Regular readers of Gold Goats ‘n Guns know that I’ve been handicapping a major sovereign debt default to begin here in 2018 or early 2019. But, what do I mean by that?
How does a sovereign debt default come about? And who will default?
There are a staggering number of factors that feed into this thesis but, for me, to keep it simple it comes down to five important trends coming to a head at the same time.
I call them the Five Pillars.
#1 Massive Foreign Corporate Debt
After ten years of ‘experimental monetary policy’ which drove borrowing costs in U.S dollars down to record lows, foreign companies still reeling from the after-effects of the 2008 financial crisis borrowed trillions of dollars to fund the global expansion of the past few years.
That debt pays investors in US dollars.
But, foreign companies tend to book revenue in their local currency.
A falling local currency makes dollar-denominated debt more expensive to pay off.
This leads to the next Pillar…
#2 Quantitative Tightening.
QT is simply the opposite of QE, Quantitative Easing. QE expanded the stock of dollars. QT is contracting it. This is what is fueling a rising U.S. dollar. This, in turn, is making it harder for foreign companies to keep up with their bond payments.
They are forced to sell, aggressively, their local currency and buy dollars in the open market.
This is why the Turkish Lira is in serious trouble, for example.
That puts pressure on the country’s sovereign bond market. Since a falling currency lowers the real rate of return on the bond.
Falling currency, falling bonds, Turkey will put on capital controls next.
This feeds into the next Pillar…
#3 Political Unrest in Europe and Emerging Markets
Smaller markets are more vulnerable to runs on their currencies because they already are considered high-risk investments. Hot money chasing easy profits goes in and comes out just as quickly when policy changes.
But, what I’m handicapping isn’t another Asian Crisis like 1998 where Russia and Thailand were the epicenters of default.
No, today, what’s happening in Turkey is a taste of what is happening in the European Union. Political unrest is everywhere. The U.K. over Brexit Betrayal. Germany and Italy over Migrants. Poland and Hungary are challenging EU authority over what’s left of their sovereignty.
Spain still has a couple of secessionist movements simmering below the headlines.
Confidence in national institutions’ ability to weather these storms is what drives investor decisions. Right now, the European Central Bank still has some credibility with investors, who believe Mario Draghi when he says he will do whatever it takes to safeguard the euro.
But, what happens when Draghi is looked at the same way as President Erdogan in Turkey?
The same thing that is happening in Turkey.
Which leads to the next Pillar …
#4 Trade Wars and Tariffs
President Trump is trying to remake the now obsolete post-WWII institutional order, beginning with NATO and ending with a summit with Russian President Vladimir Putin. He is threatening decades of empowering these institutions by tying their unfairness to American workers with trade policy designed to bring us lower and Europe higher.
He also rightly sees China as more than a potential threat and wants a more level playing field. Unfortunately, his views on trade are, as David Stockman recently put it, from the 17th Century.
Tariffs and a trade war with China will only accelerate the demand for dollars as China devalues the yuan in response. This month’s move down in the yuan was faster than in 2015 which rocked capital markets around the world.
The euro is flirting with a disastrous breakdown. Trump’s full-court press to sanction everyone who does business with Iran is disrupting oil markets.
Falling global trade means lower profits which makes servicing debt that much harder, feeding a stronger dollar.
A rising dollar feeds back into all of the previous Pillars leading to…
#5 Rising Interest Rates Around the World
The Fed has to raise rates. Domestic investment needs, like pensions, require this. The ECB has to begin raising rates but it cannot without creating a stampede out of the euro and European Sovereign Debt.
* * *
This is why every time someone like Merkel or Rosenstein makes a move to win a short-term political battle, they ensure their demise later. It lays bare their real agenda, which is saving themselves and supporting policies the people have rejected. That feeds a loss of confidence in institutions which assists the shift in investor sentiment from trust in institutions or government to people and hard assets.
Gold Goats ‘n Guns is built around this critical shift in human behavior that the nearly-incompetent people in charge can see but are truly powerless to stop.
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Author: Tyler Durden