In February 1990, when Jimmy Carter was US president, the financial world was shaken to its very foundations. The cause? The failure of the Democrats and Republicans to sort out the economic problems of their nation.
Ring any bells?
Once again, the two parties are at loggerheads; this time over how to avert plunging over the the “fiscal cliff” on 1 January. The politicians have just 2 months to sort it out.
And if they don’t? Well, maybe… just maybe… we’ll see a repeat of what happened in February 1980.
So what did happen in 1980? The implosion of the bond market bubble, followed by the complete collapse of the US Treasury bond market. The trigger: investor concerns about out-of-control inflation.
But hang on. We don’t have an inflation problem, do we? At least not yet.
Yes, that’s correct. And ever since the 2008 banking crisis, analystshave been arguing about whether we are or are not experiencing a bond bubble.
Indeed, some argue that deflation is the greater danger. If they’re right, then bond prices will keep on going up and bond yields will keep on going down. Heaven help us all if that happens. Japan has been dipping in and out of the deflation trap for more than 20 years, with no convincing sign of escape.
In my view, we do have a bond bubble. Because of the turmoil caused by the financial crises on both sides of the Atlantic, investors have piled into bonds, driving yields down to near-record lows. The yield on 10-year US Treasury bonds is down to a miserable 1.7%.
Furthermore, Ben Bernanke and his merry men at the Federal Reserve are hard at work destroying the value of the dollar through money printing on an heroic scale. He has vowed that America will never fall into deflation, as the Japanese have done, since he will go on printing money for as long as it takes…
At the end of October, the total national debt of the US stood at an astronomical $16.21 trillion. Of this, some $4.85 trillion is intra-governmental holdings. You’ll recall that, as part of its “QE Infinity” money printing programme, the Fed has been buying up Treasury bonds almost as fast as the US Treasury can issue them.
That leaves $11.41 trillion held by the public (individuals or organisations).
Of that $11.41 trillion, 48% is owned by overseas investors in the form of Treasury bonds and the like. China and Japan are the biggest overseas investors, with around $1.1 trillion each.
These overseas investors are especially important because not only are they getting a pathetic yield on their investments; the value of these investments is also being eroded by the fall in the dollar versus their home currencies.
But it’s worse than that. America depends on foreigners to finance its huge deficits. As America continues to add to its national debt at an astounding rate, how much longer will they be prepared to keep America solvent?
China in particular has had enough of this. It has substantially cut back on its purchases of US government securities and is endeavoring to place its huge surpluses into safer assets such as gold.
If America is not very careful, there will come a time when foreign investors lose patience and there will be a bond holders strike. Instead of buying, many holders will sell. And as bond prices start to fall and yields rise, more and more bond holders will dump their holdings until the selling turns into a rout.
That’s exactly what happened in February 1980.
For the bond market bubble to burst, there needs to be a trigger. In the run-up to February 1980, that trigger was inflation, which is anathema to bond holders.
But the trigger doesn’t have to be inflation. It can be anything. Failure to resolve the fiscal cliff issue, so that America plunges straight into recession could be a trigger.
Failing to agree a rise in the debt ceiling could be another trigger. America will hit its current ceiling in February or March next year. You probably recall what happened last year when the two political parties failed to agree on this issue last year – credit ratings agency Standard and Poor’s stripped America of its coveted triple-A rating for the first time in history.
A third trigger? Rising interest rates. Absolute (as opposed to inflation-adjusted) interest rates have rarely in history been as low as this.Interest rates may have to rise to persuade overseas bond holders to finance America’s debt. But rising interest rates are as bad for bonds as inflation. So again that could trigger panic selling.It happened in 1994.
The current bond bubble will implode, as sure as night follows day. History will repeat itself – but we don’t know exactly when. And it won’t unfold in the same way as in the past.
Or as Mark Twain succinctly put it: “History doesn’t repeat itself, but it does rhyme.”
That’s why, when it happens, it’s likely to come out of the blue. Because inflation is quiescent, people think it can’t happen, because that was the trigger last time. They fail to see that inflation is not the only trigger.
The next two to six months are a period of great danger in America. We hope there are enough wise heads in Washington to help steer the nation away from trouble. But on the evidence of the recent past, we fear the worst.