End of Bonds Rise in Rates – A New Type of Inflation
QUESTION:
Dear Martin,
First I would like to congratulate you on your excellent analysis and market views.
I am a bond portfolio manager for 25 years and I can only be shocked by current interest rates, specially in Europe. I have recently cut my long exposure to Bunds and everyone says it’s crazy to be short when ECB is buying but… with 10 year French bonds at 0.40% (less than 2yr US Treasuries), not to mention German bunds at 0.15%, these can only end badly. Also with 30 year Germany at 0.65% is assuming inflation is dead forever… something I strongly don’t believe. My question is what can bring inflation up end the biggest bond bubble made by central banks?
Thank you and best regards,
GC
ANSWER: There appears to be coming a very difficult period that will have (1) massive deflation as capital formation is reduced from public debt moving into default, and (2) rising asset inflation that is money trying to get off the grid, which is not demand inflation led by consumer spending. This will cause tremendous confusion. Some will call this Stagflation, which dominated the 1970s where consumer spending declined but prices still rose thanks to the Oil Price Shock of OPEC.
I have stated many times before that a stock market crash at best is good for a recession for a small amount of capital parks in equities. A depression is caused when capital formation collapses caused by a debt collapse. This took place following the Panic of 1837 set in motion by Andrew Jackson’s destruction of the central bank, which set off Wildcat Banking at the state level. They needed to be bailed out and states issued debt trying to support the banking system and they ended up defaulting on their bonds as well.
There will come a is a disconnect between the PRIVATE v PUBLICissues of debt. The differential between AAA Corporate and government peaked also in 1932. We have the FDR confiscation of gold and the devaluation of the dollar by January 1934. Note that the differential fell to a low in 1937 as the Dow Jones Industrials also peaked that same year. This illustrates the shift in CONFIDENCEfrom PUBLIC back to PRIVATE.
We have to also understand the 1929 period. The USA was bankrupt in 1896 and that is when JP Morgan arranged a gold loan to bailout the country on February 8th, 1895 (1895.106). Grover Cleveland approved the third treasury bond sale to a syndicate headed Morgan. However, when news of this deal broke, public opinion turned against Cleveland even more than before. Most people ignored the fact that Cleveland had saved the United States’ gold reserves. When people learned how profitable the deal turned out to be for the banks, who had immediately resold the bonds at marked-up rates, more contempt confronted Cleveland. There were even rumors that he had profited personally from the deal. The Morgan issue only helped to accelerate the decline of the Gold Democrats (austerity – sound money) in favor of the Silver Democrats (inflationists). This played out with the 1896 Presidential Election and William Jennings Byran’s famous speech that labor will not be crucified upon a cross of gold (austerity).
From the Morgan Bailout in February 1895, 34 years later we end up with the 1929 bubble. This was a massive capital migration to the USA inspired by World War I and the fall of Britain from that position as the Financial Capital of the World. We can see the huge rise in debt in Britain because of World War I. This ended their reign as the leader of the free world shifting it to the USA.
We can see that the bonds fell during the 1927-1929 stock rally for stocks rise with interest rates and fall with lower rates – opposite of TV pundits. You see the initial flight to quality from 1919 into early 1931, but as the Sovereign Debt Crisis hits, the US bonds trade sideways at first and then finally collapse as they became the last one standing. We will see the same delayed action at first as capital shifts to Treasuries in the traditional flight to quality, but that will not last long in this current incarnation.
Hoover explained this Sovereign Debt Crisis of 1931 best how capital rushed from one default to the next. We saw this same response with Greece in 2010. Capital then looked at Portugal, Spain, Italy, and even France asking – Who’s Next?
The gold standard collapsed and in 15 months, the dollar soared. This led Congress to pass a protectionist act and the economy imploded. People look at currency as if it were a stock and assume a strong currency is bullish and a weak currency is bearish. This may be for capital movement, but economically, it is opposite. Strong currency reduces exports and weaker currency results in more exports.
While gold fled Europe to the USA, the Fed did not coin the gold and this led to criticism with hindsight. There was a massive contraction in capital formation for what was different during that cyclical event was that the investment banks had sold the foreign sovereign debt to the general public in small denominations. This is why you can buy many bond issued on EBay today. This created the contraction that unfolded as a banking crisis by 1933 and a deflationary contraction. The velocity of money also collapsed and hundreds of cities had to issue their own money just to get by. The first paper money was actually in Canada when the ship did not come in there was a shortage of money. This shortage was resolved by using playing cards as money. Money is simplyCONFIDENCE that two tangible products can be exchange be it food and labor or whatever. Boil it down to the basic element, you are money for it is your productive capacity that is the real value. If that statement were not true they how did China and Japan rise without gold?
Therefore, inflation will rise up in the form of asset inflation as money tries to get out of PUBLIC debt fearing default. This will not be consumer spending from a party time. Since central banks have already been buying in government debt, they will be unable to resell that back to the private sector. New debt will rise and tax revenue declines and deficits rise. PRIVATE ownership of PUBLIC debt will decline and this will cause rates to rise. But this will not be alone. With assets rising, the Fed will respond with raising rates believing they must defend against inflation or be blamed for creating the bubble. As they raise rates, the government interest expenditure will skyrocket. We could see interest expenditures exceed defense spending as early as 2017 with rates rising, but by 2020 if rates remain the same.
The Coming Public Debt Crisis
COMMENT: Hi Martin
I am a macro manager. I read your article on April 9th about Public/ private.
I agree it will happen but Commercial banks hold only a tiny part of the US Treasury as you will see from the graph attached. They will probably buy on the way up and China reserve growth is slowing making domestic buyers the prime target . There is scarcity of quality collateral with all new type of regulations (Dodd, Basel III etc..)
Thanks for your good work.
Best
b
REPLY: The bank holding of Treasuries is not significant. With QE1-3, the banks complained that there would be no securities to park money in. Hence, the Fed created the Excess Reserve facility where banks park over $2 trillion in cash collecting 0.25%. That would have been an admixture of Treasuries and loans otherwise. Those who think everything is about fractional banking do not know what they are yelling about for to create that effect, the bank must lend. Between Excess Reserves and Treasuries, fractional banking is reduced – not expanded.
Nonetheless, the banks will buy into the peak in Treasuries. Consumer Credit is declining in many areas as taxes are rising and you can see the recession coming already. The Banks have never learned to trade against the business cycle. They buy the highs and sell the lows and fire the people that make those decisions so the next crew does the same thing lacking experience. Their buying of Treasuries will continue into 2015.75 for this is the bubble in government rather than wilds consumer spending.
It is the central bank holding of Treasuries and the bulk of private holdings, composed of pension funds and insurance companies, who are the biggest domestic parking spot for now. Then there is the inter-agency holdings of Treasuries like Social Security. The Fed holding of Treasuries is at 13% and this becomes dangerous for they bought in the supply from the marketplace and are unlikely to reduce that holding as the Fed should do right now moving into 2015.75. If the Fed FAILS to sell off their bond holding now going into 2015.75, when the economy turns down, they will have to buy in even more. This will be the catalyst post-2015.75 when confidence in government slips and falls from the crisis in Europe. We still see Greece defaulting and will most likely leave the Euro thanks to the stupidity of Brussels. Therein lies the contagion for the next cycle phase.
Of course you have the people with prejudiced views and blame fractional banking attributing $50 trillion in new credit since 2007. Besides them dreaming, they cannot see that retail participation in the stock market is at record lows. The rise in consumer debt is mostly new cars (collateralized) and student loans. How has fractional-banking contributed if people are not borrowing even in Europe? The NY money-center banks are trading, not lending aggressively. Now even their dealing lines to their traders are starting to decline with liquidity.
The debt bought in by central banks is unlikely to see the private debt markets ever again and new debt coming out will meet higher resistance when we begin to see a rude-awakening that the debt crisis is not the consumer and private loans which are largely backed by some collateral (even if it declines by 50%), but buy public debt that is totally UNSECURED and has no backing whatsoever. That is where the debt crisis comes into play – the new debt will rise causing interest rates to reverse and the budgets will explode exponentially. That is when it becomes more obvious to the general public that this is a government problem – not private this time.
The 8.6 seems to be in Religious Texts as well
COMMENT:
Marty – love your analysis based on 4.3 and 8.6 year cycles. You state that this is all over everywhere and in all markets. Correct, and it is even seen in the Book of Daniel (Bible). Towards the end of Daniel, we see the angel mentioning about 1290 weeks. Well, 1290 (just the number) is an exact multiple of 8.6 – 150 times.
Of more interest is that 1290 is exactly 300 times 4.3! This is YOUR 300 year number and I guess we can say that there is no new thing under the sun!
Best regards
Gerry
REPLY: Fascinating. Another has pointed out that 430 is an important number from the Bible. As the story goes, God told Abraham in a vision that his descendants through Isaac would end up as slaves in a foreign country. God would, however, release them from this bondage after 400 years (Genesis 15:12 – 16). Exactly 430 years later to the very day, on the same night, this prophecy was fulfilled as the children of Israel left Egypt on the 15th day of the first month (Exodus 12:40 – 41). So I was told that this number has worked to the very day before.
I find all religions interesting for there seems to be kernels of wisdom in all traditions and beliefs. Is this 8.6 frequency just the perfect cycle?