Record Bond Market, Debt Deleveraging Deflation

By: DK_Matai

Deflation is probably the last thing on anyone's mind. As a result of the latest financial markets plunge, gold has surpassed a new record of $1,820 per troy ounce. We all recognise gold as a hedge against inflation. In parallel, the government bond yields of a number of major countries including the US, UK, Germany, Sweden and Switzerland are at or near record lows since the Second World War, which means that their prices are at an all time high. For example, the bond yield on 10-year US treasuries fell to a record low below 2% today during intra-day trading. What is the significance of this record bond market?

Equities and bonds are the equivalent of husband and wife in the financial markets. Sometimes, the husband does not listen to his wife. Eventually, he is forced to do so! The same is true of the bond market, which eventually forces all other markets to listen to her because she holds the trump cards. So what are the record low high-grade bond yields telling us within the growing shambles of the global financial markets? When the bond market prices the rate of return or yield of public debt she communicates extremely important messages, which all other markets and their interlocutors ignore at their peril.

1. Deflation & Deep Recession; NOT Default & Inflation

Deflation and deep recession are the most obvious interpretation of low bond yields. In essence, the bond market is signalling that she views the risk of deflation and deep recession as far greater than that of default and inflation. If deflation really lies ahead, is looking for opportunities in equity, commodity and property markets almost a waste of time? What can one hold in a deflationary environment that will preserve value?

2. Debt Deleveraging

It is important to keep in mind that 10 year rates of government bonds are telling us what investors are expecting over the next 10 years. Low yields on long dated government bonds imply low interest rates in the future. Low interest rates in tandem with weak or falling asset prices, including property, imply that people are more intent on deleveraging, ie, repaying their debts.

3. Capital Preservation, Demographics and Changing Mindset

Are the record lows on government bond yields the result of investors seeking capital preservation over return on investment given the extreme market volatility? Do the low yields imply a common search for risk-free return? To add to the complexity, is the demographic shift in the industrialised world coupled with the fear of highly volatile financial markets driving the popularity for high-grade bonds? Is this what causes the bond yields to go lower, year after year?

Conclusion

The equity market cannot remain separated from the bond market for too long without severe pain. If the bond market is pointing to a protracted slow down, no matter how good the expected earnings might appear to be, the equity market does eventually end up recalibrating downwards. Why? Long term low bond yields imply collective investor belief that global growth will slow down markedly for many years to come if not decades. As a result, earnings expectations also have to be recalibrated downwards. Commodity prices and property prices also end up falling to reflect the decline in global and domestic demand over time.

Fundamental Question: If the bond market is pointing towards deflation and deep recession in the future, how can any asset class -- including equity, commodity and property markets -- remain elevated for too long?

What are your thoughts, observations and views? We are hosting an Expert roundtable on this issue at ATCA 24/7 on Yammer.

By DK Matai

www.mi2g.net

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