Meet the bear who sees another credit market collapse building: Maley

Global funds managers may be uber-confident but one prominent hedge fund manager has warned that the current situation is “eerily similar” to mid-2007.

According to a survey conducted by Bank of America Merrill Lynch global funds managers are the most confident they’ve been for years and are taking on the biggest risks since January 2006.

The poll of 188 global fund managers – responsible for investing $US569 billion in assets – found they had built up record overweight positions in equities and commodities while their cash balances had dwindled to an extremely low 3.5%. (As the compilers of the survey note, “a level of 3.5% or below has in the past signalled an equity market correction on a four-week horizon”).

But Kyle Bass, who manages the hedge fund Hayman Capital, offered a dissenting voice.

In his latest letter to investors Bass, who in 2006 warned of the looming crisis in the US housing market, looks past the euphoria to warn of severe systemic risks.

“Thus far the systemic risk that was prevalent in the global credit markets in 2007 and 2008 has not subsided, rather it has simply been transferred from the private sector to the public sector,” he says.

“We are currently in the midst of a cyclical upswing driven by the most aggressively pro-cyclical fiscal and monetary policies the world has ever seen.

“Investors around the world are engaging in an acute and severe cognitive dissonance. They acknowledge that excessive leverage created an asset bubble of generational proportions but they do everything possible to prevent rational deleveraging.”

Equity markets are continuing to climb despite clear signs of stress in European debt markets.
“It is eerily similar to July 2007, when equities continued higher as credit markets began to collapse,” Bass says.

He is particularly scathing of the policy adopted by the US central bank, which has been to try to lessen the problems caused by excessive debt levels by keeping interest rates close to zero.

“That policy only temporarily delays the painful process of debt restructuring – whether of household, corporate and/or government debt,” Bass says.

“The only meaningful reduction of debt throughout this crisis has been the forced deleveraging of the household sector in the US through foreclosure.

“Total credit market debt has increased throughout the crisis by the transfer of private debt to the public balance sheet while running double-digit fiscal deficits.

“In fact this is an explicit part of a central banker’s playbook that pre-supposes that net credit expansion is a necessary pre-condition for growth.”

But he says keeping interest rates close to zero only ensures that more debt is built up and that means even more severe problems when short-term interest rates eventually – and inevitably – return to normal levels.

Bass pointed to the US, which is approaching its current debt ceiling of $US14.2 trillion dollars. Every one percentage point increase in the cost of borrowing will force the US government to pay an extra $US142 billion in interest payments each year.

If short-term interest rates were to move back to 5% the annual US interest bill would rise by almost $700 billion annually – compared with forecast US government revenues of $2.228 trillion this financial year.

Even if US government revenues were to return to their 2007 levels of $2.568 trillion Bass argues that the impact of a rise in interest rates would still be staggering.

And the situation will get even worse, with the US expected to add a further $9 trillion in debt over the next year.

It is plain, Bass says, that the US simply cannot afford to move away from its policy of keeping interest rates close to zero.

“If US rates do start  moving  it  will  most  likely  be  for  the  wrong  (and  most  dire)  reasons,” he says.

Bass points out that the only historic precedent for that situation is Japan, where central government debt is close to one quadrillion (one thousand trillion) yen, compared to central government revenues of roughly 48 trillion yen. In other words debt is almost a “fatal” 20 times revenue.

Fund managers in Japan are happy to buy 10-year bonds and receive a yield of less than 1.5% because deflation in Japan is running at 1-3% a year. As a result investors get a “real” yield of between 2.5-4.5%.

But if the Bank of Japan was to target an inflation rate of 1-2%, 10-year bond yields would have to rise to more than 3.5% to give investors the same “real” yield.

But that would push up the Japanese government’s annual interest bill by more than 20 trillion yen.

Bass points out that every percentage point rise in average borrowing costs is roughly equal to 25% of the entire tax revenue collected by the Japanese central government.

He argues that the Japanese government will face borrowing costs in coming years as the ageing population starts drawing down on its savings.

He says if Japan had to pay the same cost of borrowing as France “the interest burden alone would bankrupt the government. Their debt service alone could easily exceed their entire central government revenue – checkmate.”

Because bond markets tend to anticipate events before they develop Bass predicts that a “Japanese bond crisis is lurking right around the corner in the next few years”.

One response to the crisis would be for the Bank of Japan to print money and to buy up Japanese bonds. If that happened, he says, the yen would plummet and Japanese interest rates would soar even higher.

Japan is the most extreme example but Bass argues that the central banks of other major developed countries are in a similar bind.

“Neither the Fed, the Bank of England nor the European Central Bank have been able to consistently suppress bond yields through purchases with printed money – the bigger the purchase, the greater the risk of a collapse in confidence in the currency and capital flight,” he says.

“No matter how they attempt to quell the crisis, no matter where they turn, they will realise that they are in checkmate.”