Is the Bond Market Threatening the Deficit Spending Consensus, and Will It Reverse the Inflationary Asset Boom?

With the interest rates the U.S. Treasury having to pay rising almost daily now, despite the Fed’s renewed Treasury bond-buying program, the expectations the government has had for its interest expense are looking low now.  We shall just have to see whether tax receipts are rising by at least the same amount as interest costs are.  If they are not keeping pace, then the government may need to cut the amount of new debt it has to sell fairly rapidly.  Otherwise, the “roll” of existing debt can do to the U.S. what is widely discussed as perhaps happening to Japan sooner rather than later.  If so, the Fed would be so underwater on its aggregate holdings (i.e. technically insolvent) that there would be an uh-oh set of moments in Washington.  If that came to pass, presumably actions would be taken as they were taken in 1979 and at other times.  

The preferred outcome for TPTB, though, would be for rates to suddenly plunge, just as only months after threats of hyperinflation abounded in 2011 (silver approaching $50 an ounce, etc.), rates collapsed concomitant with the faux crisis over the debt ceiling.

Economic data continue to be uninspiring, though there are so many cross-currents I don’t want to opine on that topic.  More relevant in my ever-present fear of a bear market is the fact that the student debt crisis has begun to be featured in the MSM, per Overdue Student Loans Reach ‘Unsustainable’ 15%, Fair Isaac Says (LINK): 

“This situation is simply unsustainable and we’re already suffering the consequences,” Andrew Jennings, chief analytics officer of Fair Issac, said in the statement. “When wage growth is slow and jobs are not as plentiful as they once were, it is impossible for individuals to continue taking out ever-larger student loans without greatly increasing the risk of default.” 

While I saw this on Bloomberg, those interested in more commentary and Fair Isaac’s source material may find it on a detailed Zero Hedge post (LINK).  I take the Bloomberg article as an early warning that the next crisis and recession (if we will ever have a recession in the next couple of years) will have student loans as one of the publicly-identified instigators.  It does take bad news to cause a sustained bear market, and a worsening of this situation would qualify as truly bad news.

When the U.S. is not in a recession or about to exit one, loose fiscal policy and loose monetary policy generally mean risk-on markets.  The question in my mind has been the ECRI recession call.  Their calls have served me well for a number of years, but in the context of the dire warnings that accompanied their recession call of September 2011, it looks as though they erred in at least one key point.  To wit, they asserted in a public position paper that the business cycle would triumph (negatively in their view) over the stimulative fiscal and monetary policies of the authorities.  Maybe not!  It just may be that there would have been a recession, but the Fed and the deficit spending were so massive, so far from anything they had ever seen other than during a major war, that ECRI did not account for those factors adequately.

The pattern I see is similar to Japan at certain points in the 2000s, during up-cycles in the economy.  Interest rates were pressured.  Growth returned.  Cyclical stocks moved up.  But deflationary pressures were present.  Zero population growth was present.  

This is similar to the U.S. here and now.  The Billion Prices Project showed price declines in both November and December.  Despite a huge volume of speculative long positionss in various commodities such as platinum, palladium and (almost as extreme) crude oil (along with similar speculative bets in commodity currencies such as the AUD and NZD), the failure of prices of those commodities to reach prior recent peaks suggests to some underlying price weakness.  While waiting to see how those play out, the flip side of that coin is extreme bearishness on bonds per institutional investor surveys, the general media, and (per ZH) T-bond futures put  buying (LINK).

Once again I am not calling a top in anything.  I don’t fight the Fed, thus I am not bearish on bonds either except for letting the stock bulls/bond bears do what they will with prices.  The bond bears are, however, fighting the Fed.  I think of the stock bears in the 1980s and 1990s, who pointed to overvalued stocks.  However, corporations were shrinking aggregate shares outstanding, and the bulls kept winning out, overvaluation or no.  The same could end up being true of bonds, though obviously in a stranger way, given the ongoing Federal deficits.  It usually doesn’t pay to do the opposite of what the ultimate insiders are doing.  (This goes for the gold bears as well; central banks are buying, not selling.)

My experience as an insider in the AAPL fanboy community has given me an additional insight.  AAPL ended up entering a sudden bear market for no real reason other than that it had gone up too far, too fast at a time when headwinds were mounting.  The fans kept pointing to a reasonable valuation in terms of trailing P/E of, say, 13, with current growth rates that were felt to be higher than that (but who knows?).

The same thing may sooner or later be true of the general stock market.  As Japanese stock market investors found out, Mr. Market can reprice your stocks, or all stocks, downward no matter what the level of bond interest rates is, and no matter whether the central bank is financing the governmental deficit.  They also found out that for all practical purposes, that downward repricing can be permanent.  

The lack of fear of loss of principal is pronounced now in the markets.  This psychology was punished in 2011 without Fed or fiscal tightening.  It was punished in Japan more than once in its ZIRP period with no or minimal Bank of Japan tightening.

The now-general acceptance that the Fed is backstopping ever-rising asset prices strikes me as the single most dangerous factor in investing in U.S. markets today.

As in Japan, if push comes to shove, I expect the Fed will save the bonds and let the stock market go.  Push has not yet come to meet shove, but if the action of AMZN is any guide, it may not be as far off as many would like.

 

 

 

 

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1 comment to Is the Bond Market Threatening the Deficit Spending Consensus, and Will It Reverse the Inflationary Asset Boom?

  • JB McMunn

    The Fed’s mandate is “maximum employment, stable prices and moderate long-term interest rates” (fail, fail, and fail). In reality Job #1 right now is to keep government borrowing costs minimal, so I think we know what they will do. Will the bond market rebel? Maybe, but where else will you find that big of a market that has highly-rated bonds for banks, pension funds, collateral, etc? Japan? EZ? The US is still the leper with the most fingers.