by Jerome a Paris
Thu Jun 11th, 2009 at 07:56:40 AM EST
Contrary to what the general public thinks, the most remarkable bull market in our times has not been that of that stocks, or even of real estate, but rather that of bonds. The chart below (via Yahoo) shows yields on 10-year Treasuries, the most traditional, safest long term bond. Yields are the net interest you'd get from buying such a bond on the secondary market today and holding it: they go down when bond prices go up:
Bonds price have been going up for more than 25 years, with a remarkable spike in recent months, which is now being retraced. The increase in yields from record lows of 2.07% in December to a recent high 3.99% in the most recent auction is much commented and seen either as (along with the recent increase in oil prices) a sign that financial markets are getting worried about inflation and the massive increase in public debt, or as a welcome return to normality as panic buying of government bonds recedes and money starts flowing again to other productive uses.
The debate is not only amongst academics or on ET itself, but has taken a political angle with Merkel speaking publicly about it recently.
As the graph above shows, we're still at a point where both interpretations (a jump in inflation worries, or a return to pre-panic levels) are justified, and only time will tell us whether interest rates continue to shoot up, ie markets do worry about inflation as too much government paper floods the system, or to stabilise, as government spending allows the economy not to crash too badly.
My position is simple: this bond bull market is a gigantic bubble, fed by the combination of stagnant incomes and ever rising levels of debt (and thus asset prices) to sustain otherwise-constrained consumption. The virtuous circle of low "inflation" (ie stable income costs) and increasing asset prices (not seen as inflation, for some reason) has created a systemic shift in the relative remuneration of labor and capital, and a massive transfer of wealth from the middle classes to the very rich. As long as house prices went up, that was fairly invisible and tolerable for the unsuspecting public, but ultimately, the financial markets pushed their logic too far and started to "create" wealth by depleting the economy rather than just distributing to its profit the fruits of everybody's work. In other words, they captured so much that it did not leave enough to the rest of the system to be sustained, which required capturing an ever bigger share of a now shrinking pie - to the inevitable endgame of a crash.
Or: you cannot live above your means forever. The economy is going to have to come back to its real value creation level, and is likely to look worse for a long while as it needs to pay down the accumulated debt. This will happen either by way of deflation and a long recession, or by way of inflation and a long recession. This is a fight between various finance players who are invested in inflation-protected assets or not and, ultimately, it matters little to the rest of us: all we'll see is the recession and sharply falling spending.
The problem was consumption funded by debt; the solution is not on the demand side, but on the income side. Thus, governments' plans to increase spending are useless per se, unless that spending goes (i) to increasing incomes (social spending, redistribution) and (ii) to investment in collectively useful infrastructure that makes it possible for more value to be created and distributed.
So far, governments have spent lots of money to prop up banks, ie replacing a private asset bubble by a public debt bubble. It will burst, by default or inflation. The only way out is for governments to spend their way out of the recession smartly; the question is whether financial markets will allow that way out (by financing it at reasonable rates, ie betting that smart spending will allow to avoid default in the end) or whether it will be imposed on them in indirect (inflation) or direct (a take-over of finance by the State, which is always possible and unthinkable to day for ideological reasons and not for practical reasons) ways.
Unfortunately, the markets are unlikely to willingly accept to see their share of the pie reduced, so I expect inflation hawks to prevail and prevent socially useful spending by governments: we'll get higher interest rates AND no meaningful redistribution, until banks, even propped by trillions of public money, crash again (something I actually expect to happen fairly quickly).
I guess that makes me a "Doctor of Doom" - but I actually think that those economies where the households have not gone into a debt binge (ie most of continental Europe) will do a lot better, ultimately, even if everybody suffered from last autumn's financial "heart attack."