The Cats and Dogs of the Equity Markets

dogcatSome 70 years ago, Congress spelled out the economic growth objectives for the U.S. economy in the Full Employment Act of 1946. The mandate was for the government to support policies that would bring about sufficient economic growth so that employment would become “full.” Congress also included a restraint to the mandate that would limit inflation, but over time, both interpretations and priorities change. After all, this is politics as well as policy.

In aiming for full employment while controlling for inflation, the greatest responsibility fell on the shoulders of the Federal Reserve, which had the short-term flexibility to vary the cost of credit to manipulate aggregate demand.

To do so, there had to be an understanding of how much aggregate spending was needed to generate employment levels considered to be “full” without accelerating the inflation rate. This led to the development of a macroeconomic target called “Potential GDP,” which defined how much GDP spending would be needed to create enough demand in markets that would cause firms to hire just the number of workers consistent with full employment. Too few, and targets wouldn’t be met. Too many, and there would be inflation.

The goal, then, was for the Fed to match an equal amount of demand to Potential. This concept and its calculation was the work of Arthur Okun in l962 that become known as Okun’s Law.

The second link of what needed to be established is how that amount of aggregate demand would relate to the Federal Reserve’s main policy instrument, the short-term interest rate. This was accomplished by the Taylor Rule in the early l990s. It provided an estimate of the short-term interest rate that would generate the demand that would cause business firms to hire enough workers so as to be at full employment.

All these machinations of determining the right short-term interest rate to drive spending to the right number that would, in turn, cause businesses to hire the right number of workers to claim that employment is full is an ongoing exercise because the relationships that determine that interest rate are constantly changing. That is to say, the latest calculation of Okun’s Law (how much spending is needed) and the Taylor Rule (what interest rate creates that amount of spending) are subject to the latest economy-wide responses — and those do change.

For Wall Street, the Federal Reserve’s plan to raise interest rates, is seen as an attempt to put a dent in the economy and, hence, corporate profit growth and — in turn — stock prices. What Wall Street doesn’t realize is that the interest rate adjustment is supposedly one that will get the economy to full employment (and prevent inflation acceleration) and keep it there.

But the stock market’s obsession with the Fed’s intention to raise interest rates is largely misplaced: The Fed is looking to maintain growth, while allowing for some inflation which is viewed as a means to depreciate debt outstanding. To the extent there will be an interest rate increase, it’s likely to be little and late and an almost symbolic fulfillment of their duel Congressional mandate.

Nonetheless, all the major stock market indexes for U.S. equities since the beginning of the year are flat, reflecting a deterrent to growth that the Fed rate adjustment would supposedly create.

But there is other reason for Wall Street to be concerned with the general advance of stock prices.

When employment growth occurs, as it has, in this slow-motion up-cycle, labor becomes relatively scarce and wages increase. That’s the whole point of the macroeconomic exercise of targeting full employment. But in turn, rising wage rates increase the costs of production, which reduces profit margins and total profit.

We are at that point for many firms. Actually, we are beyond that point.

The more ominous rate for Wall Street should be the wage rate — not the interest rate — that flows into corporate employee costs. This creates a larger dent to overall profit than is being added either by more output and/or higher prices as the economy approaches Potential.

The wage component of employee costs is now bumping along at close to a 3 percent rate, but that only partially reveals the deterioration of profit due to employee compensation. There is a rarely viewed government statistic called the ECEC, or the Employer Cost of Employee Compensation. This calculates the employment cost to employers, taking into account not only wages but also benefits. Those have amounted to a 4.9 percent increase over the past two quarters.

The employee cost component is rising, but employee benefits are rising at a more substantial pace as the Affordable Care Act (among others) kicks in.

But that still doesn’t fully reveal the dent in corporate profit that will be delivered from tighter labor market conditions. It’s not just employee expenses that matter but also the extent to which those costs are offset by greater productivity of labor. That is, if labor costs rise and are offset by more output per employee, labor cost per unit of output can actually decline, resulting in a larger bottom line. But that’s not happening. Rather, the opposite is occurring.

The Bureau of Labor Statistics indicates: “Productivity decreased 3.1 percent in the nonfarm business sector in the first quarter of 2015; unit labor costs increased 6.7 percent (seasonally adjusted annual rates).” In manufacturing, productivity decreased 1.0 percent and unit labor costs increased 3.4 percent.

The significance of this 6.7 percent increase in unit labor cost must be compared to profit margins per unit. On average, pre-tax profit (as a percentage of corporate value added, as a proxy for profit margins) is at a very high 12 percent per unit produced, as can be seen below. Hence, we are looking at a collection of firms potentially losing half of pre-tax operating profit to employee compensation — and stock market shocks will follow.

Thus there is a built-in contradiction of achieving macroeconomic success of driving the economy to where employment is full and simultaneously providing stock market returns. The only way the two can simultaneously occur is if firms invest in capital equipment to raise productivity more than the growth in employment costs. But that happy state of affairs is not occurring.

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So at this juncture of the business cycle expansion, we are looking at increasing labor cost per unit produced with a large dent to profit margins and reduced profits for firms with heavy dependence on U.S. labor. This implies U.S. service industries are the most vulnerable.

But yet there is still a stock market opportunity with widening profit margins for firms that use foreign labor (via outsourcing) and are paid in cheaper foreign currency given the stronger U.S. dollar.

Some firms will benefit from global access to cheaper employee costs. Basically, there will be a dispersion of positive and negative shocks from firm to firm with the ratio of the advancing-to-declining stock decreasing. Some stocks will become dogs and other will be purring cats of profit expansion due to cheap foreign labor.

The implication for investing in a broadly diversified range of firms would mix the dogs with the cats and the outcome would reflect the same: stagnant returns on average, along with a general sense of uncertainty as some firms experience earnings surprises, both positive and negative.

Firms that benefit from this macroeconomic environment are those that deliver goods to U.S. consumers that are produced more cheaply abroad. Detecting and targeting those cats from the dogs in this environment is more the issue for U.S. stock market investors than a generalized fear of interest rate liftoff.

 

 

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Manna from Heaven and Government Debt

 

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Baby Boomer entitlements, long viewed as an over-the-horizon problem, are now upon us. These unfunded liabilities are morphing from a forecast into actual debt, a process that will continue for decades, and the accumulated debt is already undermining aggregate economic performance. It’s a problem that is crying out to be addressed and the sooner the better.

The implications of government debt accumulation have been the subject of posts on this site and throughout the blogosphere, but the topic usually receives a “head in the sand” treatment from governments and politicians, alike because the implied cure — to rescind entitlements — is a political third-rail.

If not addressed, debt default ultimately occurs, but that doesn’t seem to even arouse a response other than the hope that it occurs on someone else’s watch. (Observe the Greek debt theatre being played out.)

So the question is: What fixes can governments apply now that can still sustain the economy and all the things that go with it? Certainly supply-side policy should be front and centre in that discussion. Everything the government does needs to be viewed from the prism of economic growth which provides the income to sustain debt.

Having run out of conventional solutions within a government toolbox of macroeconomic fixes, the European Central Bank (ECB) is implementing a desperate or some might say a creative and subtle use of its money printing ability. Sadly for Europe though, it will have unfortunate side effects.

The policy, while being labelled quantitative easing (QE), is much more than a monetary policy to create extreme low interest rates. It also has a Manna from Heaven component that can be used for multiple purposes. Allow me to explain.

Quantitative easing originated in Japan and also turned up in the U.S. as large-scale central bank bond purchases. While it seems on the surface to be Keynesian interest rate policy, its more pressing, unspoken reason was debt service containment, both for government and private debt.

Manna from Heaven is unleashed when QE, as implemented by the ECB, is taken to the next extreme level. The ECB intends to buy a large quantity of Euro investment-grade debt, including sovereign debt on secondary markets. To reach their target requires that the ECB offer a higher price to induce present owners of investment-grade debt to sell their holdings to the central bank.

Investment-grade bond purchases by the ECB have been targeted to be approximately twice the current issuance of investment-grade debt (for both private and government issuers) hence reducing the available supply of investment-grade bonds in the market. That puts financial institutions and foreign central banks in a bind given their mandates to hold bonds of this character.

Therefore, there is great competition for Euro-denominated investment-grade debt, and it becomes scarcer with each ECB purchase, driving investment-grade bond prices not just higher but in excess of the principal and all interest until maturity for most debt issues. This is the definition of negative interest rates and reveals how it comes about for market-traded debt. The premium prices paid for by new money issuance is the Manna from Heaven and generates windfall gains for the sellers.

And in the hope of not being considered too irresponsible, the ECB has put a cap on the price premium above the bonds’ total proceeds of 20 percent (which puts a floor under just how “negative” interest rates can go).

Despite the premium prices the ECB is willing to pay for investment-grade bonds, it has come to believe that there will not be sufficient availability of offered bonds on secondary markets to meet their quantity objectives. As a cover narrative, they claim their quantity goals can only be reached if they also purchase original issuance of Euro sovereign bonds at up to the 20 percent premium despite the Euro prohibition on such transactions.

Now think about what that means, as it means a lot.

First, the premium prices paid produce negative yields not only for the central bank buyer but also for pension funds, insurance companies, banks, and endowment obligations (or savers in general who invest in this market). While the central banks can “afford” negative yields, most certainly the private institutions cannot — and they are ultimately on a collision path of not being able to fulfil their contractual obligations when their investment income derived from bonds declines so dramatically. They then become future government bailouts waiting to happen that would substantially add to government debt.

Second, the ability of the central bank to pay premium prices for investment-grade bonds results in windfalls for both debt holders and debt issuers. For them it’s veritable Manna from Heaven financed via central bank printing.

Third, with the price paid being greater than all future commitments on the part of the debt issuers’ means there now becomes a large incentive to keep issuing debt, including government issuers, as they receive greater proceeds than their corresponding obligations. Or to put it another way, they are being paid to borrow.

Fourth, the Manna becomes a new free policy option for governments. Their choice becomes to use the excess cash proceeds to either retire other government debt obligations and dissolve their debt overhang or will they choose to issue yet more debt for which they are being paid? Or yet will they take the cash proceeds and lock up an amount equal to their future obligations of principal and interest and spend only the Manna? They are being given those three options by the ECB. Whatever way is chosen it’s an incredible test of the inclinations of government to act responsibly and address the debt problem or keep on spending and borrowing.

Fifth, irrespective of governments’ use of the Manna, there is a balance sheet effect for the government whose debt is purchased by its own central bank.

As an aside, when the ECB as a policy board orders a buy of a country’s debt, it is purchased by the country’s own central bank. (Yes, the individual country central banks continue to exist even though there is an ECB. The individual country central banks are the operational banks within the Euro system, as are the 12 Federal Reserve Banks carrying out Federal Reserve policy.)

Now, if a Euro central bank purchases its own government’s debt, it defeases (annuls) that debt. A balance sheet defeasment occurs when the government and its central bank balance sheets report on a consolidated basis. The debt of the parent organization (the government) is owned by its subsidiary (its central bank) and, as a result, only net debt not owned by the subsidiary can be reported. Indeed, the U.S. now reports government debt outstanding on a net basis to mollify those concerned about government debt balances.

Sixth, the ugly government debt problem disappears (on a net basis) when central banks buy its sovereign’s debt and pays monetary premiums for it but, in its place, there is a classic fear that there will be an inflation tax. That is a real reduction in the value of fixed income assets held by the public due to inflation. This is a fear that is totally justified despite today’s weak and deflationary-prone environment, as the increase in the monetary base would be very, very large.

For example, in the U.S., if the Fed were to monetize the total outstanding $18 trillion of U. S. government debt, and with some premium paid above that amount equal to the ECB premium, the total monetary base would easily go above $20 trillion. This compares to a monetary base of $0.8 trillion at the outset of the Great Recession. That would cause a 25-fold or 2500 percent increase in the money base as compared to a cumulative 13 percent increase in real output over the same period. It might take some time to play out but this will certainly lead to inflationary devaluing of fixed income assets and currency and result in capital flight to a more stable medium of exchange.

This is no way to run a government and its finances if a country expects the world and its own citizens to hold wealth denominated in its own currency. Indeed, it is second-best policy not just due to the inflationary potential but also as a result of undermining insurers, pension funds, banks, and endowments to perform on their obligations. Furthermore, negative yields create a poverty class of retirees, of which there will be many.

But somewhere between zero defeasance and total defeasance of government debt is likely to be a better place for debt overloaded countries, giving them the option to use the proceeds to retire rather than squander the proceeds or give in to the incentives to borrow and spend even more.

Manna from Heaven, on its face, can be helpful if done on a very limited and disciplined scale, but when have we ever seen governments do that? The Manna becomes a litmus test of governments’ inclination to act responsibly and effectively, as it could either defease debt or be incentivized to add to debt.

At best it can only be a small help as compared to policies to unleash the supply-side of the economy to generate growth that will sustain the developed world’s debt problems.

Given all this, we find that the monetary sleight-of-hand to produce Manna only goes so far before producing unwelcomed side effects. It’s not a replacement for containing debt within supportable limits. All in all, John Maynard Keynes did a disservice some 80 years ago to suggest otherwise.

We must conclude, the rules of propriety have changed. Many naïve among us believed that when governments borrowed they intended to subsequently tax in order to retire debt. But at least it was thought that taxes would pay interest to service the debt. This too has proved to be a false premise as central banks drive interest rates to zero or negative to accommodate over indebted governments. And now in the final assault on propriety, governments are being paid by central banks to issue yet more debt.

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Milton Friedman and the Monetarist Reflex: Can the Fed create inflation?

These are complicated times, especially when it comes to inflation.

An excess of debt, both private and public, has retarded the spending stream, resulting in sluggish economic growth. Given the Fed’s legislated commitment to prevent financial implosion and unemployment, rounds of central bank monetary responses have followed. The intuition of more money in our pockets chasing a limited supply of goods, as well as our long intellectual history of monetarism, sets off the reflex that printing results in inflation. That hasn’t appreciably happened yet, but multiple rounds of QE keep markets on edge given the teaching of Milton Friedman,

To add to the inflation paradox, last January, for the first time, the Fed committed to producing moderate inflation (2 percent) “over the long run“. However, as recently reported by David Rosenberg, inflation at the producer level was flat over the last quarter, and given the Euro recession and continued U.S. sluggishness, it appears likely that the inflation goal might not be reached. Indeed, many credible sources are forecasting long-run deflation, a la the trend in Japan.

On top of that there is the conjecture, mentioned in a recent post that in the (likely) event of an uncontrolled government deficit, the role of the central bank would be to generate actual inflation that exceeds the expected inflation premium that had been priced into interest rates. The purpose would be to reduce the real cost of government debt. This seems to suggest that the long-term Fed inflation target is to keep expectations anchored at a number the Fed hopes to exceed.

But in the longer run, while accumulating four decades of baby boomer entitlement debt, it would take one surprise after another to exceed expected and priced inflation. And each would have to be larger than the last to continuously have actual inflation exceed that which is priced by the market. This is the implied path to what is journalistically called “runaway inflation.”

The Fed inflation targeting in the long run is one thing, but the real question is whether the Fed can deliver when it so far has not.

The paradox of strong growth in the monetary base without the inflation implied by monetarism first surfaced when the first Federal Reserve balance sheet leap occurred in 2008. At the time, many people believed that a doubling of central bank money chasing a short term fixed supply of goods would bring about a doubling of the price level.

Obviously, that didnt happen. The question is why not.

First off, at that time, the commercial banking system did not have the requisite regulatory solvency (an excess of asset values relative to deposits) to expand balance sheets if they had the risk tolerance. That is, today’s excess cash reserves of $1.5 trillion held by banks and a commercial bank money supply multiplier of say 10 would normally result in $15 trillion of lending and spending. A surge in bank-financed spending could roughly double the present $15 trillion annual flow rate of GDP and, with it, inflation.

The predicted proportionality of prices to money didn’t occur, as spending not only failed to increase appreciably with more central bank base money, but fell short of the economy’s supply potential so that deflationary forces from excess capacity still exist today. (This same phenomena to monetarists would be the explanation for the decline in the velocity of money.)

So the issue of inflation depends to a large extent on the ability and willingness of commercial banks to run with the base money given to them. The most recent reading of that is not encouraging to either the growth of spending or inflation, as the graph above shows.

Despite having been given a stealth capital buildup via an essential zero cost of funding program (in addition to the TARP subsidy), the commercial bank books claim solvency, but lending contracted in the first quarter. The Keynesian notion of the liquidity trap is still alive and festering with banks pointing to a lack of borrowers and borrowers pointing to a lack of willing lenders. The problem, more than loan risk analytics, is likely behavioral. As aptly discussed by Kevin Flynn:

“For the last 50 years banks have been behaving the same way — turning a profitable sector into a credit fad and then drowning it in the name of market share, management bonuses, takeover avoidance, or whatever. Once they blow a sector up, nobody wants to hear about lending to it again for another generation of CEO management, which runs for about five to 10 years (the last thing that managers brought in to replace disgraced managers want to do is more of what got their predecessors sacked). Banks finally got around to blowing up housing, so now we have a generation of bank executives in place whose unifying feature is the determination to avoid a housing bust that won’t happen again for another 70 years or so. The Fed can’t do anything about it.”

Given these impediments to produce monetary expansion and lending through banks, there are other routes by which the Fed might reach its inflation objective. Without bank follow-through, the impact of monetary expansion is limited to the Fed’s first round of financial purchasing power. This limitation of its firepower is what turned the Fed to large scale QEs, since there would be no commercial bank follow–through: They had to do the job themselves. But since the Fed is not a commercial lender, it mainly relies on what is known as a Pigou effect — a generalized market value of wealth spreading from bonds to equities and other assets that in turn induces limited spending but not at a rate sufficient to create inflation.

Another approach to inflation (which the Fed scoffs at) is un-lovingly called helicopter money. This was the first thing done when the financial meltdown occurred, in the form of the Fed putting money more directly into the hands of spenders (as opposed to financial asset markets). That is, rather than just continuing more of the same Fed expansion, helicopter money delivers fresh spending power directly to the end user (the consumer) over the heads of the moribund banks.

Believe it or not, this was implemented in the dark days of 2008, when the Fed purchased Treasury bonds that enabled the Treasury department to mail out an equal amount of government green checks directly to spenders. It flew under the radar screen as the checks were called tax rebates, and few knew the source of the funding. However, a wider distribution of government green checks coming from the Fed or the Treasury would require a more obvious money gift that would create contentious comparisons of need. To further rule out more green checks to consumers (especially voters), the Republican Party platform is now at odds with at grossly expansionary Fed tendencies, and the Fed is not likely to expose itself to legislative constrains to its independence.

If the government wishes to depreciate its debt and consumer debt with inflation, a more likely inflation alternative would be for the Treasury Department to turn to treasury currency, the United States Note. As previously explained, the government used this tactic to pay its bills during the Civil War.

In this case, the financing of government spending is facilitated by Treasury currency printing rather than Federal Reserve printing. Treasury currency would have a greater inflationary impact as it directly finances spending in goods markets. In this case, inflation would be a fiscal byproduct rather than a central bank contrivance.

Treasury currency would be more effective as it goes over the heads of the blocked banking system and reluctant spending units, and on behalf of the taxpayers, goes directly into the spending stream when the government pays for entitlements such as Medicare. As such it is a kind of super-helicopter money delivered to the goods markets rather than the financial markets or even to the consumer to be used for debt reduction as the new currency is injected into the spending and income stream.

When political leaders are pressed to “do something, it seems that this would be the “something” that could simultaneously finance entitlement spending, reduce the size of the fiscal cliff, and reach a desired inflation target. This is a something for nothing policy solution that politicians who take the path of least resistance would find difficult to ignore–and its in the law.

What an irony.  Despite the accusations being made, the Fed in these circumstances is only able to produce inflation expectations whereas Fed generated inflation is dependent upon a generational replacement of commercial bankers.

It seems the notion of an inflationary future one way or another is still alive and ticking. Recently, inflation adjusting assets including energy pipelines, gold, income producing real estate and infrastructure are now moving up in the markets and fixed income assets are moving downward. Though the Fed has struck out on the inflation front, the bet has switched at least at the margin to the government doing “something” in the long run to ultimately reach an inflation target. Keep tuned to see how these improbable policies and events work out.

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The Bond Market Rocket and Fiscal Unsustainability Are On a Collision Path

Recently, the bond market has been in rocket mode. It has achieved liftoff and slipped the surly bonds of earth. And some believe it will keep going.  The price of the U.S. Treasury 10-year bond recently reached an all-time high, generating yields at all-time lows. Moreover, the market yield on the British perpetual bond is reportedly at a 300-year low.  Bond mania has even spread to the sovereign debt of Denmark and Singapore and others where negative yields exist.  More astonishing is the ability of France to issue short-term sovereigns with negative yields!

The U.S. has eclipsed the record interest rates that prevailed when the 1930s Depression era came to an end with the onset of World War II, as shown in the chart to the right.

To get to the previous low yields of early December 1941, the U.S. economy had experienced a decade of depression with cumulative deflation of 30 percent.  With that decade-long trend influencing expectations, the future seemed to call for more of the same.  In that environment, investors favor long-term fixed income that appreciates in real terms as a result of deflation if the long bond is successfully paid and retired despite depression circumstances.  Hence the asset category of choice in a deflationary depression is survivable high quality debt.  In the ’30s, this also included surviving corporate debt that appreciated along with Treasuries, and the AAA-Treasury spread narrowed over the depression years.

Since we presently are in an era of Federal Reserve QEs, you might suspect that the Fed was possibly behind the rising Treasury prices and lowest yields of that era.  However logical it might seem in today’s context, the Fed was nowhere to be found on the buy side of the Treasury market during the depression (something Bernanke seeks to not repeat). Indeed, the money supply declined by 30 percent over the course of the depression, so the bond market did it all on its own, without Fed support. Indeed, being in a pre-Keynesian world, the rationale or desire for manipulating the interest rate or credit conditions was not part of the Fed’s understanding of how to run a central bank.

Then as now, the private market participants price the expected risks and costs of holding a debt instrument over its life, and they require additional yield for each risk and cost they anticipate will materialize.  They generally make this assessment of risk by extrapolating previous trends or by finding a similar historical episode to benchmark the likely gains or losses in value that might take place. Today we find many forecasts (even on this blog) citing the withering force of deleveraging due to over–indebtedness, which takes down an economy and softens demand and prices for goods.  Hence, today’s natural historical model for bond pricing would seem to be the 1930s.

However, while there are similarities, there are also big differences. Today it is the government that is over–leveraged, whereas in the l930s it was the corporate debt sector which makes today’s long Treasury yields suspect.   Though the economy is weak today, we are not in a decade-long depression, and while inflation is low, it is not in a cumulative deflation.  And while the Fed held back this week, they still have a commitment to positive inflation.

The greatest difference is today’s checkmated body politic, which is unable to resolve an ultimately un-financeable Federal deficit. This week we had another episode of kicking the can down the road, with the agreement to run the debt meter another six months before facing the music. This is all in sharp contrast to a much lower government debt load and an obsession to run a balanced fiscal budget despite the depression that prevailed in the 30s.

While the growth/inflation profile is different in the two eras, it is more important to note the difference in long-term fiscal sustainability.  Somewhere during the unfolding drama there will be an unspoken need (not mentioned in legislation or treaties) for the Fed to pull a “Super Mario” Draghi — who, last week, signed up to “do whatever it takes,” which apparently meant ignoring the ECB mandate and directly supporting Spain’s bank and government debt because the market no longer will.

Indeed, in the U. S. at the outset of WWII, the Fed presented the patriotic idea of wartime bond support to the Treasury, not the other way around. Central banks are not shy in the ultimate moment of money needs.

In what should be considered a “white paper,” the Fed’s role in these dire circumstances is recently discussed by Renee Haltom and John A. Weinberg in the Richmond Fed Annual Report, 2011, titled Unsustainable Fiscal Policy: Implications for Monetary Policy. In a rare Fed admission they indicate that “a central bank can reduce the government’s debt burden by creating inflation that was not anticipated by financial markets.  Inflation allows all borrowers, the government included, to repay loans issued in nominal terms with cheaper dollars than the ones they borrowed.”

Indeed, if the Fed were to create inflation, it would not be totally unanticipated.  This is the outcome seen by many observers, including Bill Gross of PIMCO.

And Bill Gross is not alone, as the bond-buying public seems to believe little of the fiscal sustainability story.  Indeed, the flow of funds data, at least for 2011, indicates that the private sector purchased a minority of net new government debt issuance.  Hence, private investors are not the leading purchasers of U.S. Treasuries, causing the all-time depressed bond yields. The graph indicates that the Federal Reserve is buying the lion’s share of net new Federal debt, and foreign investors are in second place. That market thrust no doubt represents a flight from European sovereign exposure, which is in a more advanced state of fiscal decay at the moment.

No doubt some have bought the1930s deflationary depression story as a model outcome to justify buying and holding sovereigns, but this time around it doesn’t lead to the necessary conclusion that sovereigns will appreciate from here.  At today’s entry point of taxable low nominal yields and negative real yields, betting on both a deflationary depression with fiscal sustainability is not only a long shot but is mutually inconsistent.

A deflationary depression doesn’t generate government tax revenues to reach fiscal sustainability unless the voting public is willing to accept a substantial entitlement haircut. Moreover, if the low bond yields were to be maintained it would systemically cause defined-benefit pension plans to underperform.  They would become forced sellers of sovereign bond holding to meet payouts — as is now finally occurring with Japan’s Government Pension Investment Fund.

The bond market rocket can glide for a time, perhaps years, until it collides with fiscal unsustainability. At that time it will be revealed plain enough for all to see when the private demand evaporates, much as it did with Spain this week. At that time, the U.S. Treasury is no longer a riskless debt instrument, nor is it immune from inflation.

(That being said, it leaves open the question of whether intentional inflation is bravado in the absence of bank lending, which will be addressed in a subsequent blog.)

When the market comes to understand that sovereign bond strength from a central bank is a mixed blessing — as it both purchases government bonds but also intentionally seeks to create “unanticipated” inflation —the bond market rocket is susceptible to the gravitational pull of Earth.

When that happens, there will be a large debris field for those who entered this untenable crowded trade (or stuck with it) so late in the game, supported not by the bond-buying public but only by a central bank wishing to do its patriotic duty — which includes inflation generation.

This indeed is not the 1930s.

 

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