Bubbles – Bonds and The Baltic

The world is full of bubbles. Much focus this week has been on the Westminster political bubble. But beneath the surface, more fundamental tectonic plates have been shifting, and ruptures have appeared. The bond market bubble is deflating, and bubbles surfaced in the Baltic. We are yet to discover quite how significant these events are.

LDI Breaks the Bank

UK pension funds got an early taster this week and forced the hand of the Bank of England to avoid a Lehman’s moment due to Liability Driven Investing. Who had LDI on their “tightening until it breaks” bingo card? The sharp increase in bond yields reveals that these beacons of financial prudence use a TLA (three-letter acronym) as cover for using our pension assets as collateral for derivative trades. Does this remind you of anything from a previous episode? It is all a bit Scooby Doo. The unmasked villain isn’t the janitor who would have got away with it if it wasn’t for those pesky kids, but financial derivatives based on infallible risk modelling. Who could have guessed? But what has been revealed is a fault line in the UK’s financial plumbing, and we must face its consequences. UK interest rates will be higher for longer, the value of the pound and UK house prices will be lower for longer, and our political instability will endure. Other second and third-order consequences will also soon be available in a market near you.

Bubble to Bubble

The critical moments over the past forty years when financial news has moved from the back pages to the main headlines have been when capital shifts rapidly from one bubble to another. The dot.com crash resulted from malinvestment in unprofitable technology. Capital then sought the reassurance of real asset backing in mortgage lending. The derivative alchemists didn’t take long to turn subprime credits into grade-A loans. Rising rates in 2007 quickly revealed bank balance sheets to be works of fiction, and the price of socialising the bailout losses was for banks to be neutered and force-fed government debt. With all these new buyers of government debt, interest rates stayed low, and long-duration assets, such as (now very profitable) technology stocks, soared. And governments, well, they just carried on borrowing to the new tune of MMT, Modern Monetary Theory (aka More Money Today).

Rate Free Risk

As the bond bubble gently inflated underneath our financial world over the last decades, we have been lulled into a false sense of security. Our whole way of life has come to regard bond values as a certainty upon which our financial futures should depend: the 60/40 bond, equity portfolio, the financing of our mortgages and the safe keeping of our defined benefit pension liabilities. The government and their agents resolved these life risks for us, fluffed our pillows and placed chocolates on them. But in the same way as Hemingway described how he went bust, first gradually, then suddenly, the bond market bubble has burst.

Baltic Bubbles

Last week saw the collision of our deflating bond bubble with immutable axioms of physics. Someone (we assume Russian) decided to blow up the Nordstream pipelines. Boyles Law was obeyed, and the Baltic bubbled with a massive quantity of methane belching natural gas. Notably, the primary reporting in the FT and WSJ focused on the potential environmental damage from this act of aggression, not its financial or economic significance. But what happened in the Baltic will be the week’s most consequential event, but not because of the damage that might occur to our environment. The lack of critical analysis of this act of economic sabotage simply illustrates that Europe (not just the EU) hasn’t woken up to the underlying causes of its current problems.

While Rome Doesn't Burn

Last week as the EU was putting the final touches to its windfall tax on hydrocarbon suppliers, Belgium closed down a perfectly functional and safe nuclear reactor. The latest atomic power plant closure was part of an ongoing policy to reduce nuclear from more than 50% of its total electricity supply in 2011 to zero. The Belgian energy minister said in the EU price capping debate that “we don’t have a gas shortage; it is just that the price is too high”. (I will just leave this comment hanging as I am lost for words). What is clear Europe (not just the EU) fails to realise that we need much cheaper, more abundant, non-intermittent high-density energy. That means both hydrocarbons and nuclear. It means not taxing or closing the sources of these building blocks to our very existence but taking measures to boost their supply. Liz and Kwasi understand this, but they have so completely frightened the horses in their rush to try and do something about it that they have jeopardised their ability to take action.

Energy Contingent Liability

As the British Pound and the Euro have plummeted, commentators have been puzzled as to why our developed market currencies are performing worse than the Brazilian Real, the South African Rand or the Russian Ruble. The UK’s financial crisis makes us look like a banana republic. This isn’t how things are supposed to happen. But while the BoE and ECB might be able to do whatever it takes financially, neither can print energy molecules. The currency markets have realised, and bond investors are not far behind, that Europe has significant long-term, open-ended energy liabilities denominated in US$, and they are doing nothing to fix the problem. They are, in fact, currently making things worse.

I recently did a video on the energy industry from an investment perspective.

NOT INVESTMENT ADVICE, DYOR. 

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