Catalyst for Chaos

Monday, March 27, 2017
By Paul Martin

by Michael Pento
MARCH 27, 2017

Up until very recently, stocks had been humming along without so much as a minor speedbump and volatility was becoming a distant memory. However, it now seems prudent to once again remind investors that this extremely overvalued market is headed for an epic crash. The Cassandras, myself included, have been wrong about this warning for what seems like a long time. Nevertheless, much like those who warned of a housing bubble a few years before the bottom completely fell out, reality is destined to slam into the current triumvirate of asset bubbles, and those sounding the alarm will be proven correct again.

The governments’ massive interest rate manipulation and record amount of new debt accumulation have engendered unprecedented equity, real estate and fixed income bubbles across the globe.

But what could finally be the catalyst that sets off the inevitable deleveraging and reconciliation of asset prices into motion?

A very good candidate for this is the eventual tapering of the Quantitative Easing (QE) programs currently underway courtesy of the European Central Bank (ECB) and Bank of Japan (BOJ). There is a very good chance that upon the announcement of a commitment to end the QE programs in either of these countries will lead to a sudden and chaotic surge in borrowing costs worldwide.

Of course, Wall Street cheerleaders will scoff at this notion; claiming that the Fed was able to begin winding down QE in December of 2013 and was done by October 2014, with nary a hiccup in stock prices.

But there exists a huge difference between the Fed’s tapering of QE and potentially that of the ECB and BOJ.

When then Chairman Bernanke started to wind down QE, the U.S. Ten-Year Treasury was yielding around 3%. And, according to the BLS, the year-over-year rate of inflation was 1.5%. Therefore, real interest rates were already positive and the nominal rate was above the universally-adopted central bank inflation target of 2%. Hence, the tapering of asset purchases did not cause yields to spike; and that quiescence of borrowing costs kept the stock bubble expanding.

Another reason for the temperance in Treasury yields was the commencement of QE programs from those very same countries. The BOJ and ECB started to print money right around the time of the Fed’s termination of asset purchases. BOJ Head Haruhiko Kuroda began Japan’s massive bond buying spree in April of 2013. Kuroda pledged to buy at least $1.4 trillion in assets back then and is still going strong with an additional 80 trillion yen each year.

In addition, the ECB President, Mario Draghi, announced he would do “whatever it takes” to drive down yields in the Eurozone in July of 2012; then followed up with an official announcement of QE in January of 2015. Draghi’s money printing continues to this day and will amount to a minimum of $2.4 trillion worth by the end of this year.

It is important to note that although the ECB announced a quasi-tapering of assets from 80 billion, to 60 billion Euros per month beginning in March of 2016, it was not a genuine tapering in the least. Not only did Mr. Draghi extend the duration of his bond purchases by another three months, he also stated at his press conference that quantitative easing is open-ended and could extend well past the proposed end date of December 2017. Yet, despite this half-hearted and minuscule step towards tapering, the ECB still caused a doubling of German 10 Year Bund yields in the past month.

Most importantly, the major difference between the Fed’s taper and the inevitable turn from the BOJ and ECB is the level of their respective real interest rates.

Japan’s 10-Year Note offers a nominal yield of just about zero percent. However, as mentioned already, the BOJ has an inflation target of 2%. If Mr. Kuroda ever has the temerity to end his bond-buying scheme, borrowing costs in this bankrupt nation, which has a total debt to GDP ratio of around 600%, would have to abruptly surge over 200 basis points just to keep even with the central bank’s inflation target. Alternatively, rates could surge given the fact that insolvent Japanese Government Bonds will be losing the only buyer willing to receive a guaranteed yield of zero percent.

This difference in real yields is particularly striking in Germany. An inflation rate of 2% isn’t just a target…it’s a reality. The 10-Year Bund currently yields 0.43%, and the February year-over-year rate of Consumer Price Inflation (CPI) is 2.2%. Therefore, real interest rates are currently a negative 1.77%. If the ECB were to seriously commit to ending its QE program, fixed income investors and speculators would panic to get ahead of the removal of Draghi’s bids; and Bund yields could surge well above the rate of inflation in a very short period of time.

Therefore, it is a very credible assumption that the free market will rush to front run the offers from Draghi and Kuroda, and cause chaos in global bond markets.

The Rest…HERE

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