When the Log Rolls Over

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Emerging Markets (EMs) are highly fragile. This is due to the fact that usually when there’s a recession, capital flees, the currency melts, inflation increases and interest rates explode, choking businesses, and making the situation far worse than it would otherwise be. To fight this, the local Central Bank often aggressively raises rates, which defends the currency and reduces inflation, but often makes the economic situation even worse. Recessions are not kind to EMs.

You may ask why it is that interest rates climb during an EM crisis. It comes down to the fact that during a recession, the government’s fiscal situation worsens, deficits expand and frequently the government will resort to money printing to fill the gap, leading to accelerating inflation and a weakening currency. Even if the government in question tries austerity, the budget deficit expands so rapidly that investors still panic.

On the other hand, Developed Markets (DMs) have this unique privilege where during a recession, capital returns home and seeks out the perceived safety of government bonds. This reduction in interest rates, spurned on by the Central Bank, is a salve to corporates who can lower their funding costs and better survive the pullback in economic activity. Sure, DMs have widening deficits and excessive money printing, but the flow of inbound capital tends to overwhelm that, and the bond market rallies anyway. Meanwhile, the appreciation of the currency, allows the Central Bank to aggressively print money, almost without consequences, allowing for a fiscal response.

Of course, not every situation is the same, but these appear to be the rules, as best as the market understands them, and this rulebook has been in play for decades now. DMs do not realize how lucky they’ve been. 

In fact, this state of affairs is so well known, that traders tend to crowd into bonds when they suspect a recession is coming. During a market crash, many traders not only offset the decline in equity markets, but frequently make stupendous sums by leveraging their long positions in bonds. This Pavlovian response is now so well engrained, that in my opinion, duration is currently the most over-owned asset class amongst aggressive funds. 


I bring this all up as I worry that the playbook may have changed. What if during the next crisis, the US acts more like an EM than a DM? What if investors are spooked by 8% deficits during the boom, suggesting double-digit deficits during the downturn?? What if investors become disgusted by what I believe is rampant corruption, incompetence, nepotism and kleptomania at play in Washington?? Of course, our government has always cheated a bit—that’s not new—however the scale of the grifting has become unnerving. What if investors wonder about rule of law after we nationalized Russian yachts, cut off SWIFT and froze various assets of private citizens?? I don’t care if you hate Trump or not, the US had a long tradition of leaving past Presidents alone. Arresting your political opponents on dubious charges is almost emblematic of becoming an EM. Finally, what if investors now have other options, liquid options that can absorb capital and provide safety?? What if during the next time down, the US bond market rolls over, and acts more like Turkey’s bond market, instead of the US of old?? What is the financial outcome that would destroy the most speculators??? Probably this outcome.

A year ago, in my Fed Is Fuct series, I asked these questions out loud. I asked them because no one, except a few goldbug doomers, could even contemplate this possibility. At the time, I thought the risk was remote, but I was still troubled enough by the possibility that I wanted to put it out there. Today, I believe the odds are much higher that bonds roll over during the next crisis. In fact, bonds rolling over may actually initiate the next crisis.

Sure, the Fed will probably try yield curve control—they’ll utilize “Operation Twist.” However, I think this just accentuates the money printing and accelerates the inflation that’s leaning down on the bond market. Markets can be manipulated, but they yearn to be free. Zimbabwe couldn’t hold their bond market inline forever. Neither can we—markets are bigger than governments. 

Courtesy: Bloomberg

Real investors don’t trade TLT, that’s for retail. However, I’ve cued in on it as the $100 level seems so material. It’s bounced off of that level a few times now. However, TLT seems to slowly be leaking lower. Each bounce has less energy, simply less of a bid to it. TLT feels tired. I’m increasingly of the view that a clear break below $100 sets off the scenario I detailed above.

In the end, everything comes back to incentives. Seriously—who wants to lend this government money for 10 years and earn less than 4%?? Especially when deficits are running at nearly twice that rate and inflation appears to be structural, as opposed to cyclical. The buyers today, are buying because they think bonds rally during the next recession. If bonds keep leaking, these buyers all become sellers. Then, who’s left to buy?? At 6% on the 10-year, which sort of sounds inevitable to me, I think most CUSIPs die. What if the 10-year doesn’t stop at 6%?? What if it shoots through it and keeps on going??

What’s the proximate cause of this?? Could it be a rally in oil?? Inflation isn’t dead, it’s just obscured by the decline in oil. What about a political scandal?? If our leaders are corrupt like African leaders, we get African interest rates. What if another bailout is needed as banks, private equity, venture capital, real estate and every other sector that gorged on cheap credit suddenly seizes up, now that rates are slowly normalizing with historic US interest rates?? I can think of many scenarios that lead to the floor at $100 giving way. I’m not saying it’s inevitable, but I’m saying that if you aren’t terrified, you aren’t doing your job as a risk manager.

For me, I’ve taken exposure way down. There’s something about how TLT recently knocked on the door of $100 and only gingerly bounced back above it. There’s something about how everyone appears crowded into this same trade, often with obscene levels of leverage. There’s something about how the regional banking crisis doesn’t seem over. It seems to have barely even started. There’s something about how all sorts of non-traded assets are marked to model, yet it’s obvious that they’re impaired. Investors frequently suspend disbelief if their friends do the same, but they always panic together.

Once again, this isn’t my only roadmap, but it increasingly seems like the most likely one. Watch $100. If it gives, I feel pretty strongly that $2,000 on gold will also give. They’re tied together. If $100 gives, all I want to own is hard assets. Gold, uranium, land; assets that cannot be created easily—preferably assets that are gushing cash flow.

I genuinely worry that the next crisis, is one that no one here in Western Markets is prepared for. We all live, think, and invest as if we’re a DM. What if we’re an EM, but we haven’t realized it yet???

Disclosure: Funds that I control are long a whole lot of hard assets.


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