Here Comes The Great Hangover

Written by Adam English
Posted May 1, 2018

The time has finally come to see if the Fed can pull off its biggest trick yet.

Can it finally pull the punch bowl away?

For years, it kept the party going and every single dollar possible in equities. Then it tried for years to warn investors that it wouldn’t last forever.

Now it is increasingly clear, especially after the release of the FOMC minutes earlier this month, that the Fed is committed to raising rates and shrinking its balance sheet.

It ran out of time to retain any flexibility, and it is increasingly clear that its extraordinary interventions are going to cause an extraordinary change across the market.

It’s “last call” time. The music is stopping, the lights have been turned up, and no one has to go home, but they can’t stay here.

The Fed managed to stave off a full reckoning after the Great Recession. Is it ready for the Great Hangover that’s coming though? And are we?

Follow the Leader

As the Fed increases rates, so will everyone else, from small lenders to other countries.

The ECB is widely expected to follow suit by increasing rates and scaling back its intervention in bond markets.

And emerging markets are especially vulnerable to changes in U.S. rates, due to their heavy reliance on debt issued in U.S. dollars.

As the U.S. tax changes drive up federal spending, the Fed will be looking to reduce its balance sheet by over $1 trillion in two years.

That will only serve to push the yields of bonds, and thus the cost of debt for borrowers, even higher.

The 10-year bond already jumped from 2.4% to just over 3% for a while last week. The upward pressure has just begun.

Worries about a flattening yield curve, a strong signal of a coming recession, will persist and continue to erode confidence.

Over the past year alone, the gap between the 2-year and 10-year Treasury note yields has fallen from just over 1% to just under 0.5%.

That’s the narrowest it’s been since 2007.

Hard to Justify

Speaking of Treasury yields, the increasing yields are putting their own pressure on the stock markets.

As yields, and thus returns, increase from bonds, it only serves to undermine expensive stocks.

Market analysts, especially bullish ones, would argue that what counts is the equity risk premium and not the earnings yield.

And so they justified higher stock prices to themselves since interest rates have been so low for so long. That is turning against them.

The earnings yield of the S&P 500 is 4.7% based on last year’s earnings and 4.1% using a seven-year trailing average.

Compare that to the 10-year Treasury yield, and you’re only looking at a risk premium of a bit over 1% for owning stocks.

That is a painfully small premium as stocks' price-to-earnings ratios remain historically high and volatility returns.

Lots of Paper

Finally, there is the issue of all the cheap paper that has been floating around for years.

The bills are coming due. Either they get paid or rotated into new debt that is significantly more expensive.

Global debt has reached a record $237 trillion. That’s more than 327% of global GDP.

Overextended debt played a key role in blowing up the global economy about a decade ago, and debt has increased by $68 trillion, or more than 50% global GDP, since then.

As the Fed, and thus everyone, increases interest rates, the risk to highly indebted borrowers — corporate and sovereign — will cause rapid increases in financing costs that disproportionately affect illiquid and riskier high-yield bonds.

Exactly the same high-yield bonds that have attracted so much money during the engineered “risk off” QE programs.

Higher rates will also create large mark-to-market losses on existing debt. A 1% increase in U.S. government bond rates is estimated to exceed $2 trillion on the global scale.

Earnings reports will be dismal, collateral used to secure loans will become insufficient, and economic growth will be sluggish at best as asset values slide.

The Big Squeeze

So can the Fed keep everyone calm through all of the pressure we will face?

Developing economies will be looking at another brutal drought of capital, if not outright capital flight. Defaults are sure to follow, with the ratio of debt-to-GDP at a whopping 280%.

Developed countries may fare no better, with massive spending guarantees and a debt-to-GDP ratio above 200%.

Even the U.S., the go-to place to park wealth when the rest of the world looks weak, will not be spared.

The new tax law sends interest payments up to 3.1% of GDP in 2028, up from 1.6% in 2018, as trillion-dollar yearly deficits appear around 2020, according to the CBO.

A whole lot of cash will be diverted to servicing debt, from households to Main Street to Wall Street to governments.

And what will we have to show for it? A lot of share buybacks at all-time high prices, some paper profits that can easily disappear overnight, and a false sense of confidence as major economic policy flaws that have only grown beneath the piles of cash we buried them under begin to appear.

The money largely didn’t go to anything productive, and it will only leave debtors worse off than they were before they took large amounts of dirt-cheap debt for granted.

A cascading and compounding list of problems is dead ahead, and far too many companies and their investors aren’t ready to sober up and face reality.

Take care,

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Adam English

follow basic @AdamEnglishOC on Twitter

Adam's editorial talents and analysis drew the attention of senior editors at Outsider Club, which he joined in mid-2012. While he has acquired years of hands-on experience in the editorial room by working side by side with ex-brokers, options floor traders, and financial advisors, he is acutely aware of the challenges faced by retail investors after starting at the ground floor in the financial publishing field. For more on Adam, check out his editor's page

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