The outlook for 2025
Rising bond yields will be the surprise, ending the largest credit bubble in history. Central banks will probably inflate in a vain attempt to rescue financial markets and the economy.
ALASDAIR MACLEOD
The background
It has been a time of political change, driven by electoral discontent of incumbent administrations.
Thus, it was that Javier Milei almost exactly a year ago ousted the corrupt socialistic administration in Argentina, following Giorgia Meloni’s election in Italy.
That was two for the right.
In Britain, the Conservatives were ousted by a highly socialist Labour Party masquerading as moderates.
In the USA, Trump trounced Harris, who had inherited the leftist administration of a bumbling Biden.
On balance and given the US’s size, it has been a marginal win for the capitalists over the socialists which might be expected to lead to a better world.
However, this is unlikely to be the case.
We must focus on the US, because if she sneezes, we all catch colds.
Under President-elect Trump, the outlook is of greater economic isolationism.
Make America Great Again is aimed at protecting US industry from “unfair” foreign competition.
The dismantling of international supply chains will accelerate, a post-covid process which started under Trump’s previous administration following covid lockdowns.
The killer for international outsourcing is trade tariffs.
But we must admit that it is one thing to call tariffs “the most beautiful word” while campaigning for office and another when facing practicalities post-election.
The hope is that Scott Bessent, Trump’s nominee for Treasury Secretary is not so ideologically driven and that tariff wars with China and the EU are pre-election rhetoric.
But this doesn’t account for how Trump works.
He drives the agenda and Bessent was a hedge fund manager, almost certainly ignorant of the economics of trade and unlikely to argue against tariffs convincingly.
Meanwhile, the tax agenda will almost certainly lead to higher budget deficits in the expectation that deficit spending will not only underwrite economic activity but cuts in income and corporation tax should lead to higher revenues in time.
Hope may spring eternal, but an economic policy it does not make.
Ask Liz Truss, who tried something similar (absent spending cuts, but I’ll come to that) and ended up crashing the UK’s gilt market.
With a debt to GDP of about 126% and rising, a stagnating private sector, and stubborn $2+ trillion budget deficits already Trump’s tax and tariff policies will almost certainly drive US Treasury bond yields higher, even without a foreign buyers’ strike.
This may be what is already driving them up, as the chart of the 10-year US Treasury Note’s yield clearly demonstrates.
The chart tells us that this bond’s yield is set to rise further and test the 5% level seen in October 2023, potentially rising even further if that level succumbs.
This matters for all financial asset values, particularly equities which are close to all-time highs despite the bear market in bonds.
The chart below shows what is now a record valuation disparity between these markets — indicated by the double-ended arrow — which is now twice as extreme as at the time of the Dot-com bubble in 2000.
This topic introduces us to the valuation bubble of financial assets generally, which is entirely due to the inflationary expansion of credit.
This credit bubble is the latest of a series going back to the mid-1980s, which have never been allowed to wash out malinvestments from the economy.
Instead, each bubble has fed into the next making this last one in the series a super-bubble.
Though few investors are aware of it, it is undoubtedly the largest in recorded economic history — larger even than that of the late-1920s which ended with the Wall Street Crash because it is truly global.
And as the chart above shows, it has led to equities being more than twice as expensive relative to bonds than at the time of the dot-com bubble in 2000.
All history screams at us that credit bubbles always lead to higher interest rates and bond yields which ends up destroying them.
The reason for this is simple.
Due to credit expansion, banks’ balance sheets are always become overleveraged compared with cyclical norms, and bankers attempt to derisk them when they switch from greed for profit to concern over risk .
They then decline to roll over loans to businesses, calling them in where possible or demanding higher interest rates.
And they reduce the maturity mismatch between obligations to depositors and those of their assets.
While an individual bank can reduce its balance sheet, it is virtually impossible for an entire commercial banking system to do so.
This is because of the nature of credit.
Any reduction in obligations by one bank results in an increase at another.
The only ways in which a system-wide credit reduction can happen is by writing off bad debts or by banks themselves going bust.
The contraction in bank credit in the early 1930s was because both businesses and banks failed in huge numbers.
Including currencies, all transactions are settled in credit.
It is how that credit is deployed which matters.
When a banking system collectively sees too much risk in lending to the private sector, it diverts credit to the public sector by buying treasury bills.
Driving these factors is what is commonly termed inflation, a process which is better understood as the loss of purchasing value for the currency, which is a nation’s medium of exchange.
Understanding inflation
Macroeconomic theory informs us that in a recession, inflation disappears to be replaced with deflation.
But that looks only at demand for goods and services.
The error is to ignore the contraction of supply signalled by rising unemployment.
Simplistically, with some timing differences supply and demand broadly contract together, as argued by Say’s Law which was widely understood by economists before Keynes published his General Theory in 1936.
This alone does not explain why prices rise.
The purchasing power of a fiat currency declines if an increase in its quantity is not deployed productively; that is to say invested in production aimed to satisfy consumer demand.
This is why an increase in unproductive government spending funded by budget deficits undermines the currency’s purchasing power, whereas increased credit deployed in production does not.
Additionally, a fiat currency’s value is affected by changes in its credibility in the minds of the two groups who hold it.
There are the foreigners who hold it for international reasons, and citizens who use it domestically.
These two seperate camps have different motivations.
In the case of the dollar, it is the principal reserve currency held by foreign central banks and used by foreign corporations for trade settlement and commodity purchases.
It’s the common currency of international debt and is the largest repository for financial assets, including portfolio investment.
It is therefore vulnerable to contractions of any or all of these functions which depend on one thing in common: faith in the future use and therefore current value of the dollar to foreign holders.
Faith in a currency’s value is completely overlooked by the mathematical approach of macroeconomists.
But as we have seen this last year in the relationship between gold and the dollar, the western financial establishment has no explanation for the extent to which gold has risen, or the dollar declined.
For a bullion bank, gold priced in dollars should not have increased by 27% this year when US M2 money supply only increased by 3%.
So why did it happen?
It’s down to the subjectivity of values, not mathematics as the macroeconomic establishment believes.
History shows that foreign holders usually lose confidence in a fiat currency’s value first before its domestic users.
This is understandable.
Foreigners are bound to be more aware of a currency issuer’s monetary and economic policies than its day-to-day users who regard their government’s currency as the objective value in all their transactions.
Now that president-elect Trump intends to replace income and corporation taxes at least partially with trade tariffs, foreign holders of dollars will have less use for them.
And they own a lot of dollars.
According to the US Treasury’s TIC figures, foreigners own $30.883 trillion of long-term securities including $8.596 trillion of US Treasuries.
And they have short term bank deposits, Treasury bills and commercial bills totalling a further $8.012 trillion for a total of $38.895 trillion of dollar denominated financial interests.
That is about 135% of US GDP.
As well as being enormous financial creditors of America, they are also the marginal buyers of treasury debt and therefore are leading price setters.
Already, we see China backing off from dollars by selling them for gold.
And Japanese pension funds and insurance companies have also been reducing their exposure to US treasuries.
These are the two largest holders, and their absence as buyers is an obvious factor driving T-bond yields higher along the yield curve.
Next, and this will probably happen early next year, the investment establishment in western financial markets will grasp what is happening to bond yields and they will understand that they are not going to fall as currently discounted but will continue to rise.
They may not understand why but will find it increasingly difficult to ignore the evidence.
Without their support and T-bond yields rising through 5%, equities are bound to crash, undermining much of the collateral gluing the banking system together.
And mortgage rates will rise, undermining residential property values to join commercial real estate as degraded loan collateral.
Fund managers, who are currently oblivious to it, will then more widely learn that they have been riding a credit bubble which is in the process of collapsing.
The Fed’s playbook says it should lower interest rates sharply to support stocks to preserve confidence and prevent widespread bankruptcies, thereby containing the consequences for commercial banks.
This is how it has responded to every credit crisis since the mid-eighties, rolling malinvestments into the following credit expansion — kicking the can down the road.
But how can the Fed reduce interest rates, when the dollar is under selling pressure from foreigners liquidating their dollar interests?
The Fed and Treasury will have to choose.
Will it support markets and the private sector which will require additional trillions in credit?
Or support the dollar by raising interest rates and damn the consequences, Volcker-style?
This was the dilemma faced by the UK’s Treasury and the Bank of England on more than one occasion in the 1970s.
The ultimate solution was bond yields in excess of 15% and a rescue package from the IMF, conditional on a balanced budget with spending cuts.
There is no external organisation which can rescue the US and the dollar.
Clearly, the answer is found in dramatic cuts in public spending.
In theory this will come about from the proposed Department of Government Efficiency (DOGE) headed by Elon Musk.
Musk is a genius in the private sector, but he will be up against the vested interests of the permanent establishment, which has always won — ask Dominic Cummings who attempted to reform the UK’s civil service.
Furthermore, it is Congress which decides spending, not an extension of the President’s office.
And Trump’s plan to migrate income and corporate taxes into tariffs will, in the short-term, increase consumer price inflation and the budget deficit.
This is why Scott Bessent wants to defer setting the debt limit.
To increase the deficit when the government’s debt to GDP is already approaching 130% will almost certainly lead to significantly higher bond yields, not just for the US government but globally as well.
Driving the rest of the world towards crisis
Other major elements of the western financial system simply cannot survive higher dollar interest rates.
Coupled with Trump’s trade tariffs — if they are implemented — higher rates will drive America and its financial partners into a recession, likely to be very deep and financially destabilising for all.
The EU faces even worse economic and debt problems than the US, magnified by bond yields which are far too low with constituent economies stagnating.
The UK has a deeply socialist government which is plainly anti-capitalist and determined to move towards increasing state control.
Both the UK and the EU are also pursuing energy policies which will kill off economic activity and therefore state revenues.
While dependent on the dollar’s lead, the euro and pound face greater crises than the dollar when the global credit bubble pops.
With overnight rates barely over zero and core inflation of 2.7%, the Bank of Japan is also badly wrongfooted for rising global bond yields.
It is no exaggeration to suggest that higher dollar rates will lead to an immediate crisis for the Bank of Japan which owns almost 60% of its government debt, and for the yen itself.
The two charts below show the precarious of Japan’s position:
America sneezes, and the rest of the world catches cold.
The outlook for gold
Intentionally, this article has focused on credit, its super-bubble, and therefore its certain implosion which always follows.
Credit is defined as the counterpart of an obligation, or debt owed to a creditor.
When credit collapses, it is because debtors fail and credit becomes extinguished.
As the risk to credit mounts, its value declines relative to real common-law legal money without counterparty risk, which is gold, historically silver, and even copper.
But the only metal which is priced for its monetary value is gold.
And that is what central banks, aware of the dangers to credit are accumulating.
Clearly, credit in any fiat currency faces a rough ride in 2025.
If, as seems certain now, bond yields rise as intimated in this article credit values will be undermined in listed markets, over-the-counter derivatives, and on the foreign exchanges.
In modern, interventionist economies this loss of value becomes transmitted into the currencies themselves.
This means their values will decline measured against real, counterparty-free money which is gold.
Over long periods of time, gold has retained its purchasing power while fiat currencies have come and gone.
It is considerably less volatile than fiat, as the chart below clearly demonstrates:
Between 1950 and the early 1970s when gold was fixed at $35, the oil price was stable at $2.57 per barrel, rising to only $3.31 in late-1970.
Since then, priced in dollars oil has both risen substantially and been extremely volatile.
It is considerably less so priced in gold which is less than half the 1950 price, and some of the volatility would have been even lower if the US treasury hadn’t pursued policies of gold suppression.
My last chart shows the four major fiat currencies priced in gold since the end of Bretton Woods ins 1971.
The evidence from the two oil and currency charts above is that it is not gold whose prices rise, but the values of fiat currencies which decline.
This discovery is central to understanding why measured in fiat currencies prices have risen inexorably during the last fifty years.
The problem is with the currencies, which are fickle credit.
But because we all account in fiat currencies the relationship with common-law money which is gold is poorly understood.
Accounts of past currency collapses show a common theme.
When its users finally realise that it is the currency declining in its value and not prices measured in it rising, the currency is doomed.
We can monitor the progress of this sentiment as first foreign holders dealing in foreign exchange realise the risk, to growing numbers of its users, from sophisticated financial actors downwards to finally everyone.
The key to surviving the implosion of the largest credit bubble in history is to understand the difference between money and credit — to understand that gold’s value is relatively stable and that of credit including currencies is both volatile and declining.
The wise will follow the precautionary reserve policies of many central banks by reducing their exposure to credit and increasing their holdings of international, legal money, which is gold.
2024 saw the dollar decline measured in gold by about one quarter of its value.
It represents an acceleration of a fifty-year trend.
2025 promises a further acceleration.
Central bankers are already getting out of credit before everyone else realises that the post-Bretton Woods system is beginning to collapse.
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