The behavior of interest rates over the last year has been very puzzling. Since the beginning of 2001, when the Fed began easing, monetary stimulation [1] (defined as the sum of Federal debt and money supply divided by GDP) has risen 18% (Figure 1). Over the four years prior to 2001 stimulation rose on 3%. The intent of Fed actions was to increase stimulation in order to prevent the development of deflation. This was definitely accomplished as shown by the modest rate of CPI inflation since 2001, 2.3% annually, the same as over the four years before 2001.
Figure 1. Trends in inflation, interest rates, stimulation and gold since 2001
The Fed continued to ease until mid 2003, and longer-term interest rates fell with declining short-term rates as shown in Figure 1. Beginning in mid-2004, the Fed has been tightening and has thus far increased the Federal Funds rate by 150 basis points. Yet there has been no impact on longer-term interest rates as shown in Figure 1. Monetary stimulus has increased six-fold over its pre-2001 level, which should be very inflationary. The price of gold, an indicator of inflationary forces, has risen 60% since the increase in stimulation began. Yet long term rates, which are also an indicator of future inflation, have failed to rise, and the stock market set a new high for this bull market last Friday (4 March 2005). Actual inflation has remained essentially the same over the past eight years.
So what should one believe, the bond and stock markets, or gold/commodity markets and standard monetary theory? Further insight into the discrepancy between actual inflation and monetary stimulation can be gained by considering the reduced price. I introduced the concept of reduced price in a 2001 article[1] as a means to track the Kondratiev cycle in terms of prices after 1940, when it had become obscured by apparently permanent inflation. Reduced price was defined as the normal price (P) divided by a theoretical value for what the price should be based on monetary stimulation (S). For recent decades, a good approximation for reduced price has been P/S. Thus the fact that price has risen only half as much as stimulation since 2001 means that reduced price (P/S) has fallen. Falling reduced price is typical of the Kondratiev downwave.
Figure 2. Reduced price based on CPI and PPI-commodities indices.
I have typically employed the PPI-commodities index to calculate reduced price, but one can use the CPI as well. Figure 2 shows reduced price calculated for both. Reduced price (both CPI and PPI-based) reached a peak in 1981 that denotes the Kondratiev peak. Interest rates also peaked in that year, which is also typical for a Kondratiev peak. After the 1981 Kondratiev peak, both CPI and PPI-based reduced price began a downtrend that lasted until 1987. Since 1987, PPI-based reduced price has shown a flat trend that I have called the plateau because it resembles flat periods in price charts of previous downwaves. In contrast, CPI-based reduced price began an uptrend after 1987 that ended at the beginning of 2001. In previous downwaves CPI-based reduced price has shown a plateau structure like PPI-based reduced price. Because of this discrepancy I have focused on PPI-based reduced price because it visually resembled past behavior.
At the beginning of 2001, PPI-based reduced price began a sharp decline that I believed (at the time) was the start of the fall from plateau [2]. The fall from plateau is another visual feature of historical price plots of Kondratiev downwaves [2]. In the past, the early downwave has shown two distinct waves. The first wave of falling prices begins at the Kondratiev peak and ends at the plateau. After the plateau there is a second wave down (the fall from plateau). The decline that began in 2001 lasted just one year. As Figure 2 shows, no discernable fall from plateau is evident (compare to plots in reference 2). On the other hand, the CPI-based trend reduced price has shown a change in trend at the beginning of 2001.
Features such as the plateau are important because they serve as markers identifying current location within the cycle. Knowledge of position within the cycle is essential for making accurate forecasts. The fall from plateau is important because it divides the earlier part of the Kondratiev downwave (called Kondratiev Fall) from the later part (Kondratiev Winter). The Stock Cycle can also be used to divide the Kondratiev downwave into Fall and Winter "seasons". The secular bull market is Fall and the bear market is Winter. Based on the Stock Cycle, the stock market peak in 2000 signified the shift from Fall to Winter. Thus, I was expecting a fall from plateau event to occur shortly after the 2000 stock market peak and was pleased when one seemed to have begun at the end of 2000, right on schedule.
Since 2002 it has become clear that a fall in plateau for the PPI-based reduced price has not occurred in the aftermath of the stock market bubble (Figure 2). This means that forecasts for commodity prices or gold[3] using the assumption that we entered Kondratiev winter around 2000 have been wrong. Because of this, most Kondratiev enthusiasts whose primary interest is commodities or gold believe that the Kondratiev downwave has ended and a new upwave begun.
If we focus instead on the CPI-based reduced price, we see that there has been a trend change in 2001 and the direction has been downward, consistent with continuation of a downwave, and a change from the recent past. This could be interpreted as a seasonal change from Fall to Winter consistent with the Stock Cycle trend shift in 2000. If this interpretation is correct, then the next trend change, back to rising CPI-based reduced price, will mark the Kondratiev vortex, which is significant because it marks the time of the regime shift in interest rates (see Figure 1 in reference 2).
Interest rate regime can be thought of as the rules under which the bond market operates. The shift up to a high-level regime after 1980 was the beginning of the era of the "bond market vigilante", when long-term interest rates began to function as gauges of future inflation potential. The expectation at the beginning of 2004 that interest rates should rise reflects the application of this rule to the clear evidence for future inflation given by strong stimulation and soaring gold prices. The fact that interest rates did not rise, even after 150 basis points of Fed tightening, amounts to failure of the "bond vigilante" rule, that is, an uncoupling of interest rate from inflationary expectations. This uncoupling is exactly what a change from a "high" to "low" regime is about. The sort of unusual bond behavior associated with a regime change is best understood by comparing what happened after the last vortex with recent events. This comparison is made in Figure 3.
Figure 3 shows (black symbols) that stimulation and prices rose after the last vortex, while interest rates fell. The same thing has happened today (red symbols). Figure 3 shows that in the last cycle, falling interest rates were maintained in the face of the enormous stimulation of WW II, which dwarfs the stimulation of today. As Figure 3 shows, from 1941 to 1949, interest rates were about 175 basis points below their 1933 levels, or about 2.7%. Consumer price inflation over the same period ran 6.8%. That is, for years, long-term corporate rates ran four percentage points below the inflation rate. The Kondratiev cycle suggests that something like this state of affairs is in store for us again and that the strange behavior of bonds in 2004 may be a harbinger of more weirdness to come.
Figure 3. Aaa interest rate, stimulation and CPI after 1933 and 2002
By weirdness I mean interest rates that do not respond to inflation, or the absence of bond vigilantes. The idea that interest rates should be correlated with inflation is what is meant by an interest rate regime. It is analogous to the ideas about what stocks should be worth that underlie secular bull and bear markets. A regime is a mental construct, just as is the concept of "valuation" for stocks.
Cycle analysis relies on the assumption that mental constructs about the world, what I call paradigms, vary in a regular fashion that can be identified from a generational study of history. The idea of paradigms and generations and how they cause long cycles is discussed in my recent book Cycles in American Politics. Space does not permit the development of these ideas here. The thinking associated with changing paradigms changes the rules about investing (and other things) in such a way to cause real changes in asset values that in theory can be exploited by long-term orientated investors.
What I am getting at here is that a change in paradigm is beginning that will eventually lead to an uncoupling of interest rates from long-term inflationary expectations. But why should this happen? We can look at the reasons this happened in the last cycle for insight. In a speech a few years back, Federal Reserve governor Ben Bernanke explained how low interest rates in the face of high inflation occurred in the 1940's:
Historical experience tends to support the proposition that a sufficiently determined Fed can peg or cap Treasury bond prices and yields at other than the shortest maturities. The most striking episode of bond-price pegging occurred during the years before the Federal Reserve-Treasury Accord of 1951.10 Prior to that agreement, which freed the Fed from its responsibility to fix yields on government debt, the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade. Moreover, it simultaneously established a ceiling on the twelve-month Treasury certificate of between 7/8 percent to 1-1/4 percent and, during the first half of that period, a rate of 3/8 percent on the 90-day Treasury bill. The Fed was able to achieve these low interest rates despite a level of outstanding government debt (relative to GDP) significantly greater than we have today, as well as inflation rates substantially more variable. At times, in order to enforce these low rates, the Fed had actually to purchase the bulk of outstanding 90-day bills. Interestingly, though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade without ever holding a substantial share of long-maturity bonds outstanding.11 For example, the Fed held 7.0 percent of outstanding Treasury securities in 1945 and 9.2 percent in 1951 (the year of the Accord), almost entirely in the form of 90-day bills. For comparison, in 2001 the Fed held 9.7 percent of the stock of outstanding Treasury debt [4].
The Federal Reserve intervened in the bond market to maintain low interest rates in order to accommodate the funding of WW II. The need to finance WW II overrode the normal inhibitions of bankers against debt monetization. The Winter paradigm holds that politics trumps economics whereas in the Fall paradigm economics enjoys primacy.
Today the US consumer is building up a mountain of debt to sustain an import buying spree that has given a record trade deficit. Massive imports from Asian economies, particularly China, keeps manufacturing employment growing, providing jobs for unemployed rural workers coming to the cities looking for a better life. In China, these large numbers of unemployed rural workers represent a significant potential for political unrest, which poses a threat to the ruling elite. It is in the interest of the Chinese political elite that employment opportunities expand at the fastest rate possible. Strong production needed to keep workers busy means strong demand for commodities, which explains why the PPI-based reduced price has failed to fall off the plateau.
The ability of US consumers to continue to consume imports is critically dependent on interest rates. Low interest rate policy after the collapse of the stock market bubble has helped produce the massive stimulation shown in Figure 1. Tax cuts resulting in enormous budget deficits have done the rest. But stimulation is inflationary, and has already shown up in rising commodity prices as described above. But the principal way this inflationary effect would be felt is through a drop in the value of the dollar relative to Asian currencies. A falling dollar means higher prices for imports, which would lead to reduced American demand for Asian imports and the idling of Asian manufacturing workers, with the associated risk of political unrest. To stop this from happening, Asian governments, particularly China, wish to prevent the rise of their own currencies against the dollar. To this end, Asian central banks have been accumulated vast quantities of dollars.
Even with a stable dollar, rising inflationary pressure transmitted through higher commodity prices should translate to higher US interest rates that would spell the end of debt-financed consumption. This would result in a decline of US demand and destabilizing unemployment in China and other Asian nations. To prevent this, Asian central banks are buying huge quantities of US Treasuries with all those dollars they have. That is, foreign central banks are engaging in activities similar to those pursued by the Federal Reserve during WW II. The US consumer and US government have been able to continue its borrow and spending spree because foreign central banks continue to finance it. This behavior makes no sense from an economic perspective, any attempt to liquidate their bond investment would lead to a fall in the dollar, destroying a goodly portion of the investment's value. For the truly enormous positions held by the Bank of Japan and the Chinese central bank, large losses are unavoidable.
Foreign central banks are willing to do this, even at the prospect of sizable investment losses, because political stability is more important than financial return. That is, a Winter paradigm, in which political concerns are paramount, is in operation. A comparison of the Chinese situation today with that of the US in the previous Kondratiev winter can help illustrate why the Chinese are willing to underwrite American consumption at this time.
Consider the situation the United States found itself in during the last Kondratiev winter. The US had too little domestic demand to fully utilize the productive capacity built up during the Kondratiev Fall boom. The resulting sustained unemployment had persisted for years and showed no sign of ending despite the New Deal programs. The US only began to lift out of the Depression with the start of the Lend Lease program, which involved the US making and giving away goods to the British during WW II. Later, the US joined the war and started producing much larger quantities of goods and expending them in the war effort. US workers turned out prodigious amounts of goods, all of it financed by massive low-interest debt (courtesy of the US central bank which bought US treasuries as necessary to keep rates low). These goods were then given away (to the war effort). In other words, the American worker and American central bank during WW II played a role much like the one the Chinese worker and central bank is playing today.
The entire operation was financed by vast amounts of debt raised largely from American investors, which produced an enormous amount of economic stimulation (Figure 3), a substantial amount of price inflation, and flat interest rates (thanks to Federal Reserve interventions). This debt was eventually monetized, meaning that American bond investors took major losses as bonds came to be called "certificates of confiscation". Yet the outcome for the nation as a whole was favorable: three decades of post war prosperity. In the present Kondratiev Winter season, the Chinese are playing the same economic role as the Americans did in the last Winter season and can expect that the outcome will be as salutary for them as it was for postwar America.
Louis Vincent Gave of Gave-Kal research discusses a misperception about Chinese debt that may shed some light on my argument [5]. Chinese banks currently hold a large amount of bad domestic debt. Normally, one would expect them to be reigning in domestic lending, which would lead to higher domestic interest rates, which carry a risk for economic slowdown. It is the Chinese banks that are the losers in the maintenance of the Chinese economic boom. During WW II, it was American bond investors who were the losers, but a putative case can be made for patriotism leading to a willingness to buy war bonds yielding a negative return. Why should Chinese bankers be willing to do the same?
Gave tells us that Chinese banks are different. Unlike in the West, where bankers are capitalists, Chinese banks are an extension of the government, a holdover from China's communist past. Politics is central to their motivation for lending; profit is of secondary concern. Not only will Chinese banks continue to fund the economic boom at home when profits become negative, but the Chinese central bank will continue to support American borrowing to keep the dollar from falling relative to the renminbi, despite certain financial loss. The reason for doing this is to continue the economic boom, which will employ China's potentially destabilizing labor force and build the economic underpinnings for national power in the future.
The way this works, when loans go bad, rather than liquidating the assets and taking a loss on the bank's books, the government will print money to make up for the bank's loss. This is analogous to how the US government monetized its massive WW II debt, which represents a loss (waste) of wealth (productive capital). In both cases what is financially irrational behavior turned out to be politically rational, and since the agent responsible for both (government) is motivated by politics, not financial returns, it makes sense that such a policy would be pursued.
Debt monetization can be highly inflationary (e.g. the Weimar inflation of 1923) and represents a confiscation of private savings, which is why it is rarely pursued in capitalist countries during peacetime. Debt monetization also results in a decline in the real value of the currency (i.e. a rise in commodity prices expressed in that currency). A weak Chinese renminbi will be unlikely to rise against a weak US dollar and both currencies should decline together in real value. That is, China will be able to maintain its currency peg to the dollar, and may even see the renminbi fall relative to the dollar. Gave opines that betting on a renminbi (upward) revaluation might play out like a bet on Ringgit or Baht revaluation in 1995-96.
What is likely in the face of Chinese debt monetization (both domestic and foreign) is continued commodity inflation in both America and China (but not necessarily in Europe). Relative prices between China and the US will remain the same, allowing American consumers to continue to buy cheap Chinese goods and US businesses to continue to outsource to China. Chinese banks will continue to be able to recycle dollars back to the US to fund enormous federal deficits. Interest rates will remain low despite high inflation.
The strategy being pursued by the Chinese to accelerate their development has been assisted by the Bush administration choice to pursue an expensive project of nation building in Iraq (something conservative Republicans would normally eschew) while cutting taxes. These actions have provided an abundant supply of US Treasuries in which to park dollars. Had Bush been running a surplus like his predecessor, the Chinese would have had to invest in non-governmental debt or equities, which adds investment risk to currency risk. The decision to undertake operation Iraqi freedom, with the goal of regime change and replacement with an elected government was strongly influenced by the World Trade Center terrorist attack. This event produced what amounts to a "paradigm shift" in US foreign policy from the humble policy espoused by Candidate Bush in 2000 to the transformational, or even bellicose policy outlined by President Bush in his 2002 State of the Union message. The 2001 terrorist attack, it would seem, may be a triggering event for the secular crisis turning. Turnings are historical periods used in William Strauss and Neil Howe's generational model for cyclical history [6]. The secular crisis turning is correlated with Kondratiev winter [7]. Thus, we see non-economic support for the idea of a season change from Fall to Winter in 2001.
The Kondratiev Winter paradigm means that interest rates will not rise dramatically, because the Chinese (and others) will continue to support low interest rate policy, fully understanding the financial costs, in order to build the power of their state. Thus, the economy will not be thrown into recession, sending stocks into a deep bear market, despite burgeoning debt and high oil prices, both of which will likely persist. I do not expect a recession coinciding with the next Kitchin cycle low in 2006, but rather with the next Kitchin cycle low in 2010. As I discussed in my article last month[8], stock valuations according to P/R are not unusually high and advances to considerably higher levels before the next recession in 2008-2010 are to be expected.
References:
1. Alexander, Michael A, "The Kondratiev Cycle and Secular Market Trends", Safehaven May 12, 2001.
2. Alexander, Michael A, "The Kondratiev Cycle Revisited: Part One, Current Position in Cycle", Safehaven, May 5, 2002.
3. Alexander, Michael A, "The Kondratiev Cycle Revisited: Part Three, Implications for Gold", Safehaven, May 11, 2002.
4. Bernanke, Benjamin S, "Deflation: Making Sure 'It' Doesn't Happen Here", Remarks before the National Economists Club, Washington, D.C., November 21, 2002.
5. Gave, Louis V., "China Misperceptions", John Mauldin's Outside the Box E-letter, October 25, 2004.
6. Strauss, William and Neil Howe, The Fourth Turning, New York: Broadway Books, 1997.
7. Alexander, Michael A, The Kondratiev Cycle: A Generational Interpretation, Writers Club Press, 2002.
8. Alexander, Michael A, "Charting the Course of the Secular Bear Market", Safehaven, February 21, 2005.
