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Is it Trade? Or Interest Rates?

Written by Briton Ryle
Posted June 18, 2018

Interest rates and trade wars. Anybody else getting weary of these two driving the market?

Sure, interest rates have the potential to do some damage. Higher rates mean everybody's costs go up, and that may be particularly bad for emerging economies. Because emerging economies have taken on a lot of dollar-denominated debt...

It sounds like a good idea when a foreign country/company sells bonds that must be paid back in U.S. dollars. Interest rates tend to be lower because the buyer sees safety in the fact that the loan (a bond purchase is a loan) will be repaid in good ol' greenbacks.

Of course, this ignores a very obvious risk: will the bond seller be able to come up with the dollars needed to pay off the bond? And how much will those dollars cost, and what will that mean for the borrowers' financial strength? 

This risk is ignored for a pretty simple reason. As we saw from the subprime mortgage disaster, risk often has nothing to do with reality. Risk is just a number. Before the crisis, trillions in mortgage bonds were created and sold, and they all had one thing in common: default risk.

I don't know the actual number — it seems like it was either 1.4% or 1.7%. That was the number of mortgages that went into default every year. It doesn't really matter which one it is. The point is that this low number was perhaps the single-most important factor for determining the risk inherent in mortgage bonds...

The actual income levels of the homeowners whose mortgages were in those bonds didn't factor in. Neither did their income-to-debt levels. Pension funds and investment banks could hold as much of these bonds as they wanted because low default rates meant they were as good as cash.

If you think about this in terms of a bank's tier 1 capital, it makes sense. Banks have to carry a certain amount of cash to back the loans it has made and will make. Before 2008, it was like 4% or 5%. Today, it's 6%, though most banks carry a lot more.

If a bank wants to own stock so it can make a little money on its reserves, it can't count that stock on a 1:1 basis with cash. Because of the inherent risk with stock, it can maybe only count 60% as cash. Which means for every dollar invested in stock, its tier 1 capital falls by $0.40. That has a direct influence on how much it can lend. 

But if it can hold mortgage bonds that pay 7%, the bank can approach the expected return of stocks without the hit to its tier 1 capital. Perfect!

Of course, when default rates spiked over 2%, the whole thing fell apart. And there were plenty of people who saw it coming.

Once in a Lifetime...

The fact is, models simply don't price in once-in-a-lifetime events. Because the reality is that we humans care more about getting money where it's wanted (and can be profited from) than protecting ourselves from catastrophe. It's like, a lot of people will put burglar alarms on their homes. But how many have fully stocked bunkers? 

Anyway.

When Goldman Sachs goes to Greece (or whoever) and says, "Hey, you can lower your interest rate expenses by 30% if you offer dollar-denominated bonds, and we can set you up with some interest rate swaps to minimize the potential currency exchange costs for 5%..." Greece is going to say, "Let's do this."

Goldman Sachs will even help sell the bonds, and it all works fine until it doesn't. 

This dollar-denominated fear with regard to emerging markets has been lurking in the background for a few years. Everybody knows that if/when it goes bad, it will go very bad very fast. If bond default rates spike, suddenly banks don't have enough tier 1 capital, lending dries up, recession starts...

But here's the thing. Do you sell all your stocks now because there will be a recession sometime in the next five years? I imagine if you did that in 2015, you missed a massive profit opportunity. It's the same for all the people holding emerging market bonds. They won't sell until they see the whites of a crash's eyes. And that's exactly why you see huge drops like we did when we had the Italian bond sell-off a few weeks ago...

Glad we got that cleared up. Now, let's get to the trade war stuff...

So Much Winning

Yeah, the president keeps whacking the trade war hornet's nest with a stick. We apply tariffs, China matches us. In $50 billion increments, this can go on for a long time. And in purely economic terms, China is losing simply because it is much more dependent on exports than the U.S. is. 

But from a sentiment point of view, the risks to you and me as investors seem to be increasing. Every time new tariffs get announced (this is the third time), the bounce-back rally gets weaker. And it's because investors are getting beaten down, getting weary. 

Who wants to keep buying stock when a couple weeks from now, there will be another 5–8% drop? 

The irony is that the emerging market dollar-denominated debt risk is a very real risk that could have some ugly consequences. But it doesn't weigh on the average investor's consciousness. 

I still think the tariffs are a bargaining tool, getting ratcheted tighter to force China into more concessions. The problem is that anxiety is ratcheting higher for the average investor, too. Keep whacking that hornet's nest, and investors will eventually throw up their hands and say, "Screw it, I'm not buying anything until this trade BS is resolved."

We all know sentiment is a fickle thing. And I'll even put a number on it: 2,741. That's the level on the S&P 500 that marks a significant shift in sentiment. Above 2,741, and investors are still optimistic. Below that level, and it's investors walking away, hands in the air.

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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