E Two Minute Warning

Did some thinking on this. If we see the 10-year yield break below 1.50%, the next stop could be 1.0%. Central banks are out of bullets. The latest sign was last night’s warning by Japan’s Minister of Finance, Aso, not to bet on a rising yen. This is like when a team owner gives a failing coach a vote of confidence. That usually signifies the situation is bad.

In the WSJ, Greg Ip writes that markets are signaling recession. On the surface, this appears correct. However, I think there is something else afoot. The UST market, particularly the long end of the curve, is mainly pricing in low inflation/disinflation/deflation, whatever the cause. Models (which are now taken to be the end all and be all in the industry) read bond market data and price other assets accordingly. I.E. because the long rates generally trend lower ahead of a recession, trading and investing models assume recession and position accordingly. Inflation can decline for reasons other than recession. Falling prices of electronics, appliances and, in the first two decades of the 20th century, automobiles were not due to recessionary conditions, but due to greater production efficiencies.

That is the main source of disinflation now (with the exception of China). What is so disturbing to policymakers is that debt financed economies (at the consumer, corporate municipal and Federal levels) require inflation to devalue currencies (in a manageable fashion) and boost incomes in nominal terms. I.E. pay today’s stronger currency debts with tomorrow’s weaker currency income. When this scheme breaks down, the system grinds to a halt. This is why central bankers fear inflation so much.

I do not believe that central bankers can win the inflation battle at the present time. Technology and globalization are very disinflationary. Even QE, ZIRP and NIRP are powerless to stop it. I fear that we could be in a painful transition period in which large economies must decide if they will become prudent-spending market economies, or move to a more highly-regulated socialist system which discourages and even stifles innovation. This should have happened two decades ago, but because interest rates were sufficiently-high at the time, central banks had much room to ease to keep the game going. I believe that we are at the two minute warning.