Apr 15/15 – It was my understanding there would be no math

2015-04-15 9am EDT  |  #bonds #China #Druckenmiller #ECO surprise #Mexico #Two and Twenty

A few days ago Mexico floated 1.5 billion of 100 year bonds. Yup, you got that right – a billion and a half of 100 year bonds denominated in another currency. And the real kicker is; they were priced to yield just a tad over 4%. Four percent for a hundred years! In a currency that might not even be around in 10 years, forget about 100. I can’t figure out if it sheer madness or genius on Mexico’s part.

Although I understand that the buyers were mostly institutions with extremely long liabilities, there can be no doubt that the frothy environment is encouraging a desperate reach for yield, which Mexico has stepped in to fill like a butter tart. Mexican 100 year paper yielding 4% seems pretty awesome when your alternative is German 10 year paper yielding 0.13%.

But I wonder if the buyers have contemplated the massive risk they are taking with this issue. Right now it seems like inflation will never return and that we will be battling deflation for decades to come. Yet in the late 1970s and early 1980s there were scant few predicting that inflation was about to turn tail for the next 4 decades. In fact it was just the opposite. Everyone thought that inflation would never be tamed.

What if we experience an equivalent dramatic turn in outlook for inflation in the coming years? A 100 years is a long time for us to be stuck in a low inflation environment. Do you know what will happen to the price of that Mexican bond if the yield were to move higher?

The bond was issued at a price of 95.322 to yield 4.2%. Of course, in the following days the bond has been bid up to a price of 105 to yield 3.805%.

If the yield were to rise even a hundred basis points back to 5%, the price would decline to 80.16.

At a yield of 6%, which wouldn’t be unreasonable in a regular interest rate environment, the price would decline to 66.77. A simple move back to more normal rates would result in a capital loss of over 36%.

And what happens if this tinder box of monetary fuel that the global Central Banks have been piling on the economy finally ignites and we get a little inflation? At 8% yield, the price is 50.03 – more than a halving of your principal. At 12% the price goes to 33.35 and at 15% it is worth just 26.69.

There is little chance that at some point in the coming years that this bond doesn’t at least get halved in price. The buyers are not thinking about the risks they are taking. They are reaching for yield because it has been working. It is a simple as that. Good for Mexico for having the courage to stuff ’em.

Two and Twenty’s insights

Yesterday one of the best guys on twitter, “Two and Twenty” @deuxetvingt, had a few comments that explained the current environment better than anyone.

His first point was the mad drive lower in German 10 year yields is pushing investors out the risk curve in all other asset classes.

After the US bond market, the German bund market is the next most important. It is the benchmark for European “riskless” rates.

The absurdly low yield of 0.13% is making all other asset class look “cheap”.

But pushing investors out the risk curve is not without risk.

And Two and Twenty articulated famed investor’s Stanley Druckenmiller’s argument better in 140 characters than Stanley did himself in a 30 minute speech.

This last argument explains why I think that in the coming years we are going to get an across the board monster correction (at least in real terms) of diversified portfolios. We are driving financial assets to prices that are guaranteed to disappoint.

Chinese Forex Reserves

I have been shocked at how long the Chinese government has resisted the temptation to unhinge the Renminbi to the US dollar. Due to the fact the Chinese has a soft peg to the US dollar, the recent dramatic US dollar strength has made the Chinese currency the second strongest currency over the past six months.

This Renminbi strength has caused the Chinese economy to flip from the government needing to sell Renminbi to keep the peg (buying foreign currency and selling local currency) to the exact opposite.

No wonder the Chinese economy keeps struggling. Financial conditions are too tight, and tying yourself to the strongest currency in the world seems to have more drawbacks than the Chinese ever bargained for…

US economic pause is getting more difficult to ignore

Speaking of strong currencies hurting your economy… The US economic data continues to disappoint. Yesterday retail sales came in lower than expected. This morning Empire Manufacturing blew chunks.

It is becoming increasingly obvious that the American economy is not immune to recent US dollar strength and the global economic slowdown of the past quarter. How long will the hawks at the Federal Reserve be able to ignore the weak data? Apart from some decent employment numbers, all other economic indicators are still screaming slow down.

The CitiBank economic surprise index which measures the difference between actual and forecasted economic releases is still mired in deeply negative territory for the US while the European index continues its stay in firmly positive territory.

The question to ask is whether the US economy will be able to readjust to the new higher US dollar and the lack of monetary expansion in the coming quarters. Or whether in this day and age of competitive stealth quantitative easing devaluations, the country that prints the least loses…

Thanks for reading,

Kevin Muir

the Macro Tourist