The price volatility of government debt worldwide is worrisome – among other things because it might result in failures of bond auctions that could harm global markets. Even scarier is the widespread use of derivatives to hedge the risk of this debt, meaning the fallout could be still worse should this insurance fail to pay off.
Derivatives are meant to protect investors if an asset goes south. They were a big part of the problem in the 2008 financial crisis, when nearly everything crumbled.
Insurance icon American International Group almost collapsed then from its derivative contracts insuring mortgage-backed debt against default; Washington had to bail out AIG. What would happen if such a debt debacle occurred again, but harsher this time?
The size of the derivatives market is enormous. Some estimates place it at just over $1 quadrillion. Stated in dollars, that’s more than the debt the federal government racked up since President Barack Obama took office. Way more. It’s even way more than the Federal Reserve spent buying bonds in a bid to stimulate the economy.
That’s a thousand trillion, 10 times the world’s gross domestic product. While some say derivatives don't actually total that much – the Bank of International Settlements puts it at $630 billion – the amount remains vast.
So when Bill Holter of Global Research wrote an article with the headline, “Derivatives are a $1 Quadrillion ‘Ticking Time Bomb,’’ it caught our attention.
So did the series of charts he included, which showed movements in the government bond market that were double-black-diamond steep, even without moguls. Here is a snapshot from May, just after the volatility got under way, showing the whipsawing yields from U.S. Treasuries, German bunds and Japanese bonds:
We’re talking government bonds here (aka, sovereign debt), not junk bonds, not commodities, not emerging market stocks. Government bonds should be like Nebraska – flat and predictable. During volatile times, to switch into a mountain metaphor, they’re the bunny slope, not a double-black diamond.
Holter called it a “global meltdown of the credit markets,” noting that it occurred twice in May, during just four business days. He also said he expects it to be seen, in retrospect as, “THE trigger event.”
The reason Holter is alarmed is that sovereign bonds and their yields are moving in wider standard deviations than most commodities ever do – that is, they’ve been really, really volatile.
That’s not supposed to happen, as they are supposed to be safe securities, a comfort for widows and orphans. Sovereign credits are the core of nearly all the world’s retirement funds on the planet. As he puts it: “If everything else fails, it is this sector, government bonds, which should stand tall and stave off the failure of retirement plans.”
So what’s driving this volatility? The simplest explanation is that the bond selloff is out of fear of a Greek default. But Holter believes bond market weakness stems from derivatives, and the false protection they bring.
Lots of flimsy bond issuers get by on overnight loans, which hide their problems, he contends. “The recent volatility has created more and more losers,” he writes, and this in turn forces them to sell their holdings, and thus put more downward pressure on bond prices.
Holter noted that the global bull market in bonds that has existed since 1982 “has culminated in negative interest rates and we ended up with everyone on the same side of the boat with no one left to buy.” With negative interest rates, lenders charge depositors fees, which often overshadow the paltry interest they pay.
Which begs the question, why would anyone buy bonds when interest rates are zero or even negative? Remarkably, few have asked that question.
The end game, according to Holter, is the collapse of our credit system, which “has become the basis for all paper wealth and the lubricant for all real economic activity” (hence, the quadrillion reference).
“Should credit collapse (it will), everything we have come to believe in (been fooled by) will change,” Holter wrote. “Credit has come to be viewed as ‘wealth,’ it is considered an ‘asset’ … with just one problem, it is neither! Credit is only an asset and can be considered wealth as long as the borrower ‘can pay.’ ”
So back to Greece for a moment. Greece cannot (or will not) pay its debt, Greek bondholders cannot pay their own debt, which means their creditors cannot pay their debt, and so on.
It’s not Greece that matters, but the cascading counterparty risk – where derivative issuers, in an echo of AIG’s 2008 dilemma, get overwhelmed and cannot pay insurance benefits when Greece is not paying its debt. And of course, there are many other countries with Greece-like debt that could default.
“Derivatives are a $1 quadrillion ticking time bomb, soaked in gasoline and sprinkled with gunpowder,” Holter concludes, adding that volatility will ignite the explosion.
Central banks have twice stepped in and bought debt to steady the markets. Holter warns that “the day will come when it does not work. This game has gone on for a very long time and resulted in a mania where most all of the players are ‘long.’ The only potential new longs left are the central banks themselves who can only buy more debt with money created by debt.”
This control of debt creates the power to control prices.
“Once debt breaks loose and trades out of the control of central banks, these central banks will also lose the control to price everything else,” Holter maintains, so the stock market will also be affected.
And finally, “the greatest margin call in all of history will be issued … and it cannot be met!”
We can only hope that Holter is wrong.
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Brenda P. Wenning is president of Wenning Investments LLC in Newton, Mass.
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