Global Bonds Signal Deflation

“The trouble with the future is that it usually arrives before we are ready for it” – Arnold H. Glasgow.

Much of the world’s interest rates are now already as low, or lower, than they were in the two previous deflations of the 1890s and the 1930s.

 The chart below shows the 200 year history of government bond yields in France. These yields reached a low of 2.85% in the 1890s. In the 1930s the low reached was just 3.36%. That’s around where we are right now.

                             200 years of government bond yields in France

In the first few days of May, the yield on the German 10 year government bond fell below 3.40% and it has kept falling since then reaching a new all time low of 3.29%. German government bonds are now below where they were either in the 1930s or the 1890s.

 

The next chart shows the long term history of Japanese government bond yields. In Japan there were no 10 year government bonds in the 1890s, and although 7 year rates fell, the low was still quite high at 4.7%. In the 1930s, the same 7 year note fell to a low of 3.79%. But Japan’s deflation has now become entrenched. The 7 year note broke to new lows back in 1996 and kept going, reaching an almost unbelievable low of just 0.25% in mid 2003 and now stands around 0.8%. 

                   150 years of government bond yields in Japan

In the US, 10 year yields hit a low of 2.5% in the 1890s, and 1.55% in the 1930s. Currently there is much preoccupation with the idea that yields are currently so low, at 4.12%, given the so-called strength of the US economy. This misses two major points. The global context for bonds and the weak foundations of the current economic cycle.

 

Deflation?

To most people, even the idea of deflation is unthinkable. It has not happened in their life time and after all, the Fed and all the other central banks stand ready to print as much money as needed to forestall it. But if it is so easy why has Japan been locked in deflation for almost a decade?

The problem is that endless liquidity only works if people want to borrow and use that money. A sudden change in behaviour from credit creation to debt avoidance and contraction often means that the theory of endless liquidity being able to support prices, fails in practice. Deflation sets in fast and central banks may be powerless to do much about it. Then a seemingly endless period of agonizing debt resolution begins.

We have been able to ignore deflation in Japan for several years by regarding this as an “oddball” situation peculiar to Japan. But if deflation now sets in across Europe, it will be much harder to dismiss, and the deflationary periods of the 1890s and 1930s were worldwide economic events.

Summary

Unless bond yields rise soon and current levels can then be dismissed as some kind of fluke, we are likely to face economic conditions almost no-one is prepared for. If German government bond yields stay below 3.50% then we need to become very quickly aware of what deflation means and what we need to do in preparation. 

It is nearly forgotten now but the decade of the 1890s was one of sharp deflation. For those in debt it was a nightmare, but it did not stop there. A quarter of American railroads went bankrupt and in most cities, unemployment rose to at least 20%. For those without debts, and with cash and gold the 1890s were very different, however, as prices fell sharply and their living standards rose. There quickly emerged two classes: the haves and have-nots.

          We have talked a great deal, over recent months, about the hidden economic risks that were building and unresolved. But it is always the markets that tell us when and how these issues will play out. The bond markets have now sent us a clear warning signal.

 

 

 

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