What is the Bond Market Telling Us?

"Insanity: doing the same thing over and over again and expecting different results." - Albert Einstein

Around the globe the money printing continues.  Reserve banks in Europe, Britain, Japan, the United States and other countries are printing money in the trillions of dollars.  Ever since Alan Greenspan decided that the best way to save the economy was to print money the mantra of the Federal Reserve bank (and now all central banks it seems) is to hit the print button any time something goes awry.  As the quote above says, doing the same thing over and over (and in the case of printing money over and over and over and over) again expecting different results is shear lunacy but I am afraid that is what is happening.  It did not work in the run-up to 2000 as it created a stock market bubble that burst, it did not work in the run-up to 2007 as the real estate bubble burst and now it is being tried again.  Each time the quantities of money required to kick start the economy are larger and each time the effect is more muted and the problem at the end of the rainbow even more catastrophic.

After trillions have now been printed there is no true form of a recovery - it even appears likely that the world will slip into a recession in the very near future.  A study of the world's bond markets tells us a story and not one that most people believe.  I know plenty of people that believe that the bond market is the next bubble to burst.  There is no way (they say) that bond yields can be kept this low forever and it is just a matter of time before they rise quickly.  As you know by now, if a bond yield rises the price of the bond falls, so the bond bulls in effect lose if this happens.  The main thesis to the argument is that with all the money that is being printed around the world inflation will take hold and once it does, in order to fight inflation, interest rates will rise.  While this may be a reasonable analysis in normal economic conditions, I believe that it is inherently flawed for a number of reasons.

First there is the fear factor.  With all the problems that are going on around the world there is no quick fix.  Most of these problems are structural rather than cosmetic and in order to repair them a complete change to the management of the Euro zone needs to be implemented.  Furthermore a balanced budget in the United States is required and a manageable resolution to the impending problems of underfunded social security and medicare need to be performed.  Without these massive structural changes being implemented (all of which are political suicide for the leader base) there is little hope that the economy will resume its normal growth.  With this uncertainty comes fear and people seek a safe haven to protect their assets and this is driving demand for safety and keeping the interest rates down.

Second there is no desire on the part of the reserve banks of the world to let interest rates move higher.  If you take a simple example of the US budget deficit you can quickly see why.  At present the United States is running a budget deficit of around $1.5 trillion a year.  With the 10 year note at 1.5% the cost of the current portion of the loan balance (excluding social security and medicare holes) costs the United States roughly $300 billion a year to service.  Of a $1.5 trillion deficit this equals 20% of the deficit.  If interest rates rose to say 5% (as some bears say they should), the interest burden would move to roughly $1 trillion.  This would increase the total budget deficit to $2.2 trillion a year and that is completely unmanageable.  This is why when you see interest rates in Italy and Spain rise to above 6% the markets fear a sovereign default.  The reserve banks need to keep interest rates down and they are doing this by buying their own debt!

Third, you have to have inflation to push interest rates higher.  At present with all the excess capacity of high unemployment and at factories around the world, the overall cost of a basket of goods and services is not rising very fast.  Certainly there are parts of the basket that are - food and for a while oil, but even oil prices are down over 25% in the past 6 months and if the global economy contracts next year these will drop even more.  All of this is keeping a relatively tight lid on inflation for now.  Furthermore you need money to move to generate inflation.  This is referred to as the velocity of money.  At present this is stagnant mainly due to the problems that the banks face.  At present the banks are not open to lending like they were a few years ago so regardless of how much money the reserve banks print the money is not moving but is being used to bolster bank reserves.  Should this money start to move, velocity would pick up and at that point you would have inflation.  With all of the global problems and worries it appears that this will not happen any time soon.

Fourth is the crowding out effect.  As sovereign debt makes up more and more of the global debt market it becomes a major factor pinning back growth.  Already we see the impact in the United States where GDP growth is at an anemic rate of 1.9% and trending lower.  It is my contention that this drag will be felt for years to come and will result in a long slow economic recovery interspersed with regular recessions.  Under the weight of this overburdening debt the drag will prolong the problems and will result in anemic growth and low interest rates for years to come.

Based on these points there is a high probability that interest rates will remain low for the foreseeable future which is why bond investors continue to buy bonds even at these incredible low rates.  It is also why the reserve bankers continue to print money as it is cheap and they believe will eventually produce a different result!