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
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 be a disconnect between the PRIVATE v PUBLIC issues of debt. The differential between AAA Corporate and government peaked 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 CONFIDENCE from PUBLIC back to PRIVATE.
We must 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, “Whose 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 bonds 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 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 simply CONFIDENCE that two tangible products can be exchanged be it food and labor, or whatever. Boil it down to the basic element that each individual’s productive capacity is the real value. If that statement were not true, then 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.
