Capital goes to where it’s treated best. With the slow but steady breakdown of the post-1971 US dollar-based monetary system, capital is no longer treated very well. So it becomes restless, nervous, and suspicious. It flees unwelcoming homes, and knocks on the doors of those it believes might take better care of it.
Capital has already fled Greece, Portugal and Ireland. It’s now fleeing Spain in droves. The FT reports that nearly €100 billion flowed out of the banking system in the first three months of the year. You can bet that the outflow has gathered pace since then.
Whose door is the escaping capital knocking on? A dwindling number of countries — Germany, the US, the UK, and even Australia. Government bond yields in these countries are approaching their lowest levels in history.
Aussie government 10-year yields yesterday fell below 3% for the first time ever. Britain has mountainous debt, inflation and an economy in recession. But its borrowing cost, at around 1.55%, is the lowest it’s been since records began in the early 1700s.
Capital is pounding on the door of Germany and the US too. Government 10-year yields are 1.20% and 1.55% respectively.
With inflation running between 2-3% in these countries, why would investors give money to the government for such a paltry return? In real terms, they’re guaranteed a loss. Is it a forecast of deflation ahead?
It could be. But we think it has more to do with the screwed up nature of the financial system and the one-dimensional view of inflation and deflation.
Capital — and by capital we mean big money flows — is more concerned with inflation and deflation in asset markets than in product markets. We’ve long been sold the lie that inflation and deflation in product markets is what matters. By maintaining low product market inflation with doctored statistics, central bankers can keep interest rates low. It’s what allows them to maintain a steady flow of credit, avoid recession, and give the impression they know what they’re doing.
Easy money policy creates asset price inflation. Housing, commodities, stocks, China, emerging markets…and now bonds, have all experienced major asset price inflation. The money created by low interest rates spawns capital that goes looking for the best returns. If you’ve been following the story of the dysfunctional global financial system over the past few years, you’ll recognise the various homes where capital has made itself comfortable.
But a dysfunctional financial system doesn’t create stability. So the relationship between capital and the various asset classes that accommodate it is a fleeting one. Global capital might be supping at the table of a chosen few sovereign governments, but it’s probably not getting too cosy. It’s ready to flee.
Right now, the big money is concerned with asset price deflation (amongst stocks, commodities, etc) rather than deflation in product markets. So they rush into bond funds looking for a haven. The irony is that as bond yields fall, the price rises. So with many sovereign bond market yields hitting all-time lows, it’s the same thing as saying their prices are at all-time highs.
In short, global capital — that amorphous and unwieldy giant caused by decades of easy money — is in the process of forming an almighty bubble in sovereign bond markets. That doesn’t mean it’s about to pop anytime soon. European bank troubles will continue to feed these bubbles for some time.
But what do you think will happen when governments have the opportunity to continue to borrow and spend at historic low rates? They’ll continue to borrow and spend…with even more gusto than they have previously.
Eventually, this will create havoc in the big global bond markets. Governments will blow themselves up. Where will capital flow then? Back into the stock market? Gold?
The point may be a moot one. We think the dollar-based system is on its last legs. What you’re experiencing now is the chaos that happens to all systems in their death throes.
Bill Gross, from global bond fund manager PIMCO, weighs in on the topic in his latest monthly:
‘The global monetary system which has evolved and morphed over the past century but always in the direction of easier, cheaper and more abundant credit, may have reached a point at which it can no longer operate efficiently and equitably to promote economic growth and the fair distribution of its benefits. Future changes, which lie on a visible horizon, may not be so beneficial for our ocean’s oversized creatures.’ (By this Gross means Wall Street)
‘Together, there is the potential for both public and private market creditors to effect a change in how credit is funded and dispersed – our global monetary system. What that will look like is conjectural, but it is likely to be more hard money as opposed to fiat-based, or if still fiat-centric, less oriented to a dollar-based reserve currency. In either case, the transition is likely to be disruptive and an ill omen for seafaring investors.’
This was the essence of our speech at Port Phillip Publishing’s investment conference back in March. We called it ‘The Myth of the Seamless Transition’. We argued that major transitions in financial systems, often brought about by the decline of a long-standing hegemonic power, are never smooth. And that’s certainly going to be the case in the years to come.
But in the here and now, every calamitous event is met with demands/desires/hopes for an ever greater central bank response. That’s certainly what is providing support to the equity market at the moment. Hopeful investors regard the dire news coming out of Europe as bringing the European Central Bank closer to another round of money printing.
And although the US Federal Reserve has kept its head down lately, many are starting to demand/desire/hope that it does something as well. It’s hilarious really. Everything it’s done since Greenspan took over in 1987 has just made things worse. You’ll know we’re close to a bottom when ‘the market’ starts pointing the finger at the Fed, rather than asking for its help.
Our feeling is that this market is starting to look very ugly indeed. A crash from here would not surprise us. Don’t do anything stupid.
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From the Archives…
Investing in Gold as World Economies Falter
2012-05-25 – Eric Fry
A Hard Dose of Medicine for the Greek Economy
2012-05-24 – Greg Canavan
Why Sooner or Later in Europe Someone Will Have to Pay
2012-05-23 – Dan Denning
To the Class of 2012
2012-05-22 – Bill Bonner
The Early Stages of a European Bank Run
2012-04-21 – Dan Denning