The past 10 days since the weekend of Saturday, March 7th, when Saudi Arabia started a severe oil price war, have had some of the most dramatic financial market movements ever, even more shocking than a few parts of the 1929 and 2008 crashes. What is particularly unusual is the end of the pattern where bond prices rise when stock prices fall. Instead bond and stock prices both fell together recently by significant amounts.
This is because stocks are still significantly overpriced and need to go down much more to reach fair value. Bonds have been hurt by the politicians’ promises of massive deficit fueled stimulation to try and offset the damage caused by Corona Virus quarantine, etc.
There are two ways to cause inflation. Type 1 is to have a strong union shop labor force with strong import restrictions that lock out cheap EM made goods thus creating purchasing power for the domestic masses so that they can afford to engage in a bidding war to buy things, thus causing prices to rise. This was the case of great inflation of 1965-81.
The other way (Type 2) to cause inflation is the central bank simply prints up money to buy new issues of ever-increasing government debt (called monetizing the deficit). The second method is dangerously powerful. It is the fear of this second method that has caused the bond market to raise interest rates, despite lots of evidence that the global economy is entering into a deflationary recession.
However, the attempt to create inflation and to increase GDP through fiscal stimulation has rarely worked in modern Developed countries. If one ignores 1923 Weimar Germany as a unique outlier and ignores pre-central bank era (pre-1913) situations then no Developed country has successfully created inflation through government debt monetization, except for the final years of WW2. Japan tried and failed over 30 years after 1989 peak. Typically when fiscal policy has attempted to stimulate it hasn’t been enough or it was wasted (resources deployed unwisely) or some power block in the legislature that represented “Hard Money” advocates tried to stop it and water it down into a trivial stimulus. This happened a lot in Japan, in Germany vetoing the EU’s stimulus goals, and in the U.S. in 2011 regarding Tea Party deficit hawks.
When these programs are announced the bond market panics and bond prices decline, but over time the truth comes out and the bond market decides the fiscal stimulus won’t cause real growth and thus no inflation scare. When the U.S. Federal Reserve started a QE program, bond prices fell (yields went up) because of fear that it would lead to inflation. Once a QE program ended then yields fell and bond prices rose.
I think if, rhetorically speaking one has a goal to create inflation, there is no substitute for using Type 1 techniques to create inflation and thus the proposed Type 2 stimulus probably won’t lead to inflation. Of course, there is always the possibility of a first time, but if the U.S. ever becomes Banana Republic with worthless currency that would probably take several economic cycles, or another 30 to 50 years, which is too far in the future to predict. Hopefully at some point the country can learn to improve its deficits. Perhaps future administrations will raise taxes to reduce the deficit; this acts to dampen inflation. To make tax increases more affordable the government could ease import restrictions and immigration restrictions, thus pushing down on wages and consumer goods, thus leading to lower inflation. With such a tight Federal budget the government needs to promote a near zero rate for short term Treasuries, which helps lower consumer credit costs for those who are “A” paper type of borrowers.
I’m much more concerned about the risk of getting stuck in a near Depression than I am worried about the risk that a federal deficit will trigger inflation.
Today’s 1.15% yield for the ten year Treasury is reasonable. It is only about 0.4% below some other well established low points such as the 1.38%, or 1.45% or 1.66% low point areas of 2012, 2016, and a month ago before the crash. The fact is the rest of the world is a very messed up place with much worse financial conditions such as low growth, huge deficits, deficit spending programs that don’t produce jobs, etc. Thus the world’s capital needs to flee into the U.S. (along with a few much smaller countries like Switzerland, Singapore, etc.). This creates downward pressure on U.S. rates. The world is awash with excess manufacturing capacity and desperate governments trying to create jobs using aggressive export manufacturing programs, thus global inflation will be low after the virus caused problems have been fixed.
Looking at a 30 day chart of the 2, 10, and 30 year Treasury yields, it appears a bottoming process has occurred, which I interpret not as a reason for yields to go up but rather as a sign of the bond market having burned off its anxiety and beginning to stabilize. Once the SP goes down to a fair value of 1,550 (based on PE10 theory and not based on the problem of the virus) and stays there that will exert a huge negative wealth affect that will dampen inflation and thus encourage the bond market to stay in the vicinity of today’s rates for several years. Once investors find their short term bond portfolio has been refinanced by the borrowers with the new yield then pushed down close to zero then investors will buy more ten year bonds thus acting to support the current 10 year Treasury bond price. However, there is the possibility that investors could become emotional and panic sell their bonds, making prices go down until a month after the new virus stimulus programs have been enacted.