More on bonds, and an alternative view

Antal E. Fekete is a professor of money and banking in San Francisco (such a beautiful place, too). He has a pet thesis about the bond market, which is that every time interest rates halve, effectively the capital value of (older) bonds doubles, to match the yield on new bonds.

So as long as we expect the government to try to stimulate the economy by lowering interest rates, there's a killing to be made in the bond market. Theoretically this could go on forever, even in a low-interest environment - the logic holds if rates go from 0.25% to 0.125% - provided the Treasury doesn't simply go straight to zero interest, of course.

Anyhow, his latest essay says that the monetary stimulus will simply be used to settle debts, since debt gets more and more burdensome in a deflationary depression; and settling debt instead of making and buying more stuff, continues to drive deflation. In this enviroment, few businesses will want to take on more debt (certain and fixed) in the hope of increasing their profits (far from certain, and very variable). On a national level, and following the ideas of Melchior Palyi, he now sees every extra dollar of debt as causing GDP to contract.

Therefore, valuations of most assets will continue to decline - except for bonds, which are now the focus for speculators. To this extent, he agrees with Marc Faber (cited in the previous post): we now have a bubble in government bonds.

But something will go bang. The real world shies from the inevitable conclusions of mathematical models. I think it will come as a crisis in foreigners' confidence in the dollar - there will be a reluctance to buy US Treasuries (we've already seen failed sales of government bonds in the UK recently, and when the next one succeeded, that's because it was a sale of index-linked bonds). Even now, the Chinese have switched from Agencies (debts of States and municipal organisations) to Federal debt, and within the latter, from longer-dated bonds to shorter-dated ones. If government debt was an aircraft, the Chinese would be the passenger insisting on a seat next the emergency exit near the tailplane.

To use a different analogy (one I've used before), drawn from the Lord of the Rings, the rally in the dollar and the flight to US Treasury debt seems to me like the retreat to the fortress of Helm's Deep: a last-ditch defence, doomed to be overwhelmed. Can we see a little figure about to save the day by dropping the Ring of Power into the lava in Mount Doom? We can hope; but you don't make survival plans based purely on optimism.

I therefore expect a transition from deflationary depression to inflationary depression, at some point. Perhaps a sort of 1974 stockmarket moment: an apparent turnaround, which when analysed can be shown to continue the real loss of value for some years. Only when national budgets are brought under strict control, will there be the environment for true growth. I don't see a willingness to tackle that, on either side the Atlantic, so disaster will have to be our teacher.

Horrifying budget

Fraser Nelson in the Spectator:

To comprehend the scale of the sickening task awaiting George Osborne if he becomes chancellor, consider the following. If he were to raise VAT to 25 per cent, double corporation tax, close the Foreign Office, cancel all international aid, disband the army and the police, release all prisoners, close every school and abolish unemployment benefit he would still be unable to close the gulf between what the UK government spends and what it raises in taxes.

Where does all the money go? How can we get out of this in one piece?

Visions of 2008

Following Dearieme's comment on the previous post*, I'm going to try to visualise a chain of events over the next year - guesswork, of course, with plenty of obvious ones:

USA

a marked deflation in property prices
a reduced demand for luxury goods and services
reduced imports of the above
consequent recession abroad
further interest rate cuts
higher unemployment
higher taxes
higher State and Federal budget deficits
a sell-off in equities
increased demand for bonds
a weakening currency
higher prices for food, fuel and clothing

increase in the price of good-quality agricultural land
consumer price inflation indices will not be able to continue to mask the real increases in costs of living, and this will have further consequences for public finances
public enquiries, leading eventually to a thorough reform of the financial system

UK

much the same as above, except I don't think our house prices will fall so far - the US subprime mess will hit investments, but we will drop our interest rates to devalue the pound to maintain stability against the dollar

Gold

will continue to fluctuate interestingly, but although some smart money is after it, there will be less spare money around generally, and other commodities will offer interesting opportunities for inflation-beaters. It's already above its inflation-adjusted long-term trend, and lenders will make sure that the real value of their loans is not destroyed by hyperinflation

... in short, slumpflation.

UPDATE

*and, by way of comparison, here is Karl Denninger's outlook in his Dec 24 post.
... plus a more sanguine assessment by Nadeem Walayat.

A Merry Christmas to all, and thanks for your visits and comments.

What is long-term investment?

Jeff Prestridge, in today's UK "Mail on Sunday" finance section, reports that the Personal Assets trust, controlling £188 million, has changed its weighting from 60% cash earlier this year to 100% cash now. He's sniffy about their performance over the last 5 years, contrasting them with the likes of Baillie Gifford.

Well, I'm not a respected Fleet Street money journalist, merely a no-account bearish personal financial adviser, but I'd suggest that in the exciting investment world of today, maybe a five-year period is not a good basis for comparing long-term results, or conditioning expectations for the future.

I had a client ask my opinion about investments a couple of years ago, because his bank had been showing him their fund's marvellous growth over a three-year period. I took time to explain to my client that over the five years to date (then), the graph (as for the FTSE 100) described a kind of bowl shape, and the period chosen by his bank just happened to draw a line from the bottom of the bowl to the lip.

I then showed him the five-year line in all its loveliness:

I think it's fair to say that these are not ordinary times. There has been a steady build-up of electrical charge, so to speak, over something like a decade (some would say, much longer), and there may well be some powerful bolts unleashed as a result. Where will the lightning will strike next: a steeple, an oak tree, a cap badge - who can tell?

Massive debt; changes in the balance of international trade; demographic weakening of future public finances; sneaky currency devaluation; wild financial speculation; wars and the rumours of wars; imprecisely known ecological limits to growth; declining energy resources; the desperation of the world's poor to join our fantastic lifestyle; our fear that we may lose the comfortable living we used to imagine was our birthright; the corruption, abuse and neglect of the young; the selfishness of their parents and the middle-aged; the increasing burden and growing neglect and abuse of the old.

In all this turmoil, making five-year investment performance comparisons has an air of unreality, like planning tomorrow's menu on a mortally-wounded ocean liner.

Lead, kindly light

A glimmer of hope: Citibank's new boss has opted to put liabilities back onto the balance sheet, much to Karl Denninger's satisfaction.

Perhaps, after the next election, a new US President, with the strength of a fresh mandate, will be also able to act so decisively.

US debt - projected

The US Government's own (2006) long-range forecast shows an expected sixfold growth in Federal debt held by the public, expressed as a percentage of GDP, by 2075. The table above is in a section frankly entitled "An unsustainable path" (pp. 208-209).

Calls for a fully-funded Social Security pension

Free Market News Network (July 2) interviewed Peter Schiff, who said that the current rob-Peter-to-pay-Paul pension system will unravel in a few years, because of demographics. Newt Gingrich (former Speaker of the House) thinks a funded pension system should be introduced, but control of the funds should be out of the hands of the government.

This is very similar to proposals put forward in the UK by the Pensions Reform Group, chaired by former minister for welfare reform, Frank Field MP. The working name for it is a "Universal Protected Pension". The proposals betray the same worry as Gingrich implies, which is that the government may find a way to steal all or part of the fund.

Some highlights from the Levy Economics Institute

A few nuggets from the July 2007 Levy Economics Institute conference:

Dimitri Papadimitriou foresees an improving current account deficit over the next three years. Private sector debt should level off as a proportion of GDP. The Congressional Budget Office's forecast and targets for 2010 assume continuing home borrowing, but if this doesn't happen, the model suggests that budget deficit needs to increase to 4.6% of GDP. The alternative is a depreciation of the dollar, which is unlikely because (a) this would increase inflation and (b) China does not wish the renminbi to rise significantly against the dollar. A propos the last, Robert Barbera explained that a renminbi appreciation would raise the price of China's farm products and hit the living standard of its large rural population.

Robert Parenteau looked at US private borrowing: "the prospect of a hard landing should be taken seriously".

Wolfgang Muenchau of the Financial Times thinks that despite having stronger fundamentals than America, Europe is likely to be affected by a US downturn, because European stocks, property prices and interest rates tend to follow America's lead, and a strengthening of the Euro against the dollar would hit European exports and economic growth.

Torsten Slok considered longer-term inflationary pressures in the US: demands for pay raises, an increasing proportion of retirees overstraining the budget, and the possibility of an overheating Chinese economy that would up US import prices.

James Paulsen thought that the US could regain some of its consumer market share through "a long-term sustained contraction of its trade deficit to revive domestic manufacturing".

Frederic Mishkin of the Federal Reserve was relatively relaxed about subprime borrowing, saying that such loans represented less than 10% of all mortgages.

Crisis report from a very credible source

I looked up an important official today, of whom most of us may not have heard. His job is to review on government spending and report to Parliament. His name is Sir John Bourn and his title is the Comptroller and Auditor General, at the National Audit Office.

Now imagine that this person was so worried about the unravelling of the country's finances that he began touring the country, warning the general public and trying to get the issue onto the agenda for the General Election. I think you'd start to worry, too.

This is exactly what's been happening in the USA, as commented on by Michael Panzner in his website. David M Walker, the Comptroller General, has been playing Cassandra for months. To see the 60 Minutes video about this man, click here.

Could someone tell me the situation here in the UK? We don't seem to have such frank and authoritative public discussion as in the US.

UPDATE

In the CBS video, David Walker notes not only the expense of US medical care, but how many people are uninsured, and the rate of medical error. If you'll also read some of my comments in the globalization thread on Cafe Hayek, you'll see I'm of the view that we should start taking better care of ourselves, rather than trust to Dr Kilpatient.

America's debt economy

As part of a longer item explaining why China is becoming the world's most important economy, Puru Saxena crisply summarises America's position:

"...the U.S. is the largest debtor nation the world has ever seen, its debt to GDP ratio is over 400%, it has a negative personal savings rate, its currency is overvalued and its society is heavily dependent on consuming cheap, imported goods."

If you, personally, owed 4 times your annual income and were now supplementing your income by further borrowing ("negative savings rate"), you'd look for debt counselling.

Add this to Jim Willie's comments about the export of jobs, and you can see why The Mogambo Guru is raving in his latest letter.