Human Action p. 546
Like nervous prairie dogs standing tall on hind haunches, many analysts have been on the watch for inflation. It is only a matter of time, most reason. The wolf will eventually come and one must be ready to quickly dive into the burrow. After all, for the first time in living memory, North Americans have witnessed proverbial "money printing" first hand. Up until recently, this was a topic only found in economic textbooks or a Weimar era newspaper.
Actually, "money printing" has mostly been over-hyped in the past ... really, for the most part, a malapropism. However, as of the Fall of 2008, the US central bank (and others around the globe), actually began buying significant quantities of treasury bonds, asset-backed securities and government sponsored agencies to the tune of $1.15 trillion. To the extent that these funds were not parked in excess reserves, this "effectively" was money-printing ... also considering the effect of other programs such as TALF.
And so, the prairie dogs are now especially vigilant. However, could it be possible that the little critter is craning its neck in the wrong direction ... or at all?
Now, some 18 months after the inception of these "money printing" actions, analysts are still left asking "Whence inflation?" To date in the US, the CPI -- the popularly accepted inflation indicator, the Consumer Price Index -- remains relatively comatose, the core rate even having logged negative rates month-over-month recently. Even US M2 growth has planed down to year-over-year growth rates under 1% recently.
Yet, for those influenced by the Austrian School (a group that we identify with) vigilance is called for all the more. We are looking over our shoulders wondering not only whence, but where inflation? Just what channel will "monetary inflation" traverse this time? Just where will this deceptive chameleon of theft and wealth transfer, strike next? Will it be expressed as wage inflation; or as the price inflation of the current economic output of goods and services; a specific type of asset inflation; or a velocity phenomena? Could it be all of the above?
Actually, the possible manifestations of inflation are even more complex, many of its distortions not even recognized. Mises' quote on the front page makes this point. Every major inflation warps and distorts input/output prices in the economy. In time, the entire statistical dataset becomes tainted, even impairing inflation's diagnosis itself.
We have made the case in the past that even the mispricing of interest-rate risk spreads can be a manifestation of inflation. Indeed, if the object of the Fed's monetization produces depressed interest rates on asset-back paper, it is paper liable to be overpriced ... i.e. inflated in price.
Likely, most people and political policymakers would enthusiastically embrace another asset inflation. This is the type of inflation people most enjoy ... at least, when it is in an upswing. In fact, lots of homeowners would like nothing better than a bit of "asset inflation" to again skate their mortgages on side. Future pensioners, too, would also not refuse some asset inflation in securities markets, were it to buoy the valuation of pension accounts. Crucially, given the massive amount of money creation (printing) recently, just what type of inflation could occur next?
Though insisting that we continue to stand high on our hind haunches -- lest the wolf surprises us after all -- we are inclined to an answer. It is an inflationary manifestation already well underway.
Inflation's Object of Ardor--Bonds
Every inflation must have credit/debt growth -- usually, as it happens, to the point of excess. For that to occur, there must be a marginable asset or something that can serve as collateral or surety for a loan. In the 1970s, a period of price inflation, high wage growth greased debt serviceability. Since that time, monetary bubbles were more likely to vent into an asset inflation. However, now that real estate is no longer a viable candidate, what other asset could serve as the lightening rod for a renewed inflationary, debt-fueled spire?
It is bonds, we think, the last and final dance partner of monetary inflation.
A novel way of documenting the inflation thrusts and its prime object of attraction in the past is to compare price trends versus the average weekly wage of private production workers. Figure #3 shows how many weeks of wages (pre-tax) it required to buy one unit of the S&P 500 stock index. Who can say financial markets are not subject to fashions and manias? From requiring as little as 18 hours wages in 1977, investors were willing to slave over 3 weeks for the same stock market purchase in 1999.
Figure #4 shows the same swing in asset preference relative to wages in the case of residential real estate. While it is clear that this asset inflation has rolled over, the fall to date still seems modest from this perspective.
Then, what of bonds? The graph on the front page tells this story. Without a doubt, it has become much more expensive to buy interest income in terms of average wage levels. One can discern the bulge in the python -- the baby boomers -- turning their focus to future income. But more on this later.
For now, the salient question is this: Just how long can the rising fashion for bonds be expected to continue?
Bonds--Hara-kiri or Safe Haven?
A number of respected analysts are now quite bearish on interest rate trends, believing that bonds are over-bought and over-priced. The further observation that households have being strong buyers of fixed-income instruments over the past year (and shunning equities) logically also invites a contrarian stance on bonds. No doubt, bond markets are liable to gyrate -- in fact, we expect them to remain relatively volatile. However, that is not the same as arguing that bond yields will soon soar.
The experience of Japan over the past several decades provides an anodyne for this inflationary sequence to bonds, though perhaps not a perfect one. Arguably, Japan today has the largest bond bubble in the world. Actually, this has been the case for at least a decade, if not more. Consider that retirement is doubly expensive for the Japanese as for North Americans (assuming similar retirement lifestyles). The Japanese must save twice as much to buy a 10-year government bonds, sufficient to fund their retirement.
No doubt, the supply of government bonds may seem bottomless. Outstanding domestic bonds (according to the latest BIS statistics) rose 27.5% in the 7 quarters between end-2007 to end of the third-quarter 2009. Issuance of a gargantuan $7.3 trillion in government bonds accounted for 87% of this increase. Yet, despite this enormous surge and the screeching of a lot of vigilante prairie dogs, interest rates are not radically higher today than at end-2007. In fact, they remain lower.
And, looking ahead, not much is predicted to change with respect to government debt issuance ... at least anytime soon. Today, there are enormous budget deficits in countries representing more than 40% of world GDP. Based on these factors, should present trends continue, the outlook for government bonds is understandably grim. Therefore, it is no wonder that the consensus is so bearish on interest rates. However, the focus has been on supply issues alone. What about demand?
There are a number of countervailing factors to consider. Here, the matters to judge are the timing, structures and extent of the current secular "inflation" impulse. Most definitely a bond bubble is already well underway. But what remains still unknown is how long it will continue and why. Most importantly, human behavioural factors and demographics come to play on this question. Financial structures also play a defining role in that they serve to shape the impact and nature of these behavioural factors. In short, the case we make is the demand may be underestimated.
Firstly, let's consider the key financial structures that could allow a bond bubble to continue to run for yet some time. For one, commercial banks today own remarkably little in the way of government treasury bonds. As Figure #2 reveals, treasury bond holdings amount to only 1.3% of bank financial assets. That compares with holdings nearly as high as 40% of financial assets some 60 years ago. Total holdings of fixed-income securities (including also corporate, MBS and other sectors) amounted to only 9.0% of financial assets, and are also at historically low levels. Given low loan growth (in fact, even a run-off in loans over the last 15 months) fixed-income securities are an attractive asset for banks given the currently-steep yield curve.
According to the most recent H.8 report from the US Federal Reserve, commercial banks have bought $169.7 billion in treasury bonds over the past 12 months (to end February 2010), accounting for virtually the entire increase in securities holdings. Actually, it seems remarkable that banks have not bought more, given that loans and leases declined $610 billion over this period. This may say something about the extent of "dark matter" still on bank balance sheets (i.e. assets that are not correctly valued nor categorized). As in astronomy, "black holes" are not directly visible, but they can be discerned through their impact on other celestial bodies. Incidentally, this is an aspect of monetary conditions that is often not well appreciated. There can be monetary destruction though the various monetary aggregates may not accurately reflect this dynamic.
Conclusion: Russian Roulette With Bonds
The sequential bubbles of recent decades in wages, stocks, and real estate have all rolled over as our comparatives to average weekly wages have shown. The roll-over in US fixed income, however, has yet to occur. We are not sure when this will happen ... though this is certain ultimately. However, it is very possible that a bond bubble could yet continue for quite some time. It may take years to roll over. Then maybe not.
However, separating short-term from long-term factors as well as structural ones, there is a case to be made for bond demand. With the super-trend of an aging population in the developed world, the only sure tactic for future retires is to focus on real income. Currently, real yields are attractive and most future retirees have sorely under-saved.
Given how expensive it has become for the average worker to secure future retirement income as we have illustrated, this becomes a powerful impetus for more saving. This is especially poignant now given that a whole generation has just belatedly awoken to the realization that the past busts in asset inflations (stocks and real estate) and over-consumption have left the retirement kitty bare.
Furthermore, the yield curve remains near highs, encouraging money to move into longer-dated fixed-income paper. Also, as we have shown (certainly if deleveraging continues and the assets of stocks and real estate remain depressed) there is ample room for the banking system to shift its asset portfolio towards bonds. The same is true for pension funds.
We expect bond markets to be volatile. Yet a significant rise in rates seems unlikely. Economies remain highly interest-rate sensitive given the slow pace of economic growth and the deleveraging mode of many households. Higher rates would simply accelerate deleveraging and boost savings rates ... which are reactions that will be positive for bond markets.
Finally, our view that bonds are now the likely object of ardor of a major "asset inflation," also implies a sorry end ... eventually. All asset inflations eventually collapse, of course. This is not new ... a reality well illustrated by the recent slump in residential real estate prices around the world. But what is different about a bond bubble is that it is the last marginable asset class in the inflationary chain. There can be no extension to the inflation gravy train after a bond bubble comes to the point of collapse. The final scenario then plays out: A deflation, including broad income destruction. If an entity can no longer issue bonds at low interest rates, a deflation cannot be avoided.
Consider Japan today. Just what extensions are possible once rising interest costs and debt suffocate the purses of an aging population? Now with government debt near 200% of GDP and depressed economic growth, its policy options are slim. The inevitable appears obvious though the timing uncertain. Yes, it is still possible for Japan to circumvent an ultimate deflationary economic doom. However, this would require some monumental policy initiatives which are highly unlikely. For example, Japan could choose to boost its population growth through high immigration. Possible ... but not an investable theme any time soon.
Returning our focus to North America, we are inclined to believe that current real yields on offer in an Occidental world starved of income and with an aging population are attractive for the time being. The ultimate objective of all future retirees, after all, is to accumulate savings at a real rate of return. That ensures that savings will indeed exceed the advance of retirement living costs.
