The message of higher bond yields
Rising bond yields signal increasing credit risk. It indicates that the largest credit bubble in history is about to burst. I assess the consequences for credit markets, currencies, and gold.
ALASDAIR MACLEOD
The yield on the US long bond has definitely broken into new high ground post-covid.
It should be noted that interest rates and bond yields primarily reflect default risk.
In aggregate, the banking system cannot reduce credit outstanding, only lessening lending and duration risks.
The resulting credit shortage drives up interest rates as indebted borrowers seek to extend their loans.
Today, these distressed borrowers include highly indebted governments, led by the US.
The chart below shows how lending risk to the US Government has been increasing over the last three months, measured in the yield for the 10-year UST note.
Having observed a number of credit cycles over the decades, I have noticed the value relationship between bonds and equities.
Towards the end of a period of credit expansion, equities become increasingly driven by momentum rather than value. At the same time, bonds undergo the first phase of rising yields.
This is taken by the momentum bulls as irrelevant, or perhaps evidence of a growing economy and higher corporate profits to come.
With the additional stimulus of a Trump presidency, that is roughly where US market sentiment stands today.
As the chart of the US long bond above shows, yields found a bottom in late-September before moving significantly higher.
Evidently, a second phase of yield increases is in progress with the long bond yield having already risen 100 basis points to levels above those of last May.
Based on this chart, if nothing else, alarm bells should be ringing in all credit-driven markets.
This brings us to a destructive stage in the bond/equity relationship.
A new phase of rising bond yields will prove fatal for momentum driven equity markets. Sober value considerations are sure to return.
That is why recent developments in bond markets must be taken extremely seriously.
And the current credit bubble has become so extreme that the return to value-reality in equities promises to be a very violent transition, because the gap over bonds has become exceptionally large.
It is in fact a record, as my next chart shows.
I’m always reluctant to produce complex charts, but this one is worth taking the time to consider.
I have presented it in such a way that the normally close negative corelation between the long bond yield and the S&P Index is clearly demonstrated.
Obviously, distortions in the relationship do occur but these should be ignored.
Instead, the valuation gap which opened up during the 1996—2000 dot-com boom should be noted.
After initially declining, bond yields (the blue line inverted) rose through 1999 while the S&P continued rising until the disparity become too much for momentum investors to sustain.
Fortunately for equity bulls, Greenspan was at hand and quickly reduced interest rates, limiting the decline in equities to about 50%.
That was not the end of the matter, because Greenspan’s interest rate policy continued to fuel the credit bubble, with its focus moving to residential property instead.
That need not concern us here.
We should move on to the current situation, where the S&P has continued to rise despite the increase in bond yields so far.
Today, the value disparity is more than twice as extreme as that at the end of the dot-com bubble, a bubble which itself was extreme in its psychology with alarming similarities to the South Sea Bubble three hundred years ago.
The thing about a financial bubble is that the vast majority of investors are totally unaware of it when investing.
They are seized of a belief that equities will continue to rise for ever.
This time, we have the addition of bitcoin and other cryptocurrencies, the former of which, we are told will certainly rise to hundreds of thousands of dollars and millions being not out of the question.
And even those who do recognise this additional evidence of a credit bubble play along for fear of missing out — which even has an acronym, FOMO.
Look again at the first chart of the yield on the long bond.
It has now risen to new highs, stretching the value disparity between bonds and equities even further.
When wiser heads awaken to the likelihood that bond yields are not going to stop rising (we are told that further declines are still expected) but will continue rising, an equity market crash is guaranteed.
The Fed’s position
While Alan Greenspan succeeded in 2000—2002 to force interest rates and bond yields lower, the situation today is unlikely to permit Jay Powell to do the same, because with US Government debt-to-GDP at about 130% and rising, it is in a debt trap.
The marginal buyers setting the yield are foreigners backing off from the dollar and its mounting risks by selling them for gold.
If Powell goes soft on interest rates, holders of dollars will take the hint and expect an even more rapid decline in its purchasing power.
Put more conventionally, this means that inflation will accelerate.
Couple this currency effect with Trump’s promise of tariffs, and you have the recipe for a dollar disaster — measured against gold rather than other currencies.
When equities crash and bond yields continue to rise, the Fed will come under enormous pressure to ease.
Without the wealth creation engine of rising financial assets, undoubtedly the economy will enter a slump.
That is not too strong a description, given that we are witnessing the end of the largest credit bubble in recorded history as it enters a period of severe deflation.
Furthermore, falling revenues and rising welfare commitments will increase the government’s funding demands, leading to further increases in the budget deficit and pressure on bond values.
With a growing reluctance of foreigners to fund it, the Fed may be forced into monetising debt through massive QE programmes.
But before that happens, the realisation that interest rates are not going to fall as expected is beginning to play havoc in foreign bonds and the assets that depend on them.
The following charts of the UK long gilt and the JGB’s 10-year bond show the damage so far.
Currencies are collapsing as well as bond prices, as the charts of the euro and the yen (inverted) respectively illustrate.
These are next.
The underlying point is that the current record-sized credit bubble is not confined to the US and when it bursts it will create global economic and financial chaos.
It is against this background that we watch how gold behaves.
Are the days over when traders could claim that higher interest rates are good for the dollar and bad for gold?
We are seeing some evidence of this shibboleth being discarded, with increasing numbers of financial actors appearing to realise that credit as opposed to money (i.e. gold) is increasingly risky.
Furthermore, if interest rates are to rise to a level to compensate for credit risk, credit risk itself will increase more rapidly than the rise in rates to offset it.
In other words, the problems of debt traps for the dollar, the euro, the yen, and sterling are crossing the Rubicon into crisis.
The dollar is central to the world’s currencies.
It’s declining purchasing power and the loss of confidence in it on the foreign exchanges are undermining the euro, yen, and pound to an even greater extent than the dollar.
As the largest ever recorded credit bubble deflates, the era of fiat currencies is ending, and gold returns as the only medium of exchange valued by its lack of counterparty risk and its legal status as final settlement.
In other words, its status as true money is being increasingly valued.
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