Living on the Edge

2019, the tipping point for the world economy? China’s growth is slowing; debt is pushing towards a level of 2.5 times the size of its economy.  After 40 years of fabulous growth, fuelled to a large extent by private companies, the state is re-asserting control with appointments of government officials to the boards of up to 70 per cent of private companies.

The grip of President Xi and the Communist Party are being revealed. The stealthy theft of technology is being analysed in Western media together with the state-funded insertion of Chinese nationals into the world’s premier educational establishments; the use of high-tech companies to further China’s intelligence gathering, and the unjustified detention of up to 1.5 million Muslims. China is burdened with debt, fighting a trade war with the US and its currency fell by 15 per cent in 2018.

Europe is staring at a potential recession as the ECB mistimes its closure of its quantitative easing programme at a time when:

  • Lay-offs in Germany continue and its slowing growth moves its economy into recession;
  • Debt-ridden Italy seeks to refinance and the ECB is the only substantial source of debt funding;
  • France has lowered its economic growth forecast and rolled back tax programmes following the ‘Yellow-Vest’ protests, increasing its budget deficit;
  • Spain is increasing its minimum wage by 22 per cent to fight austerity;
  • The UK leaves the EU.

All of this has been exacerbated by interest rate rises in the United States. This has focused attention on $1.3 trillion of ‘leveraged loans’ – the type of loans that caused the last financial crisis, which are now far in excess of that seen in 2008.

Two months ago, former head of the Federal Reserve, Janet Yellen, warned it was an accident waiting to happen. Things at home in the UK are volatile. When the prime minister, Theresa May, announced on 10 December that she was ditching her vote on Brexit, the pound dropped two per cent against the dollar to $1.25, its lowest level since April 2017.

Before May’s announcement, commentators said that the loss of the vote was priced into the value of sterling. A huge part of the currency market is in futures. These are deals to exchange currency in the future and they are related to the much-reported spot rate (that quoted for a trade today) by the differential in interest rates.

For instance, let’s say you get five per cent on your money in the USA and only one per cent in the UK. Institutions will sell their pounds for dollars so they can get more interest. Sometimes traders follow a higher-risk strategy and will borrow pounds, exchange it into dollars and then deposit the dollars for the higher interest.

To reduce risk, at the date at which their pound borrowing is due for repayment, they may have entered into a ‘forward contract’ so that they can exchange their dollars for pounds and repay the loan. This is called ‘covered interest arbitrage’ and these trades have a big role in setting future exchange rates.

As of December, interest rates on government bonds are:

The negative rates in Germany and France come about as investors (lenders) pay more for a bond than they get back at maturity and this premium is not made up by interest, resulting in a negative yield. Because of the much lower rates in the UK, the weakness of sterling is, in part, a foregone conclusion. Comments earlier in 2018, about the continued potential for dollar strength and sterling weakness have been accurate.

The prime minister’s handling of Brexit has only served to further weaken sterling. While the turbulence in exchange rates is affected by Brexit, the European Central Bank’s closing of its quantitative easing programme has made this worse. It is difficult to see that these two events could come at a worse time. A few days before the remarkable in-fighting in Parliament, across the Atlantic, the US financial markets gave a signal that the US would plunge into recession within 12 months.

The US stock market plunged two per cent and there was a worldwide sell-off of equity stocks. This signal, a move towards a ‘reverse yield curve’, has predicted every downturn in the last 40 years. Despite a number of false alarms, it is ‘accepted’ by many as an accurate soothsayer. Let me explain why.

As you know, the yield on a bond is the interest it pays divided by the price you paid for the bond. If you paid $100 for the bond and received $5 in annual interest, the yield is five per cent. Normally, if a two-year bond paid five per cent, a five-year bond would pay more to compensate the lender (the buyer of the bond) for having taken on more risk just because his money is lent for a longer period of time. Similarly, a 10-year bond would yield still more. The bond investor has to forgo the use of their money for a longer period of time and will do so only if they can get a greater reward to compensate for the fact that, over time, stuff happens and it isn’t always positive.

If you plotted these yields with rates on the vertical axis and maturity on the horizontal axis, the curve would rise from left to right, with time. A reverse yield curve is one that slopes down, from left to right. It suggests that people are more concerned about the future, perhaps expecting lower inflation, slower growth and maybe a cut in Bank Rate or Prime Rate, as it is called in the US.

The US rates in the first full week in December flattened the yield curve. As can be seen from the table above, it has ‘recovered’ slightly, but there is a real worry that the US economy will run out of steam by 2020 and that the positive impact of Trump’s new tax regime will be finished in 2019. Following the December 0.25 per cent rise to a prime rate of 2.5 per cent, at least the US has interest rates to cut.

In Europe, with negative rates in Germany and France, there is no room to manoeuvre. Has the economic cycle turned? If so, neither the US nor China’s economy would seem likely to have the future substantial economic growth to bail Europe out of its problems. On top of all this, clearing houses of derivative instruments are vulnerable in times of stress.

The Bank for International Settlements (BIS) gave a warning that these clearing houses could cause a “destabilising feedback loop, amplifying stress.” It is believed that perhaps regulators have unwittingly made the financial structure more, not less, dangerous. In September, the Scandinavian Counterparty NASDAQ clearing house AB came close to meltdown and the BIS worries that it is a foretaste of things to come.

To put this in perspective, the notional value of the derivatives cleared worldwide is 4.4 times total world output (GDP) up from 2.8 times at the last financial crash in 2008. One bank has a position that is 1.5 times the size of the US economy.  If something goes over the edge here, it won’t be recession that will be the worry of 2019.

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