have paid more than five billion francs ($5 billion) to the Swiss National Bank since 2015 because of negative rates. The total bill for Danish banks—which have faced a deposit rate as low as 0.75%—has been about 2.5 billion kroner ($400 million).

Swiss bankers, particularly at UBS Group , UBS +1.24%▲ were highly critical of negative rates two years ago, though they haven’t been as vocal about them more recently.

The impact of negative rates is especially big for regional banks in Japan because they depend largely on lending, unlike major banks that have sought revenue from commission income or overseas businesses.

“Downward pressures from the negative-rate policy on rates and profits are expected to continue for a while,” Koji Fujiwara, chairman of the Japanese Bankers Association, said at a regular press conference in Tokyo on May 17.

Bank of Japan Governor Haruhiko Kuroda acknowledges that the negative-rate policy has squeezed banks’ profits, but says it also benefits banks by helping to boost inflation and economic growth.

Other effects of negative rates may not be apparent for some time, such as their impact on pension funds, which depend on positive rates for returns on safe, short-term assets.

Then there is the effect of negative rates on increased borrowing to buy homes. Of the 15 cities world-wide identified by UBS as having housing markets that are overvalued or at risk of a bubble, eight were in countries with negative policy rates.

Still, central banks deploying negative rates seem in no hurry to raise them. Switzerland, Sweden and Denmark are widely expected to wait until the ECB starts raising rates before lifting their own. The ECB isn’t expected by analysts to do so until well into next year, meaning it could be years before rates are positive again across the Continent.

If there is a recession or shock to the economy, these central banks might have to tinker more by lowering rates even further or by eliminating exemptions, which would test the limits of how negative rates can go before inflicting bigger damage to banks.

“It would be nice if central banks have the possibility to reload before the next recession,” says Jean-Pierre Danthine, who was vice chairman of the Swiss National Bank when it adopted negative rates in late 2014.

IMF Sees Risks in U.S. Fiscal Policy

     Photo: iStockphoto 

The International Monetary Fund is warning that current U.S. fiscal policy poses risks to the global economy.

The international organization said in a statement Thursday on its annual checkup of the U.S. economy that a combination of tax cuts and increased public spending will boost debt, potentially spark inflation and lift the dollar, Bloomberg reports.

The fiscal stimulus backed by the Trump administration and the Republican-controlled Congress will give a short-term boost to the U.S. economy, the IMF said. But it also warned that adding fiscal stimulus when the economy is growing “will elevate the risks to the U.S. and the global economy.”

That stimulus raises the risk of an “inflation surprise” for markets, and a quick increase in inflation could force the Federal Reserve to raise interest rates faster than expected, the IMF said.

The IMF’s warning comes as the global economy is seeing its strongest upswing in seven years, Bloomberg notes. The IMF expects global growth to pick up in 2018, but it expects momentum to wane in coming years as central banks raise interests rates and the effect of U.S. fiscal stimulus wears off.

On Thursday, the European Central Bank said its huge bond-buying program would likely end in December, another milestone as central banks move away from their post-financial crisis stimulus programs.

IMF Managing Director Christine Lagarde warned this week that clouds over the world economy are “getting darker by the day,” Bloomberg notes.

China Taps the Brakes on Investment

By Xander Snyder


For China, keeping economic growth sustainable keeps getting harder and harder. Last week, the Chinese government released a report that showed the annual growth of domestic fixed asset investment hit its lowest point in 22 years during the period from January to May. At almost 45 percent, investment is the largest component of China’s gross domestic product (ahead of consumer spending and exports). China needs to keep building construction and development projects to prevent a cyclical downturn from threatening employment and social stability. A slowdown in investment, therefore, portends a general economic slowdown. It’s important to understand its scale and what caused it.

Fixed asset investment is a broad category that encompasses all sorts of investments, including agriculture, construction and manufacturing, and infrastructure and services, so long as the investment is toward a physical asset. In China’s case, much of the reduced growth is a result of a slowdown in infrastructure investing (to 9.4 percent in the first five months of 2018, compared with 20.9 percent over the same period last year), much of which comes from China’s local governments.
China’s local governments are strapped for cash because Beijing is trying to rein in debt in its financial system. China’s happy growth story in the past few decades was made possible to a substantial extent by massive credit growth, which helped provide the capital for development. But that approach has a darker side: It fuels a property bubble that, should it burst, can wreak havoc on the economy.

Among the many financial hazards posed by the complex interconnectedness of financial and non-financial institutions in China and their lending to the real estate industry, local governments are a unique threat to Beijing’s goals. Local governments derive tax revenue from land transactions (technically, from the transfer of land use rights) to property and infrastructure developers. More credit for developers means real estate and construction companies can afford to buy more land at higher prices, and thus local tax revenue rises.

Local governments have tried to line their own pockets by getting more credit into the hands of developers. Technically, local governments cannot take on debt, so they have established so-called local government financing vehicles, whose affiliations to local governments are usually elaborate and hazy. These entities are often development companies, which take on debt and use that money to purchase land and pay local government taxes on the transfer. In essence, local governments are borrowing to fund their own tax income.

This scheme has created some obvious problems for Beijing. For starters, it has resulted in debt that is less transparent, such that the true scale of liabilities has been difficult to discern. Second, it’s a challenge to Beijing’s centralized authority. Local government officials are willing to borrow money now since they can implement more initiatives with the additional tax revenue, with the hope of moving on to a more important official position by the time the debt comes due. But with so much riding on its success with debt alleviation, Beijing cannot afford to have local officials defying its directives on borrowing activity. It makes bureaucrats and local bigwigs too powerful and makes Beijing appear too weak to manage them. The central government has needed to bring what remains of local power under its thumb and stamp out opposition to its national plans. Its deleveraging campaign, which has restricted the amount of credit available to local governments, is one way Beijing is bringing local governments to heel.

But it is not just local governments that are facing tighter credit. Beijing recently rolled out restrictions on wealth management products, a shadow banking security that contributed to the growth in opaque and difficult-to-assess securities. WMPs are often “off-balance-sheet” items, meaning banks do not report them, even if they own affiliated entities that issue the WMPs. This lack of transparency meant that Beijing couldn’t even understand the true scale of its problem. No longer – after forcing greater transparency in this market, Beijing has issued new regulations that are significantly decreasing the issuance of WMPs (by 20 percent in April on a month-over-month basis), and funneling that money toward other types of securities that are more transparent and less risky and are required to be reported by banks (“on-balance-sheet” items). And it’s not just WMPs that are falling. Total social financing – a broad measurement of credit issuance in China’s economy – fell by almost 50 percent from April to May to 761 billion yuan (about $120 billion).

All this said, it’s important to keep in mind that slower fixed asset investment growth doesn’t mean investment is declining. It’s simply growing less quickly. This is clearly not good for China’s growth prospects, but it’s a necessary part of the process.