Written by Neil Maedel,
Mountains of debt and the leverage that goes with it can make economic life increasingly precarious. Last April’s short-lived rise in America’s benchmark Fed Fund’s rate (to 2.4%) on the tail end of a year of quantitative tightening, was enough to send stock markets’ plunging globally, and in response, America’s Federal Reserve back peddling on its planned interest rate rises. This time, the latest threat to global solvency, the Covid-19 pandemic, has no fast or easy solutions. The pandemic is rolling around the world like a hurricane, leaving devastated economies in its wake. Wuhan, China was where it all began. The city’s local officials botched the response, were sacked and replaced by President Xi Jinping’s hand picked cadre’s. Xi promptly ordered the People’s Liberation Army be brought in to handle the growing epidemic. In total more than 60,000 civilian and military medical staff were assembled to fight Covid-19 in Wuhan and its neighboring cities. In a can-do bureaucratic recovery, rarely seen elsewhere, two 1,000 bed hospitals were built and staffed in as many weeks.
At the same time 100s of millions of Chinese were subject to travel and quarantine restrictions to ensure the virus did not spread. In total 81,250 were reported infected and 3,133 died until March 19th, first day when no new local cases were reported. Many health experts initially criticized the countrywide restrictions as excessive and unnecessary, but have since changed their tune. Newspaper, Jing Daily claims China’s economic deep-freeze is over. Though the rate of recovery varies across China, Jing Daily reports Industrial centers such as Shenzen have 80% of their factories operating, albeit at a rate that is far from capacity, restaurants starting to take customers in most cities, and the partial reopening of Shanghai’s Disney. As he shuts stores in the US, Starbucks CEO Kevin Johnson, says more than 90 percentage of the coffee chain’s 4500 stores in China have resumed business. Volvo reports shuttering its plants in Europe and America but says business in China is back to normal. Car sales are anything but, having plunged 79 percent in February – the largest decline in history.
For Western economies the pandemic, Italy and Spain excepted, is only just making landfall. Few are prepared, none less so the the US. Until a few weeks ago America’s President Trump was calling the pandemic a democratic hoax. More recently, in a NPR led poll, 38% of America’s said they considered the outbreak to be “blown out of proportion”. The country’s testing program is only just getting underway and if you get really sick with the virus (and have health insurance) there are only 2 ICU beds per thousand people compared to Japan and Germany’s 6. The virus by now is widely spread and firmly entrenched.
In financial terms, corporate America shares the same lack of readiness. Company debt in the US reached a record high of US $10 trillion last November. US$1.9 trillion is concentrated in the energy sector where, with oil prices below US$30 a barrel, few wells are economic. A third of the debt consists of BBB rated bonds, the lowest investable grade. Adverse changes in business conditions, like a sudden collapse in energy prices reduce revenues. If negative enough the bonds get downgraded to junk status, a rating which compels their sale by institutions that are restricted to owning investment grade securities. With virtually all economic indicators are flashing red – The Empire State Manufacturing Index just collapsed from +12.9 to – 21.5 its largest drop, ever – many are not waiting for a down-grade, and are selling now.
Global Debt Bubble
The US is not alone, low interest rates have fueled a global debt binge. The Institute of International Finance, calculates that the amount companies owe banks and other creditors totals $75 trillion globally – the highest in history. In 2018 the International Monetary Fund released a study which outlined the marked deterioration in the ability of many companies in the US, China and 6 EU countries to service their debts. It warned that in the event of a slowdown only half the severity of the GFC, the unserviceable debt would increase to US$19 trillion or “almost 40% of the total debt of enterprises in the countries” reviewed. A study by Factset shows that 17% of the world’s 45,000 public companies did not earn enough to cover interest costs for at least the past three years. Bank for International Settlement’s economists, using the Worldscope database covering 32,000 companies and similar but narrower definition, finds that the world’s share of companies unable to service their debt from income has risen to 12%. And these are pre-pandemic numbers.
Pandemic Deep Freeze
As the world’s respective economies go into a pandemic deep freeze, these zombies will be joined by a global tsunami of heavily indebted companies who will also be technically insolvent,. Last week’s waves of selling of almost every equity and bond with a bid is a consequence of failed risk parity strategies, deleveraging of relative value trades, and Investor’s growing recognition of rocketing insolvency and counter-party risks.
US Dollar’s Perfect Storm
As both bonds and equities plunged a feedback loop occurred which helped drive US dollar exchange rates higher. Foreign holders of US debt or high dividend equities often hedge the dollar value of their investments. The higher the dollar value of these investments, the more US dollars they hedge by selling short dollars. When the value of these investments declines, the dollar hedge positions are reduced, ultimately by purchasing back the US dollars sold short in the original hedge. This dollar buying to unwind currency hedges is among the factors at play when US equity or debt markets are plunging and the dollar exchange rate spikes.
US dollar denominated debt overseas can also act like a giant, synthetic short position which is just waiting to be squeezed. According to the OECD it totals US$13.5 trillion – in real terms, twice what was outstanding in 2008. Of this amount, US$3 trillion consists of corporate loans in emerging markets whose economies are heavily dependent on commodities or Tourism and thus they are among the most at risk. Imploding bond markets and devalued currencies will make refinancing these debts a real challenge for all borrowers. This year a record US$1.3 trillion is due for repayment, followed by a further US$2.9 trillion in 2021 and US$4.4 trillion in 2022. It just gets worse.
Adding to this $13.5 trillion, is a mountain of additional USD liabilities which exist in the form of ILOCs (irrevocable letters of credit). They sit on on bank balance sheets globally like little monetary landmines that are not counted until used. How much? No one knows for sure. Given that 80%of world trade is in USD, it cannot be a small amount. The activation of ILOCs, and the payment of other USD based transactions such as interest on US denominated debt can translate to a need for more dollars than a corporation has on deposit. When this happens the needed dollars are borrowed in the US dollar swap market. But as currently the case, there is not always a ready counterparties to supply dollars on the other side.
The first tremor
Last September a dearth of short term lenders in the repo market drove overnight rates from 2% to 10%, forcing the Federal Reserve to step in and begin expanding its balance sheet by providing cash. (repos are sale and repurchase agreements, usually for a government security which are exchanged on a short-term basis in return for cash.) The dislocation also spilled over into US $3.2 Trillion (daily) swap market sending the premium to borrow dollars overseas shooting higher. The repo – swap crisis exposed a dangerous market dislocation which many attribute to more stringent post-GFC bank capital reserve requirements which limit US banks’ ability to provide cash bids and act as market makers for either market. At the same time the coming pandemic prompted many companies to draw down their lines of credit as Boeing just did to the tune of $13.8 billion. Like a run on a bank by depositors, if enough companies use their credit lines all at once they will impair the bank’s capital ratio and compromise the bank’s other capital-requiring activities. In this way the banks may have been kept largely from the repo and swap markets.
The crisis also highlighted the role of relative value hedge funds such as Capula Investments and Millennium Management in changing the market dynamic as they buy treasuries and sell equivalent derivative contracts such as interest rate futures, against them. As Zoltan Pozsar at Credit Suisse describes it, “since the financial crisis, non-banks eclipsed banks as the biggest borrowers in the FX swap market: a hallmark theme of the post-QE global financial order has been the secular growth of FX hedged fixed income and credit portfolios at non-bank institutions like life insurers and asset managers – the new shadow banking system epitomized by money market funding (FX swaps) of capital market lending (Treasuries and credit).” To leverage up these trades they use the same treasury to secure a cash loan in the repo market. To add further leverage they then take the borrowed cash and buy another treasury, sell more contracts against the new treasury and then repeat the process. According to an IMF study, on average, the same Treasury will be re-hypothecated 2.2 times, that is one real owner and 2.2 users.
In reality no one really knows how much double and triple accounting really takes place – at least maybe until there is a cash shortage or a hedge fund blows up. The relative value players often generate as much as five times the IMF’s average leverage. Given the undersubscribed plus $1trillion dollar daily repo funds the Fed has begun providing, Fed Chairman Jerome Powell may be trying to limit what is an unknowable quantity of forced deleveraging in this part of the market. The key takeaway is that even the regulators really do not know the extent of the leverage in either the repo or swap markets. According to Christopher Giancarlo, the former Chairman of the Commodity Trading and Futures Commission “it is impossible to record and know counter-party risks and have visibility of cleared and uncleared swaps globally”. To counter this dangerous reality (and react to the US dollar exchange rate spike) the Fed has re-opened US dollar swap lines with the virtually all major central banks except China and Russia. These other central banks will then be in a position to loan US dollars to their respective domestic banks and other institutions. When Banks and other institutions can’t supply liquidity to the repo or swap market, which seems to be the new normal, the Fed will supply dollars along these new swap lines, just as it did during the Global Financial Crisis. The days of acting as a lender of the last resort solely to banks, however, are long gone. The Fed in short is likely to be forced to provide a floor for everything from commercial paper to corporate bonds and stocks if we are to avoid a complete collapse.
The dollar shortage and the unknowable amounts of leverage employed in global financial markets are not, however, the only issues the Covin-19 pandemic is bringing to a head. The number of companies unable to service their debts and pay their employees is about to go ballistic in each country where the virus takes root. Pick a sector. Airlines, trucking construction, real estate, banking, they are all going down. The wave of selling in global markets is a rational response to the approaching pandemic and the debt implosion in its wake.
As the world’s defacto central bank, the Federal Reserve’s support buys time for governments’ to enact multi-trillion dollar fiscal rescue and support lifelines to both industry and the public. Both Credit Suisse’s Zoltan Pzsar and Bank of America’s Marc Cabana expect the Fed will need to provide a no-limits backstop to virtually the entire capital market. Goldman Sachs predicts unemployment will spike by 2 million in the next quarter and is predicting a depression-like -24% crash in Q2 GDP , Morgan Stanley estimates -30% while St. Louis Fed president James Bullard says the worst case scenario is -50%. Bank of America expects unemployment to reach 3 million by next week. Steve Mnuchin the country’s Treasury Secretary warns that unemployment could rise to 20% or 32 million people. According to the Brookings Institute, America’s most vulnerable are its 53 million low wage workers, with a median wage of US$10.22, 70% of which have no paid sick leave and too many no medical insurance. For this cohort, even a US$400 emergency is unaffordable and the potential loss of income is near-catastrophic. A saving grace is that they also are a significant voting block with an the election is only months away.
Helicopter Money Isn’t coming – its here
The Economist estimates that “America, Germany, Britain, France and Italy, including spending pledges, tax cuts, central-bank cash injections and loan guarantees, amounts to US$7.4 trillion, or 23% of their GDP”. This before the UK’s announcement of an additional program which will pay 80% of employee wages – the equivalent of almost US$3,000 per month. Germany’s government also just announced it is planning a €356 billion stimulus program. After his incoherent handling of the pandemic thus far, president Trump he has a lot to make up for if he is going to get re-elected. The White House backed package being debated totals US$2 billion, which includes one time cash payments to taxpayers of up to US$1200. Democrats have so far rejected it principally because US$500 billion of the bailout funds can be used aiding companies at the discretion of the Whitehouse with no disclosure for up to 6 months – timing which could allow any of Trump’s more awkward beneficiaries to be kept secret until after the November election.
Both Republican’s and Democrats want to own the rescue program so will be trying to outdo each other. It all adds up to a global tidal wave of fiscal spending and debt monetization. The effect of the Trump stimulus on America’s debt and deficit is summarized by The Washington Examiner. “Given that the 2020 deficit was already expected to top US$1 trillion at a time when unemployment was forecast to be less than 4% and the economy was expected to grow, it could easily exceed $3 trillion and possibly approach $4 trillion when all is said and done.” This would expand the deficit to from around 5% of GDP to between 15% and 20% of GDP the highest since WWII. If correct the US Federal debt will exceed US$25 trillion as early as next year, just as the Federal Reserve expands its balance sheet by several trillion in order to accommodate its support for the financial markets and the treasuries need to sell debt into the market.
The Never Ending Story
Where does this end. We know from experience neither debt nor ballooning balance sheets are ever reduced. Representative Rashida Talib has proposed one way to avoid accelerating the Federal debt increases with her ‘Automatic Boost to Communities Act’ which she has submitted to Congress. The proposal uses the The Treasury’s legal authority to issue coinage by having it instruct the US Mint to issue two US$1 trillion dollar coins. Congress would subsequently direct the Federal Reserve to buy these coins at full face value. Talib then proposes that the treasury automatically transfer the proceeds to the Bureau of the Fiscal Service which would issue pre-paid debit cards for the payment of US$2000 for the the first month and then $1,000 per American citizen per month thereafter. It sounds wacky and excessive, but recall that Germany is already enacting a program on a more selective basis that pays employees up to the equivalent of US$3,000 per month and the latest White House rescue program also has a US$2 trillion price tag. Whether it is two coins, or 10 year treasuries with a minuscule yield (which the Fed ends up buying), few believe the money will ever be paid back. So in some form Talib’s proposal may yet become a reality.
The global slowdown increases the default risk for the US$13.5 trillion worth of US dollar denominated debt. Any bond holders selling this debt in return receive US dollars, thus adding to foreign exchange dollar demand. At the same time the more the USD goes up, the less money is available to these countries domestically, as they struggle to earn local currency to pay their foreign dollar debts. In effect the dollar strength tightens the money supply and reduces economic growth in their respective economies.
According to the Bureau of Economic Analysis the US is a net debtor to the rest of the world to the tune of negative US$11 trillion. Its total liabilities reached US$39 trillion in the third quarter of 2019 against overseas assets of US$28.26 trillion. Part of its liabilities consist of US$7 trillion worth of US treasuries. China owns US$1.07 trillion of this amount providing it with a convenient source of dollars should the roughly US$500 billion worth of dollar denominated Chinese debt require it. Japan is the largest foreign holder of US treasuries and Japanese companies on average have almost no debt and instead cash reserves equalling 130% of GDP. The average for the S&P 500 is14%. (And if not for a handful of tech companies like Apple and Alphabet, it would be a lot lower.) With little foreign debt and instead a mountain of foreign investments the Japanese yen, while volatile has been among the least effected. Its dollar exchange rate is basically where it was a month ago.
Few Want a Strong Dollar
The risk for the US is that if the dollar rally persists foreign investors will start selling some of their debt securities while eschewing new treasury issues and looking for alternatives to dollar-based finance. At the same time American exports will become increasing uncompetitive just as the high dollar reduces offshore income which is about 40% of S&P 500 earnings. The Federal Reserve knows this and has been frantically opening up swap lines globally to ensure dollars are where they are needed. The Fed must keep flooding the market with dollars to put an end to the dollar short squeeze as it clearly is not in America’s (or the world’s) interests.
At the same time the prospect of multi-trillion dollar deficits and the total debt reaching 30 trillion in two or three years is unlikely to make treasuries an attractive investment for foreign investors. The fact that the entire planet is abandoning fiscal restraint will make raising new debt very difficult. The fiscal spending is mostly on the demand side which given that people are prevented from working and producing can only be inflationary.
From all this we can make the following observations
- The Covid-19 pandemic is going to be shutting down economic growth globally at least until this fall. China’s experience shows us there will be a recovery for global economies and markets and we should plan accordingly;
- Counter-party and systemic risk is significant and rising in part because of Covid related solvency risks and in part because a lack of oversight has left regulators in the dark regarding what derivative, ILOC, swap and other financial instrument leverage is and consequent liabilities are. The Fed just demonstrated this when it made available US$500 billion for the repo market and yet only US$89 billion was taken. ‘They had no idea what the demand would be’. Former CTFC Chairman Christopher Giancarlo spells this out regarding the swap market. This reality makes a core holding of gold bullion all the more important because physical gold has no counter party risk;
- There will be no end to quantitative easing, and fiscal spending growth. The Fed’s action is a lifeline to imploding markets but not a solution. The US Federal Reserve tried quantitative tightening during 2018-19 and nearly blew up the market doing so. Covid-19 is doing the job for them this year and the only palatable option is massive Fiscal spending and QE as is happening. Not spending enough risks a global deflationary collapse. But the rescue packages increase global debt further at a rate far greater than economic growth making the problem worse;
- During the 2008 crisis it was a banking crisis and there was no plumbing to transmit the Fed balance sheet expansion to consumers. This time there is via government spending. A central bank that has lost control of its balance sheet growth in order to be a buyer of last resort for virtually all financial instruments including government treasuries, makes looking for alternative unrelated assets imperative. When it is effectively the world’s Central bank, and much of the balance sheet expansion is going directly to consumers it can only be bullish for gold prices;
- Developed nations will let their economies run hot – inflation will be allowed to tick up, we have already seen what happens when interest rates are increased – there is too much debt and leverage to allow interest rates to rise appreciably, consequently the next cycle will be of growing inflation and financial repression, save a debt holiday. Because this is the only manageable solution, inflation and a negative interest rate environment which devalues debt, makes gold an exceptional option for wealth preservation;
- Gold’s sell-off in all likelihood occurred as a consequence of forced sales to meet margin calls from collapsing risk assets and leveraged ETFs. Crescat Capital described part of what occurred in its note ‘Blood in the streets’ to quote: “The chief culprit in the ETF space last week was the US$3 billion leveraged assets, Direxion Daily Jr. Gold Bull 3x ETF. It absolutely imploded, dropping 95% through last Friday from its recent high on February 21”. I would describe It as a case of selling what one ‘can’ rather than what one ‘should’. In reality with a current price of $1500, gold is only 11.76% off its $1700 high.” When the dust settles gold has every reason to resume its longterm bull market and the sell off in gold stocks and gold is likely an exceptional buying opportunity;
- Avoid leverage, the order of risk exposure begins with gold bullion, and works its way down from gold ETFs such as GLD, royalty companies such as Royal Gold and Franco Nevada, and then senior Gold producers such as Barrick, Newmont and Anglo Gold Ashanti, to the mid caps such as Agnico Eagle and so on;
- It’s a complicated story with many moving parts and I have touched on just a few of them. The key at this early stage of the gold bull market is to stick with bullion, gold producers and with risk capital achieve much greater upside potential by investing in company’s you are confident can go into production in the near future.
My Personal Project
Since I began my career as a floor trader in the late 1970s and later founded Zurich, Switzerland Based Protrader Finanz AG and the ProTrader publication, I have found some of the most profitable investments were companies’ that we’re working to develop into producing mines already known lower grade gold deposits that had been ignored because of low gold prices. The change in gold prices made these deposits prolific cash generators. In these cases there was a lot of data available so it was a lot more calculating and a lot less speculating and the difference in share price between when they were designing the mine development and eventual financing and operations, shall we say, was not small…
This is what I am doing with Sonoro Metals Corp. Sonoro has acquired a cornerstone gold asset with significant revenue and growth potential. To develop the project it has recruited some of the regions’ most accomplished gold mine developers who have already developed gold deposits in its area that are like it. Sonoro’s proposed pilot heap leach operation has been vetted by technical teams from EPC companies in China and they have informed us it has been approved as a project they would be willing to develop.
These companies are currently finalizing detailed proposals regarding the project’s debt financing, development and operation. Progress has been delayed because of Covid-19 but as you can see China is the first to begin recovering and we are in constant contact so it is only a matter of time. Going from a known gold resource to a gold and cash flow producing company has its risks and hurdles but In my decades of experience I have found it is an exceptional way to leverage the rising price of gold. We have more projects in the pipeline to keep growing the company and intend in a few short years to make it an exceptional success story.