Does the recent widening of government bond yields, especially in Japan, signal the bursting of the bond bubble? I think not. Both the equity and bond markets are bubbles and both will burst eventually. But equities are more likely to pop first.
Meanwhile, the fate of the world economy hangs on bubbles that depend on global optimism. This can’t last for ever. It contains the seeds of its own undoing since prices are sent to economically unsustainable heights.
A bubble’s life cycle relates to the credit cycle, stretching from central banks to final bank lending and on to consumer debt and house prices. A bubble can have a partial credit cycle driving the price of a single asset, such as Japanese government bonds today. Their price is fuelled by the Bank of Japan force-feeding banks with liquidity that goes no further than monetizing Japan’s budget deficits when the banks load up on JGBs.
Mutually exclusive In the short run, some bubbles look to be mutually exclusive as candidates for bursting. Either global equity markets (particularly the Nasdaq) or bond markets are bubbles, not both. Equity markets are valued on expectations of successful reflation; bond markets are dead set on continued disinflation (and deflation) damaging corporate profitability and world growth.
In the long term, though, deflationary pressures could burst both these bubbles. Deflation would increase the default risk of several categories of bonds that are flying high today, particularly emerging-market bonds and corporate credit. And deflation could also skittle the global economy and, with it, current market optimism about growth.
But in the short term either the bond bubble or the equity bubble will burst first. So which is it to be?
The past few weeks’ activity in bond markets makes it look as if the bond bubble will be the first to burst. The sell-off was particularly severe for the world’s most overvalued financial asset: JGBs. Other debt markets also suffered, with the US 10-year yield backing up by nearly 100 basis points. By contrast, global equities just went on up.
But this was driven by Federal Reserve chairman Alan Greenspan’s attempts to assure markets that deflation had been defeated. In telling the world that the US economy was set for 4% growth, Greenspan triggered the bond traders to pull the plug.
But I still reckon that the day of reckoning for equities is closer than it is for bonds. Equity market valuations, particularly in the US, are crazy. If they are to hold, the real economy must respond extremely quickly to Greenspan’s monetary expansion efforts.
That won’t happen because the forces of New Deflation have not been defeated and Pricing Power to the People will continue to wreck OECD profit margins. Corporations will therefore continue to fire people and reduce wages to cut costs and try to recoup profits.
Meanwhile, consumers will see the real burden of their mountainous debt rise as real wages fall. This will cause wealth destruction through a collapse of the house price bubble.
The bubbles that the credit cycle feeds globally won’t inflate any more because the price of the bubble asset has stopped rising. In other words, both JGB markets and the US housing market are at the top and won’t drive credit expansion for much longer. Ironically, the Fed’s last interest-rate cut has tightened monetary conditions because the dollar is up and so are long bond yields. It may take a month or two of suspension of (deflationary) disbelief for this to flow through to equity and bond markets, but it will.
Even in the JGB market (which is the most extreme bubble – if not the most globally significant one) imminent collapse is not likely. This is because the Japanese government can go on buying its own bonds through the BoJ and by lots of other underhand means.
The BoJ and government agencies already own nearly half of all outstanding JGBs. Again, nearly half of the BoJ’s assets are in JGBs and this fiscal year the BoJ will buy nearly 20% of government gross issuance. It already owns about 15% of all outstanding JGBs. So why not boost that sick symbiosis to, say, a 20% holding?
For the JGB market to collapse, sales by banks and life insurance companies would have to swamp the administration’s purchases. And for that to happen, deposits would have to flee banks and capital to flee Japan. There is no sign yet of deposit flight from Japanese banks or capital exodus from Japan.
Capital flight would make the yen a major victim of a collapsing JGB market. That hasn’t happened. The yen’s fall will come, though North Korea, rather than rational economic thinking, might be the eventual cause. When it does happen, 10-year JGB yields will head to 4% to 5%. The crashing sound will be the banks and life insurers. But by my reckoning that’s still not imminent.
| The liquidity trap |
