This article was published by The McAlvany Intelligence Advisor on Wednesday, May 23, 2018:
John Mauldin, the New York Times best-selling author and publisher of his Thoughts from the Frontline, reminded his readers of the story of Casey Jones:
For those who don’t know the story or haven’t heard the songs, Casey Jones was a talented young railroad engineer in the late 1800s. On April 30, 1900, Casey Jones was going at top speed when his train tragically overtook a stopped train that wasn’t supposed to be there.
Traveling at 75 miles per hour, Jones ordered his young fireman to jump, pulled the brakes hard, and blew the train whistle, warning his passengers and the other train. Later investigations found he had slowed it to 35 mph before impact. Everyone on both trains survived… except Casey Jones.
His heroic death made Jones a folk hero to this day. Many songs told the story and even the Grateful Dead and AC/DC paid tribute decades later. (Trivia: He actually tuned his train whistle with six different tubes to make a unique whippoorwill sound. So, when people heard his train whistle, they knew it was Casey Jones.)
Right now, the US economy is kind of like that train: speeding ahead with the Fed only slowly removing the fuel it shouldn’t have loaded in the first place and passengers just hoping to reach our destination on time. Unfortunately, we don’t have a reliable Casey Jones at the throttle. We’re at the mercy of central bankers and politicians who aren’t looking ahead. They can’t simply turn the steering wheel. We are stuck on this track and will go where it takes us.
Where are we going? Jan Hatzius, Goldman Sachs’ chief economist, gave his clients an inkling on Monday:
An expanding deficit and debt level is likely to put upward pressure on interest rates. While we do not believe that the U.S. faces a risk to its ability to borrow or to repay, the rising debt level could nevertheless have [serious] consequences….
Borrowing from the Congressional Budget Office’s analysis following the passage of the tax reform act, the two-year budget deal in February, and the massive “omnibus” spending bill passed in March, Hatzius projected that annual deficits will shortly exceed a trillion dollars a year, pushing the national debt close to $30 trillion in less than 10 years. He warned:
The current fiscal expansion … must at some point give way not just to a neutral stance, which we expect by 2020, but to a tightening of fiscal policy that could restrict growth.
The problem is that it isn’t just the government that must continually seek buyers of its debt, it’s the gargantuan corporate debt held by American companies that also must be serviced. In the next five years, wrote Mauldin, more than $4 trillion of corporate debt will need to be refinanced. Add to that the “new class” of investors left over from the Great Recession: those who took their savings out of banks and invested them in high-yield bonds for their higher returns. They are not only individual investors but corporate bond ETFs (electronically traded funds) and bond mutual funds.
Mauldin is especially concerned about that high-yield bond market, which alone is $2 trillion in size. As interest rates rise, investors will see the value of their bond holdings dropping. At some point, those holding high-yield bonds will want to cut their losses, triggering a potential avalanche of selling. Said Mauldin: “I don’t have enough exclamation points to describe the disaster when high-yield funds, often purchased by mom-and-pop investors in a reach for yield, all try to sell at once, and the funds sell anything they can at fire-sale prices to meet redemptions. In a bear market, you sell what you can, not what you want to … the picture is not pretty.”
The ripple effect is predictable: As redemption demands increase, bond managers will find it impossible to offload those high-yield bonds, and will then start to liquidate the rest of their portfolios to meet those demands. The value of those portfolios will decline while risks increase, triggering downgrades. Those downgrades will trigger further selling due to covenants under which the managers operate, and the wholesale liquidation begins in earnest.
Just how bad could it get? In his latest newsletter, Mauldin told his readers:
As in the Biblical book of Revelation, the initial credit crisis stemming from the fall of high-yield bonds will be merely the beginning of woes. Illiquidity will spread as lower-end corporate bonds fall to junk ratings. Legal and contractual constraints will then force institutions to sell, pressuring all except the highest-grade corporate and sovereign bonds. Treasury and prime-rated corporate bond yields will go down, not up (see 2008 for reference on this). The selling will spill over into stocks and trigger a real bear market—much worse than the hiccups we saw earlier this year.
The trigger is this: the inverse relationship between bond prices and bond yields. As interest rates increase, old bonds paying less are worth less. When unsophisticated high-yield bondholders get their statements and see that their accounts are declining sharply in value, some will seek the exit and redeem them before they drop further. Like lemmings headed off the cliff, redemptions will shortly exceed purchases, and the great liquidation will begin.
When it stops, only Casey Jones knows, and he found out too late to do anything about it.
Goldman Sachs: The fiscal outlook for the US ‘is not good’
John Mauldin: Train Crash Preview, Part I
John Mauldin: Train Crash Preview, Part II