Unanswered Risks That Could Affect the Global Economy For a Long Time

It is an absolutely incredible possibility to contemplate. For all the wrong reasons, too. One of those kinds of occurrences which is so unusual there are no immediate answers for it. What does it mean? What can it mean?

Over the past few weeks people are suddenly bond watchers. Quite regrettably ignoring curves (of all sorts) most of the time, once the 10-year US Treasury yield was pushed underneath the 2-year’s the world finally began paying attention to the space. As everyone is apparently aware, curve inversion means the dreaded recessionary signal.

That’s not the one I’m writing about, though. There is another curve right now whereby the 10s and 2s are in close collision: Japan. Unlike the US Treasury market, the JGB market doesn’t hold to such easy interpretation where inversion is concerned. Maybe that’s because Japan has been stuck in a recession-like existence for the past three decades.

And it has been all that time in between since its curve had done something like this. You have to go back almost thirty years to 1991 to find the last instance of the 2s10s flipping. Over the decades since, the curve had steepened out to as much as +267 bps in 1995 during those more hopeful early days of Bank of Japan “experimentation” and had been as flat as +6 bps just a few years ago in June 2016 (Euro$ #3).

In the past week, it has distorted to just +2 bps; intraday on some days to even less. Furthermore, this flattening has taken place at close to record negative yields at the longer end. It would be truly uncharted territory.

But if inversion for the UST 2s10s is a sign of market expectations toward US recession, certainly an inversion for the JGB 2s10s cannot be the same for Japan. First, there have been several official cycle declarations over the years without an inverted JGB curve. If it happens over the coming weeks maybe days, it would be breaking new ground that was just missed the last time around (2016).

To search for some answers, we should probably start in Argentina of all places. For several years, this one South American country had been the world’s darling, the financial Cinderella finally given the chance for invitation to the mainstream monetary ball. As I wrote last May, the nation’s fiscal chief was becoming famous more for his roadshows:

"Argentina’s finance minister Luis Caputo has been the world’s most visible bond salesman, so much so it’s a surefire guarantee that he has a bright future ahead on Wall Street however this all works out in South America. He even went so far as to successfully complete an underwriting for $2.75 billion of 100-year bonds in June last year [2017]. The coupon was just 7.1%."

During the passing fad of globally synchronized growth, for many emerging market economies the trend was taken seriously and at face value. This time would be different, everyone was told to believe. The idea was firmly planted by officials throughout the world who kept claiming it was.

The fact that all the world’s big economies were finally growing again and for once at the same time was supposed to have been a profound change. Some kind of invisible synergy, I guess; who knows what kind because it was never really specified. Desperate for any kind of signal, synchronized was what they came up with to try to sell eventual success.

As the dollar rose and everything turned around in 2018, globally synchronized growth meekly dissolving like powder on a wet surface, Argentina was the first in line for execution from the monetary firing squad. Its currency plummeted with dire consequences.

Hold on, loudly proclaimed the IMF. Having seen what had happened just a few years before officials within the organization attempted to use Argentina to build a firewall of sorts. To defend the rest of the world’s most vulnerable systems from the growing negative dollar wave, the organization’s director Christine Lagarde would plant her flag here and defend it no matter what.

Reaching an agreement in June 2018, the IMF would commit to the largest bailout in its history (initially $50 billion, or 1110% of Argentina’s quota). In exchange, the reforms internally would be sweeping. This was supposed to be a model for handling the new and more insidious dangers of a post-2011 dollar world.

Upon signing the agreement(s), Lagarde announced:

“I am pleased that we can contribute to this effort by providing our financial support, which will bolster market confidence, allowing the authorities time to address a range of long-standing vulnerabilities.”

The original bailout plan bought local government officials less than three months. By the end of August 2018, the Argentines were begging the IMF for more – which they received last September. Adding another $7 billion to the rescue pile, and speeding up the release of tranches from the original, Lagarde’s group also got creative with the peso, setting up a moving non-intervention zone (the details of which are immaterial at this point, the plan was scrapped several months ago).

It has been the currency around which all this trouble revolves. Devaluation is thought to be a good thing when it is intentional policy (and that’s dubious). When uncontrolled, everyone knows the disaster it will bring.

The IMF really tried hard to make Argentina work. It was a very public effort, too, simply because they thought it would work out favorably. Lagarde meant to parade around the success story, her point about “bolster market confidence” meant a hell of a lot more than this one small country in South America. The stakes were, and remain, far, far bigger.

And, as you may have heard, it blew up in their face. The largest national bailout in history barely registered on the peso – long before recent elections. The flipside of the falling Argentine currency is, of course, the rising dollar.

I am often reminded of what one long ago New York Times article had noticed about the monetary system back when Britain’s pound was in crisis. At around the same time Japan’s JGB curve was last emerging from inversion, in 1992, a (very) few people had recognized just how the world had changed and in which direction the balance of power had (permanently) shifted.

“The world’s currency markets, it seems, are no longer governed by central bankers in Washington and Bonn, but by traders and investors in Tokyo, London and New York, as the chaos in the currency markets this past week has shown.”

What are the implications of such a statement? Central bankers and even the mighty IMF would effectively become powerless once the market – meaning dollar - gets moving. While very few understood the notion in 1992, it only gained a little more awareness in 2008 at its fullest display. The idea that central banks and official institutions are at the center of the global system remains despite all the evidence otherwise, evidence that continues to pile up in the present day.

With regard to specifically Argentina, in June 2019, one year after the historic agreement, Christine Lagarde finally admitted:

“The Argentine economic situation has proved to be incredibly complicated and I dare say that many of those involved, including us, underestimated a bit, when we started with the Argentine authorities building the program.”

Underestimated, maybe, but only “a bit.” Sure. How contrite and honest.

After leading such stunning failure, how has Christine Lagarde personally fared? She has quite naturally failed upward, promoted to now President-elect of the European Central Bank, on tap to replace Mario Draghi in just a few months.

Draghi’s retirement looms at a crucial point, too. Coming full circle, he had initially supplanted Jean-Claude Trichet at the end of 2011 just as Europe’s last big crisis was coming into full view. Trichet had made the idiotic mistake of acting on his overconfidence; earlier in 2011, he pushed the ECB into not one but two rate hikes just as everything was beginning to fall apart.

No more obvious disconnect between fantasy (forecasts) and reality, he was quietly retired and Jean-Claude left it for Mario Draghi to come in with guns blazing, offering up massive LTRO’s and then in the summer of 2012 his infamous “promise” to save the euro; to do whatever it takes.

Instead, the euro is under greater threat today than it had been at any other time including 2012. Draghi believed that it was overspending Club Med which could unwind the monetary union, and so he effectively bailed out the PIIGS with various buying and guarantee schemes. Interest rates fell for those countries.

What endangers the euro now isn’t overly profligate governments and sky-high interest costs. It is the political disassociation which is gaining throughout the Continent. Populists and anti-Brussels sentiment are growing and have become viable political forces; a real alternative to the status quo.

In the recent past, these were dismissed as some form of -ism, a lack of legitimate basis underneath driving their popularity. That was the other part of globally synchronized growth. Had it been real and had the world really been on the cusp of a true economic breakout it would’ve exposed the populists for what they supposedly were (in the official estimation). Economic growth would’ve totally undercut the rationale for dissent in more than just Europe.

Everyone would’ve seen the haters as just haters.

Mario Draghi then repeated Trichet’s big mistake. The former never did get as far as rate hikes like the latter but he did spend all of 2018 and the first parts of 2019 loudly preparing Europe for them – only to have the same humiliation forced upon him. Just when he believed he had succeeded, and told everyone he had, it totally went the opposite way.

He has since been turned all the way around and at the ECB meeting next week it is widely anticipated Draghi’s final act in office will be to restart QE and take interest rates even lower than they already are. Rather than rate hikes, Draghi will leave for Lagarde a total mess and in all probability even more NIRP.

It is one thing for Argentina to be Argentina; it’s easy to dismiss their struggles as nothing more than returning to type. The country, many believe, is always a basket case so mean reversion there simply means just that.

A virulently turbulent Europe, though, that’s another matter entirely. Not only are there economic and financial considerations, the politics are perhaps the greatest risk of all. Maybe the populists do have a point underneath everything. Not for nothing, but Draghi said growth, growth, growth, and now when it was supposed to have finally arrived Europe is right back into the same mess all over again.

It never ends.

Fresh off her blunt Argentinian fiasco, Christine Lagarde confessed to Europeans this week how she “is not a fairy.” Evidently mindful of the volatile situation she is walking into, before even taking office the next ECB President is all over the media forcefully urging closer fiscal union. The ECB, she says, has done all it can – you aren’t supposed to realize how that is well short of what was constantly advertised.

In other words, they’ve tried the monetary stuff in order to live up to Draghi’s promise but it just hasn’t worked out well enough (or at all, if you are being honest).

“It’s a majority of countries in the euro area. There is clearly co-operation to be had if all the institutions in Europe, and the eurozone in particular, want to respond to the threat of populism.”

Lagarde said places like Germany and the Netherlands, the prudent and frugal North, have “the capacity to use the fiscal space available to them” to hopefully soften the blow of possible looming economic contraction, one that would arise without Europe having yet recovered from the last two. The political situation already volatile, what happens if another recession follows in the place where recovery should have been?

Whatever one might think of the basis behind each populist outbreak and its individual takes on what passes for solutions, you can see her point. Until now, economic dissatisfaction had been more of a nebulous feeling of intangible and hard-to-grasp wrongness. Give it a bump in unemployment and some (more) negative GDP numbers splashed across the internet and the populist case becomes almost too easy.

What must the angry class of Europeans think? This is “their” big solution, the establishment will reward and promote the person who has been the face of the biggest financial disaster in the IMF’s history. And her first semi-official act is to, channeling fictional Amity Island’s fictional police chief Martin Brody, recoil in horror at the size and danger of the economic shark circling their shared vessel and plead with European authorities for a bigger boat.

The world is facing all the same problems all over again – and it is becoming clearer and clearer that officials have no answers for them. Even the layperson who has been taught from Day 1 that central banks have all the monetary and brain power ever required can more readily see the myth being exposed.

The populists at least have a limited point, and it’s the one that is getting them all the votes; rather than cycling through one faceless, incompetent official after another they think about and talk about ripping things up, at the absolute minimum at least starting over with a totally new set of them. Lagarde doesn’t have any answers and yet, somehow, she will be the person all of Europe will turn to on the eve of another economic outbreak.

It’s not just Europe, though, is it? These questions are being asked all over the world. Way outside of Argentina, places like Brazil, India, and even Hong Kong. America’s forthcoming Presidential Election. Breakdowns in political alignments and social disruptions, these are becoming more commonplace. The rhetoric ever more extreme as are the intentions behind the words.

The risks are not purely economic nor financial anymore. These haven’t abated, of course, unanswered they’ve been allowed to grow and become serious structural doubts fueling more than just dreaded populism. Big risks and very big things at stake. The sort of implied consequences that could materially affect the entire world for a long time to come.

Japan’s flirtation with a negative-yield curve inversion in all likelihood has little or nothing to do with recession risk in Japan.