Is another world economic crisis coming?

A man watches the trading board at a private stock market gallery in Kuala Lumpur, Malaysia. Asian markets mostly fell Monday as investors reacted to Greece’s sound rejection of terms set by its international creditors. AP

I wrote an article last December warning of a coming world economic crisis. It said the trigger could be the fiscal problems in Greece. A default may shock Europe, but it will plug the leak, temporarily. Then after the calm may come the crash. (See “Is another global financial crisis coming?” Inquirer, Dec. 8, 2014.)

Greece is on the ropes, as predicted. As this is written, Greeks are scrambling for cash as a third of their ATMs are now empty.

I argue that a global crash is not imminent, but it may follow later, perhaps around September. Europe will be shaken after the default of late June. It will end up pouring in money to fix the Greek mess. It will do as it fears a repeat of the Great Recession and does not want Greece to fall into the arms of a wooing Russia. In the meantime, spooked investors pull much of their money out of stocks and put them in safer bonds (basically IOUs to governments and corporations).  Over the next months, investors realize that the bond market itself is fragile. Confidence goes into free fall.

Bond market warning signs

Take a look at the warning signs in global bonds. The backdrop is that the market has been inflated by the quantitative easing (QE) program in the US and Europe. Under QE, central banks “print” massive amounts of money to buy long-term bonds.

Last May, Bloomberg quoted billionaire Warren Buffett as saying that “bonds are very overvalued.”

Japanese bonds suffered their biggest fall in nearly two years last May.

In two weeks in May, the bonds issued by European governments dropped from their historic peaks, as $430 billion in value evaporated.

More than $626 billion in value vanished from an index of global sovereign funds from end-March to early June.

As headlined by a June 4, 2015 Reuters article, “There is sheer panic in the bond market.”

As bond prices fall, their yields or interest rates rise. And they are shooting up worldwide.

In just a few days last April, 10-year German bond yields exploded from 5 basis points to almost 80. That means German bond investors saw 25 years of yield disappear in two weeks.

Last May, yields on 30-year US debt surged to an almost 5-month high.

In June, European Central Bank President Mario Draghi said markets should get used to greater volatility. This prompted bond yields in the US and Germany to spike to new 2015 highs.

Investors look back at the extreme case that happened in October 2014. US treasury yields had plunged then by nearly 40 basis points in minutes. Statisticians say that should happen only once in 3 billion years.

Emphasizing the point that October 2014 was a warning shot, Jamie Dimon, head of JP Morgan Chase & Co., also said this was “an event supposed to happen only once in every 3 billion years or so.”

Cracks in the system

So what’s happening? There are clogged veins in the circulatory system of the global bond market.

Banks no longer hold huge inventories of bonds after the Great Recession of 2008-2009. New rules penalize bank trading through higher capital charges. They have thus dampened the ability of banks to provide liquidity in the bond market.

Bonds are not usually traded in liquid exchanges like stock markets. They are bought and sold most often over the counter.

These illiquid bonds are tied up in instruments that allow investors to pull out quickly. Think, for example, of mutual funds made up of bonds. Hence, crises that require these instruments to be sold quickly can sharply push down the prices of illiquid bonds.

Add this finding from Citigroup Inc. The American corporate bond market has swollen by $3.7 trillion in the past decade. However, almost all of this growth is concentrated in three main groups of buyers: mutual funds, insurance firms and foreign investors. While there used to be 23 types of investors, today they are collapsed into these three.

Now, mutual funds are forced to sell when clients redeem their cash, and they doubled their share in 10 years.

Research confirms that investors in bond funds are more likely to get back their cash than are investors in stock funds, when bad news hits.

That is according to a April 2015 paper by professors Itay Goldstein of the University of Pennsylvania’s Wharton School of Business, Hao Jiang at Michigan State University and David Ng of Cornell University.

If the Federal Reserve (the Fed, the US central bank) hikes interest rates, there will be more selling than the market can absorb, according to Citigroup Inc. strategist Stephen Antczak.

All told, a crisis prompts bonds to be sold quickly. But the exits are jammed because of liquidity flaws. That leaves the assets being sold at rock-bottom prices.

Storm after the calm

The danger is that after calm returns with the fixing of the Greek tragedy, the bond market will be vulnerable. The events that triggered the recent sell-off in bonds foreshadow the future.

In Europe, inflation rates exceeded forecasts, and that was attributed to the large QE program there. This proved that QE was working against deflation, hence the fear that it was no longer necessary. Bond investors were nervous that the European Central Bank would halt its bond-buying QE program.

In Europe, growth in the economy also led to the belief the continent would wake up from its stupor.  Last February the median forecast was 1.1 percent growth in 2015, according to a poll by Bloomberg. This is now upgraded to 1.4 percent. Hence the worry that QE would end.

In the US, economic data is favorable, leading the market to speculate that the Fed could afford to raise interest rates in 2015.  Higher interest rates would lower bond prices.

Fed Chair Janet Yellen warned last May 6 that long-term yields were low. That remark pushed up the US 10-year yield to a two-month high.

All these incidents led to the bond sell-off. The point is that the market is sensitive to changes in monetary variables: money supply, inflation, interest rates.

Around September

Now what development is at the front and center of the investors’ attention? It is when the Fed will finally hike policy interest rates in the US. The Fed has been very cautious about doing so—it hasn’t raised rates since 2006. The International Monetary Fund (IMF) has warned the Fed that the rate hike would have consequences for the rest of the world.

And yet the rate hike is long overdue. The Fed was expected to push up the rates in late 2009 as the Great Recession waned, but it did not do so. The system can no longer take the distortion of abnormally low interest rates which sweeten debt and punish pension funds with dismal yields. The dominant belief among economists is that the Fed will raise interest rates in September 2015.

Put it all together. After the Greek tragedy, Europe will rush in with resources to fix the mess. Calm returns. Meanwhile, investors will pull out much of their money in stocks and put them into safer bonds. But they will later realize how fragile the bond market is as bond prices crash. The rush out of both stocks and bonds will be pronounced when the Fed finally raises interest rates. That is the nail in the coffin. This may happen in September.