Bond yields have surged over the past several weeks as the U.S. Treasury market has priced in a tapering of the pace of Federal Reserve bond purchases later this year based on expectations for an improving economy – and maybe even a full halt to quantitative easing in a year's time, as Fed Chairman Ben Bernanke outlined during last week's FOMC press conference.
That prompts notedly bearish Société Générale strategist Albert Edwards to pose the question in his latest market commentary: "Is the Ice Age over?"
The "Ice Age," a term Edwards uses to describe a series of economic cycles characterized by " lower lows and lower highs for nominal economic quantities," driving a " re-rating of government bonds and the de-rating of equities each recovery bringing a partial reversal to the process and each recessionary phase taking us to shocking new lows, both in bond yields and in equity multiples.
Edwards doesn't think we've escaped the Ice Age. Instead, he asserts that deflation risks remain high. He points to persistently low inflation, which the Fed has seemingly dismissed as transitory, and the crisis unfolding in emerging markets right now, which he says present a " good chance of a repeat of 1998 where a deflationary wave of manufactured goods washed up from Asia."
The recent surge in bond yields was driven by a sharp rise in real yields, implying a sharply reduced outlook for inflation in the marketplace.
Edwards doesn't see that as sustainable, and given his outlook for weaker economic data in the future, he doesn't see any way the Fed will be able to ease off the QE pedal.
And that will eventually force yields back down again.
"Indeed, lets put the recent bond sell-off into a longer term context. Bond yields at 2.5% still remain locked in a technically well-established bull trend that will not be broken until yields spike above 3.5%," writes Edwards. "Who knows, the 'feral hogs' may have their grunting way but by that time, with that degree of monetary tightening we will undoubtedly be back in deep recession and yields will be back on their way down again."
(Earlier this week, Dallas Fed President Richard Fisher told the FT, "I do believe that big money does organise itself somewhat like feral hogs ... If they detect a weakness or a bad scent, they’ll go after it.")
Here's the thrust of the Edwards argument:
It is worth repeating the very simple point that an integral part of the Ice Age thesis is lower lows and lower highs for nominal economic quantities in each cycle. So, for example, in the chart below we see progressive steps down in each cycle almost unnoticed unless you take the longer view. It is this process that drives the Ice Age re-rating of government bonds and the de-rating of equities each recovery bringing a partial reversal to the process and each recessionary phase taking us to shocking new lows, both in bond yields and in equity multiples. I do not believe this process is complete, especially as I do not see the economy as reaching exit velocity of GDP in excess of 3%. Indeed, growth is still anaemic and vulnerable.
We note that, amid the carnage in the government bond market, implied inflation not only remains subdued but has fallen decisively. Maybe that reflects an acknowledgement that the economy is indeed nowhere near exit velocity. Certainly the divergence between the ISM and inflation expectations has been unusual and history suggests it is inflation expectations that eventually catch up with the economic reality ... And with events unfolding in emerging markets as they are, I see a good chance of a repeat of 1998 where a deflationary wave of manufactured goods washed up from Asia. Deflation risks remain high.
But where does that leave us in terms of QE. I fully concur with the legendary Marc Faber who when asked during a Bloomberg TV interview if Bernanke meant what he said on starting to taper sooner rather than later, responded "If you say that if he means what he says, then you believe in Father Christmas. He said if the economy does not meet the expectations of the Fed in one years' time, they will consider additional measures. In other words, if the economy has not fully recovered by mid-2014, more QE will be forthcoming. As I said already three years ago, we are going to go with the Fed to QE99."
I tend to agree with that view. The economic reality in the West will force further rounds of QE. And in addition do not forget one over-riding structural trend towards fiscal insolvency and unlimited money printing; the latest BIS annual report highlighted the fiscal Kilimanjaro that has to be climbed due to rapidly aging populations in a number of countries, most notably Japan, the US and the UK.
"[Governments] will take the path of least resistance, which is to print their way out of this looming fiscal catastrophe," concludes Edwards. "Marc Faber is right. QE99 here we come."
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