Earlier today in his weekly note, One River CIO Eric Peters explained that in their attempt to overturn the natural order of the global economic “ecosystem”, what central banks have done is “stunning, unprecedented… and arrogant”, and as a result it is only a matter of time before another “peak instability” moment emerges as “it stands to reason that our volatility-selling machine will break one day. We saw a glimpse of this in 2008-09.”
And yet, as Peters concedes in a follow up note, those same central bankers don’t have any other option but to kick the can because as the CIO notes, any attempt to break the current ultra-low rate regime would “spark massive defaults.”
Incidentally, those are the same defaults that should have happened during the “near systemic reset” of 2008/2009 but the Fed, in all its wisdom, decided to kick the can at the cost of trillions in global excess liquidity, and while it bought itself some time – in the process unleashing a global deflation wave thanks to zombie companies that should not exist yet do, and every day try to undercut each other on pricing – nearly ten years later it has discovered that it has no way out, for one simple reason: there is now too accumulated debt.
Here is Peters “modelling” out why the Fed is stuck with no way out:
“When debt expands constantly relative to GDP, there’s a limit to how high interest rates can rise without causing massive defaults,” said the Model. “There’s nothing inherently wrong with defaults, they can cleanse a system, but a rise in US defaults from today’s 2.5% to 6.0% would boost unemployment by 3%.”
America’s economy is leveraged to the financial system, which includes non-capitalized liabilities; entitlements, pensions, healthcare. “US total debt/GDP is 300%, but if you include these non-capitalized liabilities, it’s more like 800%.”
“These non-capitalized liabilities rise as both interest rates and economic growth decline,” continued the same Model.
“Low growth produces less income, and low rates supply less investment returns on pensions. Which means companies need to set aside more money to pay the liabilities.” It’s a slow-moving economic death spiral.
“The Neo-Fisher Model posits that we can escape this trap by increasing interest rates. Which will raise investment returns, while simultaneously lifting growth. Fisher’s Model may be right, but it will never be tested in reality.”
“In reality the world operates on monthly payments,” explained the same Model. “So if we tested the Fisher Model by raising interest rates meaningfully, we’d spark massive defaults.” Unemployment would jump dramatically.
“Our central banking and political reaction function ensures that each rise in unemployment is followed by monetary stimulus.” In the 30yrs since Greenspan became Fed Chairman, borrowers have learned this lesson and responded by leveraging up.
“And that’s why US interest rates will never rise sustainably above 3.5%.”
* * *
As a bonus, here is Peters on the several consensus themes in the market right now, and why it may be time to fade at least one of them:
“I have no ideas and no positions,” said the portfolio manager. “So I wrote down the things that everyone else believes,” he continued.
- “Developed world economies are slowing;
- Trump agenda has stalled;
- US equities are too expensive;
- Interest rates are artificially low and must rise;
- Central banks are out of ammo;
- China is racing toward disaster;
- China can and will maintain stability through its autumn party congress;
- Europe can’t continue down its current path;
- Brexit is bad for the UK;
- The EU has the upper hand in the Brexit negotiations.
“I sat back and considered the arguments people use to justify these views,” continued the same portfolio manager. “Sometimes things are clearer when you have nothing on,” he said, the ink drying. “It appears we’ve hit peak skepticism on Trump. He may fail completely, but people’s certainty seems misplaced. It’s priced.” He dropped his pen.
“And I know this sounds crazy, but of all the things that people believe, the two that are supported by the weakest arguments are that rates are artificially low and equities are too expensive.”
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