The Most Important “Known Unknown” in All of Finance

By Bill Bonner June 15, 2015

Today, the most important “known unknown” in all of finance – something so powerful it could change the character of the entire global economy.

But first, a short trip to Paris…

On the walls of the chapel at the French military school are rich paintings… including a couple of 18th-century masterpieces by French painter Louis-Michel van Loo.

The one behind the altar is of Saint Louis, dying from dysentery in the 13th century. There he is in his splendid blue robe… with the fleur-de-lis on it… receiving extreme unction from a priest.

Saint Louis (aka King Louis IX) died in Tunis, North Africa, on the Eighth Crusade; what he was doing there is not clear. But at least he went in person. And he died in the campaign.

Everything has a price tag. The previous crusade – which he had undertaken 20 years earlier – had been a disaster, too.

He took his army to Egypt to do battle with the Hafsid Muslim dynasty.

There, in the heat of the Nile River Valley, his soldiers must have made quite a picture – with an English contingent, led by William of Salisbury, and the Knights Templar with their banners and tunics.

Everything seemed to be going so well… until…

We’ll come back to that.

God’s Fool

We were sitting in the chapel, attending mass on Sunday. The priest offered his sermon.

We couldn’t tell if it was dull or just pointless. But our eyes wandered to the paintings on the wall… and our mind wandered to thoughts of war.

This – the chapel at the École Militaire – was the sacred heart of France’s military tradition.

This week marks the 200th anniversary of the Battle of Waterloo, a French defeat.

Since then, French military successes have been few. But before Wellington and Blücher hammered Napoleon at Waterloo, the French had won far more battles than Americans have ever fought.

French history is littered with bodies – cut, pierced, blown to bits.

The French, like the British and the Americans, celebrate their fallen heroes and pretend that their wars served a worthy purpose.

And who knows… Wars may look foolish – in retrospect. But man is God’s fool. And all His works demand our solemn curiosity.

And so, with a mixture of respect, shame, and embarrassment, this week, we turn to Mars – the god of war.

When Bonds Turn, So Will the World

But first, let us take up our usual post – where we keep an eye on markets and economies, in the hopes of seeing what mischief is afoot.

Friday, the Dow fell 140 points – or about 0.8%. Given the 108% rise over the last six years, that’s hardly significant.

But the bond market may be a different story… It’s looking more vulnerable. After 33 years of trending down, yields may have finally switched directions.

For example, the yield on the 10-year French sovereign bond quadrupled in the last two months. At 1.2%, it’s still microscopic. And neither the significance nor the permanence of this move is known. But it’s still worth taking note.

By the way, the direction of travel of bond yields – which reflects expectations of where interest rates are headed – is probably the most important “known unknown” in the financial world. Central banks influence, but cannot control, interest rates.

Knowing what Fed chief Janet Yellen wants to happen is not the same as knowing what will happen.

People are not usually prepared to lend money for nothing. Sooner or later, we expect they will want a decent return on their investment.

When they do, the world will change. Asset prices have floated higher and higher on the flood of credit over the last 33 years. When the tide ebbs, assets will fall. And the character of the economy will change.

And that change could be shockingly quick and staggeringly large. The bond market is huge. But just a few players – today, mainly central banks – dominate it.

Read more > One of the early warning signs will be a “run” on paper dollars

For example, government-sponsored agencies Fannie Mae and Freddie Mac backed 60% of U.S. mortgages between 2008 and 2013. And large chunks of U.S. debt are held by just a few players – such as the Fed, China, and Japan.

The feds have convened a meeting of major banks and bond investors this Wednesday. They are worried about what would happen in a crisis.

There could be many bonds on offer, for example, but no bidders. Bond prices would crash – provoking an even more sensational disaster.

The Battle of Al Mansurah

But now let’s return to the poor Christians… sweating in the hot Egyptian sun… seven and a half centuries ago.

They were there to sort out the Middle East and wrest control of the area from the locals – much like U.S. troops in Iraq and elsewhere.

At first, the crusaders’ campaign went well. The Muslims fled, leaving a crucial bridge over the Nile intact.

The crusaders crossed the river, led by Saint Louis and Robert of Artois. Then the town of Al Mansurah was open to them.

Thinking the defenders had run off, the Christians entered the gate. They soon discovered that they had been led into a trap. From all sides, the Muslims attacked. Robert of Artois was killed. So was William of Salisbury. The Knights Templar were almost wiped out. Only five escaped alive.

The Christians retreated as best they could. They dug a ditch to protect their camp. The sun beat down. Supplies of food and water ran short, as the Muslims blocked the crusaders’ ships from reinforcing their compatriots. Famine and disease settled into the camp like swamp gas.

Finally, a deal was struck. Louis was taken into captivity by Muslim forces, along with about 12,000 of his troops. They were freed when France paid a ransom. The price tag: a sum equal to about a third of France’s annual tax revenues.

Louis agreed not to go crusading again. But he learned nothing from the adventure. Twenty years later, he was once again sunning himself in North Africa, waiting to die.

Regards,

Signature

Bill
Paris, France


 

Market Insight

Another Sign Interest Rates Are on the Rise

 

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Another sign that interest rates are on their way up is investors’ renewed interest in the banking sector.

Banks tend to do well as interest rates rise for two reasons.

Read more > Why central banks want a zero interest rate world

First, rising interest rates usually signal a stronger economy.

A stronger economy typically increases demand for loans – banks primary source of profits. It also makes it more likely that borrowers will have the funds to repay their loans. This keeps a lid on dreaded non-performing loans (liabilities for banks).

Second, rising rates tend to increase banks’ profit margins. That’s because the “spread,” or gap, between the interest they pay you or me on a deposit – and the yield they can earn by investing those deposits in the bond market – widens.

The chart below tracks the performance of the financial sector relative to the S&P 500. When the line below is falling, it means the financial sector is underperforming. When it’s rising, it means the financial sector is outperforming.

061515-DRE-Financial-Selector-SPX

At the start of this year, financials were one of the worst-performing sectors in the S&P 500.

But as the economy has picked up, expectations of an interest rate rise from the Fed have picked up along with it… and the financial sector has become one of the best-performing S&P 500 sectors.

At least some investors are starting to price in the end of near-zero interest rates.