Here's a question: why is it that yields in Japan, Germany, the U.K., Italy, the U.S., and Australia are all surging at the same time?
Answer: Because we are watching the global sovereign debt bubble that was built up over the past nearly 15 years popping.
To understand what's happening, you have to go all the way back to the global financial crisis of 2008-09. That was the first time "quantitative easing," or central bank bond-buying, was deployed on a broad scale (it had previously only been tried in Japan). We also had what at the time seemed like "massive" fiscal stimulus by various governments to support their economies. Critics warned this potent policy mix could end poorly.
But for years and years and years, it didn't. In fact, the early rounds of QE, at least in the U.S., are credited with keeping the economy out of a deflationary collapse. Meanwhile, the Tea Party and plenty of serious policymakers were working to try and bring the fiscal situation back into long-term balance. There was an initial effort, in other words, to get back to "normal." But when interest rates remained moribund and inflation failed to materialize, those efforts gradually lost steam.
By the end of the 2010s, "austerity" talk was ancient history. Global bond yields simply weren't rising, no matter how much debt governments were issuing. In 2019, almost a quarter of global government debt carried negative yields; it seemed markets were practically begging policy makers for more and more of it, with permission to juice their economies. The New York Times started carrying op-eds promoting the idea of "Modern Monetary Theory," or near-limitless deficit spending; even mainstream economists like Robert Shiller seemed to half-endorse it.
Then came Covid. If ever there was a moment to try "near-limitless" deficit spending, that was it. But the budget deficit was already almost $1 trillion in 2019, or 4.6% of GDP (versus the 3% historical average). Debt held by the public was nearly 80% of GDP. There was no "room," in other words, for the $5 trillion in fiscal stimulus we had, other than the fact that markets (and the disappearance of inflation) seemed to be giving the green light. 10-year Treasuries yielded less than 2% pre-pandemic, and fell to half a percent in the depths of the crisis.
So indeed, as the Times wrote last February, "Modern Monetary Theory, the buzziest economic ideas in decades, got a pandemic tryout of sorts. Now inflation is testing its limits." Unfortunately, those limits were reached--and breeched. Inflation was a sure sign that policymakers, including the $5 trillion in QE by the Fed, had done too much. The Fed, for its part, had no choice but to throw the system into reverse; but fiscal authorities so far have not.
The result is a market flooded with Treasuries and other global debt, but without central banks anymore as a key buyer. And markets hate when buyers-of-last-resort disappear. They also hate losses. The combination of those two factors has now resulted in the massive selloff of global sovereign debt, as prices that always seemed unsustainable last decade have been shown in retrospect to have been precisely that.
To be sure, yields are so high now, and sovereign debt so hated, that some savvy investors are starting to be buyers. "I could see the 10-year at 4.25% in a year," one of them told me yesterday, "because I am worried about the economy going forward." Similarly, MKM Partners' Michael Darda is telling clients to be buyers: "this doesn't mean deficits don't matter," he wrote yesterday, "it simply means the dominant force is the expected path of Fed policy given the economy and inflation." And he is quite bearish.
But you still have to wonder if that's the end of the story. As Matthew McLennan of First Eagle warned us yesterday, he doesn't see a clear way out of this mess; "If we don't get a recession, we could see double-digit deficits," because of still-high interest rates, "but if we do get a recession, we could also see double-digit deficits" because revenues collapse in a down economy, he said.
Or as another observer tweeted yesterday, "Everyone has been waiting for the Fed to break something. What if it already broke the Treasury market, with huge help from the Treasury itself, but no one noticed it?"
On that note, watch the dollar. As economist Peter Boockvar wrote this morning, "Things don't really break here in terms of the U.S. being treated like an emerging market until the dollar breaks. When you see rates rising in addition to the U.S. dollar falling, that's when we're in real trouble." And if that doesn't happen, perhaps we'll find some very messy way in the meantime to muddle through.
See you at 1 p.m!
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