Sooner rather
than later, it will dawn on investors that Treasuries are over-valued
and confidence in the Treasuries market will crack: one possibility
is that rising inflation expectations or higher deficits will
then push up market interest rates, causing bond prices to falter
and then fall; an even more imminent prospect is that some combination
of the Fed’s quantitative easing and yawning Federal budget
and U.S. balance of payments deficits will cause a further decline
in the dollar that makes foreign holders of Treasury bonds lose
confidence in their investments. In either case, there is then
likely to be a rush to the exits – a flight from Treasuries
on a massive scale – forcing up interest rates in general
and inflicting heavy losses on bondholders, especially on those
holding long-term bonds.
• The
collapse of the Treasuries market will cause the banks’ previously
profitable ‘gapping’ adventure to unravel with a vengeance:
the very positions that yielded them such easy returns will now
suffer swingeing capital losses. Confidence in the banks –
never strong since the onset of the crisis – will collapse
(again) and we will enter a new (and severe) banking crisis.
• The
bursting of the Treasuries and financials bubbles will then feed
through to the junk bond bubble: the collapse in the Treasuries
market and the renewed banking crisis will lead to sharp falls
in the values of corporate bonds and sharp rises in credit spreads.
Highly leveraged firms will then default in droves, the junk bond
market will collapse and LBO activity will dry up.
We also
have to consider the nontrivial knock-on effects: the Treasuries
collapse will trigger an immediate financing crisis for governments
at all levels, and especially for the federal government, and
one which will likely involve the downgrading of its AAA credit
rating, and so further intensify the government’s by-then
already chronic financing problems. Nor should we forget that
these financial tsunamis are likely to overwhelm the Federal Reserve
itself: the Fed has a highly leveraged balance sheet that would
do any aggressive hedge fund proud; it too will therefore suffer
horrendous losses and is likely to become insolvent. The events
of the last three years will then look like a picnic.
There is
also the problem of resurgent inflation. For a long time, the
U.S. has been protected from much of the inflationary impact of
Federal Reserve policies: developments in IT and the cost reductions
attendant on the outsourcing of production to east Asia had the
impact of suppressing prices and masking the domestic impact of
Fed policies. Instead, these policies produced a massive buildup
in global currency reserves: these have increased at 16% per annum
since 1997-98 and caused soaring commodity prices and rampant
inflation in countries such as India (current inflation 16%) and
China (maybe 20%, judging by wage inflation, and definitely much
higher than official figures acknowledge) whose currencies have
been (more or less) aligned to the dollar. U.S. inflation was
already rising by 2008 (annual rate 3.85%), but this rise was
put into reverse when bank lending and consumer spending then
fell sharply. However, there are good reasons to think that inflation
will soon take off again: (1) The combination of booming commodity
prices and a depreciating dollar (trade-weighted dollar exchange
rate index down 15% since March ’09) means that imports will
cost more in dollar terms and this must inevitably feed through
to U.S. inflation. (2) Rising labor costs in the Asian economies
mean that the outsourcing movement is coming to an end and even
beginning to reverse itself, and with it the associated cost reductions
for American firms that outsource to Asia. Most importantly, (3),
there is the huge additional monetary overhang created over the
last couple of years (or, to put it more pointedly, the vast recent
monetizations of government debt), the impact of which has been
held temporarily in check by sluggish conditions over 2009-2010,
but which will must eventually flood forth – and, when it
does, inflation is likely to rise sharply.
Once inflation
makes a comeback, a point will eventually come where the Fed policy
has to go into sharp reverse – just like the late 1970s,
interest rates will be hiked upwards to slow down monetary growth.
The consequences would be most unpleasant: the U.S. would experience
the renewed miseries of stagflation – and a severe one at
that, given the carnage of a renewed financial crisis and the
large increases in money supply working through the system. Moreover,
as in the early 1980s, higher interest rates would lead to major
falls in asset prices and inflict further losses on financial
institutions, wiping out their capital bases in the process. Thus,
renewed inflation and higher interest rates would deliver yet
another blow to an already gravely weakened financial system.
