Kyle Bass on Japanese Insolvency and Systemic Risk in the Global Economy
Here’s more from the CNBC session with Kyle Bass, Managing Partner of Hayman Capital Management. David Faber introduced the topic as a discussion about tail risk and the "end of the world" trade. Bass took exception to that characterization saying that he was more concerned about a debt "restructuring that has to happen for the world to grow again". He says, "so far what we have seen is total credit market debt in the world in the last ten years has gone from $80 trillion to $200 trillion." That’s not sustainable.
This is the point I have made repeatedly about where the global economy is headed. Let’s look at the origins of the next crisis. Here’s how I delineated the issues in April:
- The concentration of economic models on flow and the failure to model debt stocks
- The empirical evidence that debt stocks have been increasing across a broad swathe of private sector dimensions
- The doom loop of ever lower interest rates that allows debt stocks to increase
- The effect that a secular decrease in interest rates has on an economy’s ability to increase debt loads
- The evidence that monetary stimulus is no longer effective in allowing debt levels to increase
- The likely outcome of a balance sheet recession and a secular decrease in debt
My thesis here is a combination of cyclical/technical analysis and fundamental analysis which says that economies build up debt over a super cycle because policy makers use policy tools to avoid the day of reckoning such that when the day comes, the adjustment path is more severe. For an investor, it creates a secular bear dynamic that’s a tricky path to navigate because there will be cyclical upswings and you can’t not be invested in those rallies. We’re in one of those rallies right now due to unprecedented monetary and fiscal policy stimulus. And it is leading us Back to the global imbalances norm. Unless things change soon, this means serious trouble when the kick from stimulus wears off.
It was interesting to see at the outset of the Bass clip I am putting up below that CNBC ran through a similar thesis regarding Japan. During the quantitative easing last decade, Japan saw a tremendous cyclical rally. But when policy stimulus was withdrawn, the market hit new multi-decade lows. Stimulus without reform leads to a policy cul de sac. For Japan, Bass says the country has been effectively insolvent for years and is in this false period of "homeostasis" only because its population is buying 10-year bonds with a 1 percent interest rate handle expects deflation.
Two thoughts here: Swiss 10-year bonds have a one handle too. The question I have is about what is fundamentally different about the Swiss and the Japanese other than the magnitude of the debt. That’s a serious question, because both countries have an aging population with external surpluses, meaning they can fund their governments internally. They both have sovereign national currencies and can print money to cover any obligations in their own currency. What’s fundamentally different about the two other than the debt and deficit? If the Japanese did a massive structural reform, cutting their federal deficit to zero and managed 2% real GDP growth to boot, isn’t that a low inflation scenario in which the debt to GDP comes down? What forces the Japanese into a death spiral then? Look, I think the Japanese debt to GDP over 200% is crazy too, but I am not saying they are insolvent. I just presented a few reasons why that’s the case. I would love to hear your views.
Here’s the other thought, from a more hawkish perspective. Isn’t it true that Japan is permanently in a zero interest rate policy environment? Let’s run through the analysis this way:
- Japan’s long-term rates reflect private portfolio preferences as determined by expected future interest rates (see Market discipline for fiscal imprudence and the term structure of interest rates). So 10-year rates are low because expected inflation and expected future short-term rates are low.
- Japan’s Debt to GDP is over 200%, meaning that any uptick in expected future short-term rates due to inflation would be disastrous in terms of interest due.
- So, to avoid this scenario, Japan must leave short-term interest rates at near zero percent or risk the crowding out of public spending that higher interest payments would entail. Only if the debt to GDP ratio declines significantly can it relax this stance.
That’s my take here. Japan has failed to make the necessary reforms and is now trapped in a zero rate policy. This is the cautionary tale for the U.S. and Europe that Bass is pointing to. But, where he sees insolvency, I see perpetual zero rates, money printing and currency debasement. Bass talks about short rates going up from this. Often the bond vigilante talk ignores the reality that the Fed can manipulate rates. The Fed could, if it wanted, decide to offer unlimited liquidity for a specific price (interest rate) somewhere on the curve as it does for Fed Funds. Moreover, longer term bond yields are only market representations of future short term yields. The bottom line is that if interest rates do move too far up, the Fed will work to bring them down; that much is assured. And because the Fed has unlimited liquidity at its disposal (because it can print money), there is no reason to believe it won’t achieve its objective if it wants to. Bond vigilantes can only go so far.
For (sovereign and non-sovereign) government debtors that are unwilling or unable to print money, the end of the line is coming and that’s when the next crisis begins. A hedge against this is in hard assets like precious metals, farmland and potentially commodities.
Earlier in the week, Bass wrote a piece addressing this theme called "The Cognitive Dissonance of it All" embedded below after the video clips. Enjoy.