Kryptonite

Superman came to earth from planet Krypton when he was just born. He grew up realizing his extraordinary powers. Only when he interacted with a holographic image of his father he realized that there was one thing which was lethal to him – Kryptonite, remnants of his long dead home.

Central banking is relatively a young profession. As they have grown up they have realized their extraordinary power. The first taste of the fatal flaw was inability to work magic on the Japanese economy post the massive collapse in the 1990s. Now they have again brought their fatal flaw upon themselves in US, Europe and Japan – zero to very low interest rates and expanded central bank balance sheets to unprecedented levels.

“The tenth amendment said the federal government is supposed to only have powers that were explicitly given in the Constitution. I think the federal government's gone way beyond that. The Constitution never said that you could have a Federal Reserve that would have $2.8 trillion in assets. We've gotten out of control.”

As they reduced interest rates they reflated bond portfolios from junk to g-secs, housing prices and equity markets globally as risk free rates collapsed. The Japanese stimulus which they expected will grow their exports will take a long period of time as local corporates have over the period spread their manufacturing globally (i.e. Honda in US). So question is will corporates restructure in response to the stimulus or global economy booms to rapidly expand export demand or the time runs out when Japanese pension funds with the adverse demographics are unable to keep up with the expanding budgetary requirements forcing up interest rates. Unfortunately, they do not have much of a choice.

The US Federal Reserve is reversing the stimulus as jobless claims decline. But the risk of miscalculation with the market expectations is high. At the same time the European Central Bank is turning on the stimulus tap worried about potential tightness the US Federal Reserve may cause in the markets and the strong Euro which is resulting marked declines in manufacturing surveys since January this year (France below 50 and Germany at 52, print below 50 represents a contraction).

Massive amounts of capital have been invested by pension funds and life insurance companies into government securities. This capital has no choice but to suffer the increase in interest rates. So let’s assume a bond maturing in 2020 trading at 19% premium to Face Value giving currently 2.5% yield. If interest rates were to become 5% for the residual duration the bonds would suffer a 7% decline. Bonds which trade on basis points, 7% change are a massacre. In response, I understand, the German life insurance industry has reduced bond duration to 6 years to protect against interest rate increase creating an asset-liability mismatch (“ALM”). How do central banks expect to plug this hole?

In India external borrowing to GDP has expanded from 4% to 18% taking advantage of low rates in the international markets and easy availability. This and potential risk on portfolio flows which finance the CAD has got Raghuram Rajan to call for coordinate action to limit liquidity issues. As interest rates rise, it will increase the risk-free impacting equity valuation and hurt property valuation including those of dollarized markets like Dubai, Singapore and Hong Kong.

Only alternative central bankers have to manage the scale of the adjustment is to keep running behind market expectations - too much perfection to achieve. But if this is the likely goal they will be incrementally cautious and run much more behind expectations. Consequently, precious metals and agri commodities (and healthcare driven by aging) will gain with oil becoming more dependent on geopolitical events as global economy is tempered by increasing rates.

Postscript:

Corn  trades at 3.7 (CBT $/bu), Soybeans at 10.8 (CBT $/bu), Wheat at 5.4 (CBT $/bu) and Sugar at 0.17 (NYF $/lbs). These are running at multi-year lows or 40-100% off last 5 year peaks. Implication: invest in a global agri commodity fund, processed food companies which have benefited from the decline will face cost pressures as the cycle turns and global inflation numbers have been benefiting from this decline.

US earnings will see a 2HCY14 rebound driven by low inventory levels which is running at 4 year lows and new order are showing a significant rebound in the last quarter.