Welcome to economic ‘fantasy’ island.
Jim Grant, the world’s most famous interest rate observer, ventured on CNBC this week to expose and explain the utterly farcical world of financial markets (and in particular, risk assets) and how grotesquely distorted global bond markets have become.
He began with an example…
“As an example of where the world is mispricing interest rates… look to Italy, which is having a big [potentially disruptive] election on Sunday…
…there is a speculative grade Italian security, Telecom Italia, the 5 1/4’s of 2022 are trading at 0.61 percent, that is a junk bond with a zero handle.”
This bond traded with almost a 6 handle just 5 years ago…
Thank you Mr Draghi.
But it doesn’t stop there, Grant warns…
“…and since interest rates are critical in the pricing of financial instruments, these distortions preceded the uplift in all asset values.. and the manifestation of this manipulation is in many ways responsible for what we are now seeing in the markets.”
These distortions and the chaotic aftermath of their withdrawal are exactly what current Fed Chair Powell warned of in 2013…
[W]hen it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.
I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. Meanwhile, we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.
“And I think there is a pretty good chance that you could have quite a dynamic response in the market. “
While Powell is anxious, Grant reminds listeners that the ‘end of the bond bull market’ does not necessarily mean disruptive change…“it took ten years for the long-dated Treasury to move from its low in 1946 of 2.25% to 3.25% in 1956…” but, as Grant points out, it’s different now, “that was before risk parity and the leverage that is now in financial instruments surrounding the bond market.”
However, Grant warns that he “suspects the tempo of a bond bear market will indeed be faster now than it was in 1946-56.”
* * *
Once again Grant is correct in his diagnosis of the symptoms… and the prognosis – all of which reminds us of his rhetorical question – What will futurity make of the [so-called] Ph.D. standard [that runs our world]?
Likely it will be even more baffled than we are. Imagine trying to explain the present-day arrangements to your 20-something grandchild a couple of decades hence – after the crash of, say, 2019, that wiped out the youngster’s inheritance and provoked a central bank response so heavy-handed as to shatter the confidence even of Wall Street in the Federal reserve’s methods…
I expect you’ll wind up saying something like this:
“My generation gave former tenured economics professors discretionary authority to fabricate money and to fix interest rates.
We put the cart of asset prices before the horse of enterprise.
We entertained the fantasy that high asset prices made for prosperity, rather than the other way around.
We actually worked to foster inflation, which we called ‘price stability’ (this was on the eve of the hyperinflation of 2017).
We seem to have miscalculated.“