Why The Current Financial Environment Is Crazy

January 10, 2018

Why The Current Financial Environment Is Crazy

  • It has never before been so easy to get money. The consequence is bubbles.
  • Some bubbles are innocuous and even funny, other bubbles are extremely dangerous.
  • The most important thing is to know how to behave in this environment, and we’ll discuss that today.



Introduction

Financial bubbles are always repeating. Sometimes they are small, just like the meal delivery businesses (like Blue Apron) craze of the last two years. Sometimes they are a bit bigger, like cryptocurrencies have been lately. Sometimes they are huge, just like the current stock or debt markets.

Bubbles will never disappear because we, as humans, favor the opportunity for short term gains in place of long term gains. Just compare the number of people playing the lottery with those investing in businesses, and here I mean investing, not speculating.

As soon as something moves in price and there is a good story around it, there is bubble potential. This usually coincides with a loose financial environment where people forget about risks and speculate with excessive financial assets.

Figure 1: The current financial stress index is at historical lows. Source: FRED.

A loose monetary environment, high employment, and economic growth get into people’s heads and thus creates financial bubbles. Today I want to discuss a few examples that will show just how crazy our current financial environment is. I’ll conclude today’s article with how to behave in such an environment, which is the most important thing.

Cryptocurrency Craze

We all know cryptocurrencies are a bubble and this is confirmed by examples like the latest price surge of Ripple which went from $0.006 a year ago to $3.46 as I write this.

Figure 2: Ripple shows how crazy the cryptocurrency environment (green line) is. Source: Coinmarketcap.

The fact that the price of ripple has surged isn’t so significant, what is significant is the surge of the currency’s market capitalization which was $133 billion at Ripple’s peak on January 4, 2018. At that point, Ripple’s founder was worth more than $60 billion which made him the fifth richest person in the world.

Figure 3: Ripple’s founder was worth more than Larry Page, Sergey Brin, and Jack Ma. Source: Bloomberg.

You probably, like 99% of the population, have used products made by most of the companies owned by the people in the list above, but you’ve never used ripple. When something like ripple—or as was the case in the 2000 dot-com bubble, an obscure online business—reaches such extreme market capitalizations, it’s a clear example of how crazy a financial environment is.

But there’s more. Ripple, Ethereum, and even Bitcoin aren’t dangerous because they have a marginal effect on global financial stability. What we are going to discuss next is the dangerous part of this market’s craziness.

The Notion Of Risk Is Gone

It seems that market participants chase yields globally and don’t really care about risks. As the FED has been giving almost free money away for a long time while the ECB and BOJ are still paying people to take their money, it’s logical that financial markets have become distorted.

The yield on the 5-year German bond has been negative for almost three years now.

Figure 4: German 5-year yield. Source: Trading Economics.



A negative yield is already crazy in and of itself, but this makes people who chase yields do much crazier things. For example, European high yield bonds yield just 2.55%.

Figure 5: European high yield. Source: FRED.

High yield means junk bonds, and junk bonds means that as soon as the financial environment changes, it gets difficult for the borrower to repay the lender. As financial conditions change all the time, a yield of just 2.55% is another example of how crazy and un-thinking about risk this market is. The story related to emerging, frontier, or not even on the map markets isn’t any better.

In September, a country not really famous for stability, Tajikistan, tapped into bond markets with a 10-year, 7.25% bond. The country borrowed just $500 million, but the issuance was oversubscribed for a total of $4 billion. The bond issuance increased the debt to GDP ratio of the country from 35% to 50%.

You might say Tajikistan is a lonely example, but the situation is much worse. The premium required on BBB rated (just above junk) emerging market U.S. dollar denominated bonds is just 1.68%.

Figure 6: Emerging market premium. Source: FRED.

So you can buy a U.S. 10-year Treasury and get a yield of 2.44%, or some emerging market bonds and get 4%. Given that the spread in case of trouble quickly goes to 10% like was the case in 2009, it’s really crazy to be content with just 4% for that amount of risk.

Now, the extremely low required yields that make investors forget about risk as money is almost free is something extremely dangerous. People taking out car loans and mortgages, companies and countries issuing bonds, are all already so used to low interest rates that nobody is even thinking that the environment could change. That’s something extremely dangerous because higher interest rates, coming from higher inflation or a loss in confidence in global currencies due to more future quantitative easing, could wreak havoc on many corporations and countries.

I’ll finish with another thing that is crazy and sustainable only with declining interest rates, which has been the environment for the past 35 years. Interest rates will have to rise at some point. Government deficits have been piling up all over the world and it’s practically normal for a government to continually operate with deficits. The U.S. budget deficit is expected to broaden over the next 10 years where total debt will reach 100% of GDP.

Figure 7: U.S. federal deficit and debt to GDP. Source: BMI research.



So there are huge risks in the current financial environment that most seem to simply overlook. Nevertheless, as anything can happen, the important thing for you is how to protect your capital and reach satisfying returns.

What To Do

The first thing to do is not to own crazy investments for the yield, use them only for trading and to take advantage of the trend with clear protections in place in the case of a trend reversal in the form of stop losses, which can be tricky due to low liquidity, or options if possible.

Further, look at absolute yields and try to estimate risk yourself. For example, the situation in Tajikistan is somewhat stable now but wasn’t that politically stable just two years ago. Similarly, a stronger dollar could really make it hard for emerging markets to repay their dollar denominated debt.

As for the developed markets’ federal debt, the only way for them to ease the burden is inflation, so be protected on that front too. As a government is highly indebted, it will do whatever to protect those in debt, so think about that. Something that can help with all this, is my list of 7 hedging methods.



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