Keep interest rates high, and risk a spiralling sovereign debt crisis.
Lower interest rates and pivot to quantitive easing – risk hyperinflation.
This is the conundrum that has pushed today’s fiat monetary era to the brink, and economic collapse arguably closer than ever.
“It’s a very toxic combination for the sovereign bond market, says market analyst Lyn Alden.
“Going to back to 2019 I was saying whatever excess there is in equities, I was more concerned about the bubble on sovereign bonds because you had record-low yields, and on the long term horizon I was seeing inflationary pressures starting to build.
“It’s surprised even me how rapidly it happened, and part of that is because we got certain catalysts that were even more rapid than we could have expected, like the energy crisis in Europe.”
Sovereign debt crisis like dominoes
2022 has seen the United States Federal Reserve raising rates at a pace never before seen, the Bank of England stepped into gilt markets to stave-off a pension fund collapse, and the Bank of Japan intervened in an attempt to prop-up the spiralling yen.
It’s an interconnected crisis of rare intensity unfolding across major economies.
Japan is perhaps the most closely watched player in the unfolding crisis, because in 2019 Japan became the largest foreign holder of U.S. treasuries.
“If we get into a situation where the treasuries are not being bought and interest rates are going higher, I think we have a sovereign debt crisis and I actually think that’s where we’re headed,” Santiago Capital CEO Brent Johnson told Blockworks Macro.
And what’s beginning to happen in recent weeks is just that.
The Bank of Japan has been selling Treasuries in their reserves so it can buy yen in the market in an attempt to halt the yen’s decline.
This is putting major pressure on the U.S. treasury market.
The unfolding Eurozone debt crisis is also a major piece of the sovereign debt horror story.
In recent weeks, the pound hit an all-time low against the dollar, while U.K. sovereign bonds saw their yields reach their highest level since 2008.
The now well-documented after-hours intervention by the Bank of England to save the U.K.’s pension fund system could be sign of what’s to come.
“We’ve written at length about the rising US dollar, and our belief that we’ll see a wave of emerging market sovereign defaults as a result, but it’s not just emerging markets that are in trouble,” said Chris MacIntosh, a prominent hedge fund manager and founder of Capitalist Exploits Independent Investment Research.
“The entirety of the Western world is in the same proverbial bind. Central banks held rates far too low for far too long, and then on each successive attempt by market forces to correct imbalances, they proceeded to intervene with stimulus, adding kindling to the eventual inferno that would engulf the whole system. That is now.
“The real issue now is that the entire system has become dependent on central banks to continue doing this and without it they will go into cardiac arrest.”
He says central banks have two unsavoury options:
A) Pause on interest rate increases and let inflation rip higher, wiping out the middle class.
B) keep raising rates, which will cause an overleveraged economy to contract massively with waves of corporate and then personal bankruptcies.
The United States is not immune to economic collapse
Against the backdrop of the bursting sovereign debt bubble, Greg Foss, co-founder of Looking Glass, describes the United States as “the best looking horse in the glue factory”
“I spent my entire life in the junk bond markets. I’m very sensitive to credit metrics, I can look at a company very quickly and say, ‘OK the rating on this company should be double-B, based on this interest coverage ratio, this type of leverage, the industry that it’s in etc’,” he told the TFTC podcast.
“If the USA was a corporation, based on its debt metrics of simple interest coverage of around 1 times – which is to say the USA only has about 1 times excess revenue over their entitlements and their military spending – a 1 times interest expense coverage ratio for a corporation puts you a triple-C, one notch above the double-C level which indicates financial distress and restructuring.”
Foss says the fact central banks can simply print money doesn’t prevent a debt crisis when that money becomes worthless, noting the situation in Argentina and Venezuela.
“Yeah you can print all the money you want, but no one is taking it from you so is that a default? In my argument that is what credit default swaps are projecting,” he says.
“The potential for a default which is an actual default, included within that is a devaluation of the currency to the point where ‘OK we printed all this money but no one will take it’ – there is your risk.
“When you’re a triple-C rated equivalent corporation, you’re basically a zombie country.”
Investing amid a sovereign debt crisis
When looking at where hedge fund managers and other expert investors suggest allocating capital in a global sovereign debt crisis, there is one common thread – energy.
“The trade is ultimately be long energy. Coal, yes. Oil, yes. Gas, yes. Uranium, yes… Even Bitcoin is a derivative of energy. You want to be long energy and all of its derivatives because of what’s transpiring,” said co-founder of macro research firm FFTT, Luke Gromen, on The Next Big Trade.
“You have peak-cheap energy and you have the first global sovereign debt bubble bursting in 100 years, and historically when you have global sovereign debt bubbles burst there’s a couple of outcomes – they can restructure the debt or they can print the difference and sovereigns almost always print the difference.
“So you’ve got something on the unit of account side – they’re going to print a lot of money to keep sovereign debt nominally solvent and you’ve got something on the geological side, where it’s not that we’re running out of oil, its not that we’re running out of energy it’s that it’s getting more expensive to find and produce and replace.
“You’re shifting from lower cost resources to higher cost resources at a time where you have a debt position that cannot afford higher cost anything without central bank money printing.”
Brent Johnson says Santiago Capital is playing currencies.
The firm remains long the USD and is bearish on the outlook for nations reliant on China.
“We think the outlet is going to be the currencies and we’re also playing the second, third knock-on effects of these currencies going down. We think there’s a number of country’s that will be in a lot of trouble if that happens, specifically Australia, Canada, China, Turkey.”
“So we think on a relative basis global capital will flow to the U.S. and U.S. dollar versus the rest of the world. The dollar will go higher as we enter the sovereign debt crisis and as a result that’ll have all these knock-on effects around the world – other currencies will get printed to a greater degree than the U.S. dollar which creates a knock-on effect where the dollar goes higher and all these other currencies go lower.
“As that happens we think China gets into a lot of trouble, they will probably have to weekend the yuan, we think the Hong Kong dollar peg will break. When that happens we think Chinese growth will fall significantly, China buys a lot of commodities from Canada and Australia.”
The USD, shipping stocks, and commodities stocks in the Uranium, Coal, Oil, Natural Gas and Agriculture sectors are among the areas where Chris MacIntosh believes investors can build “generational wealth” during what he describes as a “unique point in time”.
MacIntosh has been sharing investment ideas in these areas to a growing community of over 2000 stock market investors.
“There are at all times a number of systems in play globally. That said, the Pareto distribution, otherwise known as the 80/20 principle, tends to assert itself with one system dominating. Currency regimes are a great example of this. Transition periods are typically violent and chaotic. We’re in one now.”
You can sign up to receive Chris MacIntosh’s investment newsletter here.
If the experts are correct and we do see a global economic collapse sparked by the sovereign debt bubble, the good news is there remains time for astute investors to position their portfolios and potentially grow their wealth amid the crisis.