Analysis: Where Bonds Go, Stocks Will Follow and They’re Going Down
During a podcast last month, Peter Schiff asked a key question: who is going to buy all of the debt necessary to finance the ballooning US deficit?
In his most recent analysis, Dan Kurtz at DK Analytics explores this question more in-depth and comes to generally the same conclusion.
The dollar has lost more than 8% of its value over the last year. That decline may accelerate as bond investors sell ahead of a huge expansion in Treasuries coming into the market. Interest rates will have to climb significantly. The price of bonds will drop. As Dan put it, where bonds go, stocks follow.
We’ve excerpted some key points from Dan’s report.
A dollar under pressure means that more overseas holders of the American currency are selling it than want to buy it.This inevitably means that they will be selling dollar bonds first and foremost, but US stocks too, especially if the US unit continues to come under pressure. The reason: their home currency-based returns will come under pressure. Given America’s massive and growing trade deficit (It went from $564 billion to $599 billion last year), dramatically widening ‘official’ federal budget deficit heading back into the trillion-dollar range, a Fed that wants to shrink its balance sheet by up to $600 billion p.a., and rising inflationary pipeline pressure (below), we’ve got huge headwinds for our ‘bubbly’ dollar, bond,and stock valuations.
In short, who is going to finance a $600bn plus US trade deficit and $1 trillion-plus federal budget deficits while the Fed sells $600 billion of Treasuries on to the market? How does one spell $2.2 trillion-plus in USD bonds coming to market? How does one spell “higher interest rates (the cost of money), lower bond prices, and lower stock prices,” i.e., prior to additional economic weakness and pending official reinstatement of a Fed (Powell) stock market put?
The latter will likely underpin sliding stock prices that higher interest rates (yes, Virginia, we can see higher nominal interest rates/lower bond prices during stagflation, revisited) and a recession-based EPS compression will initially deepen, but probably only after a long overdue and deep stock market swoon. It could be an epic decline.
In other words, look for the 2008 stock market rout/financial crisis to be revisited. Back then, it took US stock market investors about six months to be convinced that neither the Fed nor taxpayers (TARP) would allow a sustained meltdown. Since Q4:2007, over a ten-year period, America has added about $15.4 trillion in debt, reaching nearly $68 trillion by late 2017. Globally, since Q4:2007, debt has risen by some $91 trillion (well in excess of one year’s worth of global GDP!) to $233 trillion recently, nearly three times the global stock market capitalization of approximately $80 trillion. From 2007 to 2017, global debt is up 64.1% to $233 trillion while global GDP over the same period is up “only” 37.1% to an estimated $79.3 trillion, meaning debt/GDP has gone from 2.45:1 to 2.94:1, “greased” by unsustainably low interest rates.
Meanwhile, as per the latest tally, there are $416 trillion in principally off-balance sheet, OTC interest rate sensitive derivatives. In a nutshell, these derivatives constitute money center bank bets on sustained low interest rates. If rates rise materially across the yield curve, those same derivatives constitute potentially balance sheet-pulverizing financial exposure risk for leading financial institutions. Risk manifestation could be liquidity and/or solvency based. Growing counterparty reticence (banks’ reduced willingness to lend to each other) helped fuel what nearly turned into a full-blown global liquidity crisis in 2008. We have learned nothing. “Too big to fail, too big to jail cronyism” was doubled down on.
Our bigger point: we continue to have outsized growth in both insolvency and monetary inflation risks, a secular decline in productivity growth, and more pervasive dense energy availability and affordability issues. This is not an environment in which bond yields, much less the real risk-free rate hovering close to zero, should reflect productivity-based deflation and Adam Smith-style, wealth of nations furthering, free-market capitalism perfection!
Sometimes a long historical perspective is helpful in this regard, as per the 706-year global depiction below. Take a look at the real risk-free return — in today’s world, in essence, a 10-year Treasury yield less inflation — trend prior to Volcker’s “tough love” monetary policy, which ultimately broke rising inflation’s back by the early 1980s. Said differently, look at the real risk-free rate trend between 1961 and 1989 below. It “housed” growing US federal and trade deficits, the repeal of the dollar gold standard, an unprecedented era of fiat currencies, and the stagflationary 1970s. During this 28-year period, the real risk-free rate went from approximately -6% to about +7%. Over the past 28 years, we’ve gone from 7% to “zero-bound.” Given our increasingly pervasive and intractable political, economic, and financial challenges, cycles, math, and “econ 101” strongly suggest a reversion beyond the mean is in store for the real risk-free rate: the impact of this on dollar, bond, and stock bubble valuations may well prove to be unparalleled.
Amidst huge valuation bubbles in bonds and stocks, which are again “tied at the hip,” we’ve got:
- Financial (unmatched QE-enabled insolvency and counterparty/liquidity risks both domestically and globally)
- Economic (global productivity slowdown triggered by financial repression-based misallocations/cronyism coupled with long declining EROEI* and an overdue recession),
- Political thunderclouds (loss of the rule of law and loss of “maker” property right protections from a) sound money to b) massive redistribution to “takers” to c) de facto transfers of American citizen wealth to both K Street and to noncitizens and to non-mainstreaming immigrants — in short, the sad story of most OECD nations).
The rain will come. And so will the lightning. The fragile confidence in a financially and morally bankrupt status quo will suddenly crumble, and the credit system will freeze up. “Overnight.”
Are you prepared?
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