Juggling Dynamite

The New Zealand central bank slashed its official cash rate by a third today–to one percent–and twice as much as expected.

In response, the New Zealand dollar (NZD) slumped nearly a percent and is back under .65 per U$.   The NZD bottomed the last cycle at .48 in the spring of 2009.  Entering this global downturn with a bank rate near zero, and a population struggling with record indebtedness, monetary easing is much harder to effect than in past cycles.  Here is a direct video link.

We expect the Bank of Canada to also abruptly shift to a rate cutting effort in the weeks ahead.  The Canadian dollar is down to . 75/U$ today and may well head into the .67/U$ range in the months ahead as the economic cycle bottoms.

In the next iteration of desperate:  this week in Denmark, banks began issuing 10-year mortgages at a rate of negative .5%, 20-year mortgages at zero-interest, and 30-year mortgages at just 1/2 percent.  Imagine.  Banks paying people to borrow money.  Try and find that one in the finance textbooks.

These are certainly not signs of strength.  You can make loans free, but people can’t take on more debt where they lack the income to repay principal, and the value of their existing real estate is stagnant and falling.  Flat wages and falling revenue among heavily-indebted populations are problems that central banks have helped to make, but cannot fix.

The fact that banks and investors are willing to make zero and negative-rate loans and buy negative-yielding treasuries is also not bullish.  It’s a symptom of wildly overvalued asset markets and a world slipping deeper into liquidity crisis.  Sober capital is seeking least damaging options given present downside risks and the prospects of a slow recovery. See 20-year mortgages hit zero for the time in Danish history:

“It’s an uncomfortable thought that there are investors who are willing to lend money for 30 years and get just 0.5 per cent in return…It shows how scared investors are of the current situation in the financial markets, and that they expect it to take a very long time before things improve.”

As the longest and most levered expansion cycle in history draws to its inevitable close, a world that borrowed heavily in US dollars over the last decade now becomes shorter and shorter of the currency needed to pay their bills.

The bulk of global debt (over $244 trillion-plus today) is owed in US dollars. (See Global debt monitor devil in the details.) As US spending and imports fall, so does the inflow of US dollars to foreign exporters who need greenbacks to make their payments. This naturally prods them to buy more US dollars, and traders pile on for the ride. These factors compound rising U$ costs and shrinking free cash flow for foreign borrowers and exporters.  At the same time, China is needing less imports than in the past, and with its fiscal and monetary levers weaker than in 2008-11, China’s power to boost the global economy is fading.

The discussion below, particularly at 3:20 on the play bar, is on point.  People cite China’s capital reserves as a sign of financial liquidity without appreciating that they have levered and loaned them out many times over through their financial system and other global asset markets.  This is the stuff that liquidity crunches and forced selling cycles are made of.  Here is a direct video link.

Hedge fund manager and Hayman Capital Management founder Kyle Bass said on Monday that without state support, China’s currency would plunge.  “What’s happening in China is they have to have dollars to sell to buy their own currency to hold it up. If they were to ever free float their currency, I think it would drop 30% or 40%…And the reason is they claim to be 15% of global GDP in dollar terms, but less than 1% of global transactions settled in their own currency.”

As North America moves near zero (ZIRP) and possibly negative policy rates (NIRP) in the months ahead, Japan remains the leading test case for these experiments, and investors would be wise to take note.  Nearly 30 years of zero and negative interest rates and asset buying by the Bank of Japan, and government debt has topped 250% while the economy has flatlined and the Nikkei 225 stock index remains 45% lower than it peaked in 1989.  Meanwhile, the viability of retirement, pensions, life insurance companies and Japanese banks has steadily eroded.  For the latest see WSJ Japanese Banks are circling the drain:

Since March 2016, shortly after the country’s negative interest rate policy was introduced, net income at major banks has declined by a fifth. At regional banks, the decline has been steeper: Net income is a third below its level three years ago.

Practically all of Japan’s regional banks have seen their share prices fall in the past 12 months. More than half have had declines exceeding 30%. They have underperformed the broader Japanese market for decades.

Desperately seeking yield spread, institutions and individuals have increased FX and credit risk to make loans in other currencies and buy foreign assets including US and European collateralized debt obligations full of junk-rated loans.  We saw similar moves before the 2008 financial bust.  Only this time, debt and leverage levels in the financial system are significantly higher, and baby boomers are ten years older, with less time to grow back capital.  This next loss cycle will be devastating for many.