Bond Armageddon ahead
The consequences of the Iran war are already driving weaker G7 bonds into multiyear higher yields. They will shape the future of all financial markets and of the currencies themselves.
ALASDAIR MACLEOD
Markets are meant to discount the future by putting a price on it.
But on the evidence, they are failing to do so as the table above intimates.
Surely, we all know that the US attack on Iran has created a supply crisis in energy and its derivatives which will raise production costs of every consumer item.
If these costs can’t be passed on to consumers, then businesses will go bust, creating mass unemployment.
Higher unemployment and loss of tax revenues destroy government revenues and increases welfare costs.
Government finances are already in severe deficit.
Yet, driven by Keynesian interventionism governments will be desperate to increase support of their private sectors and bail out consumers.
But all that additional deficit spending will merely collapse G7 currencies’ purchasing power, driving price inflation into the mid-seventies’ outcome and probably even higher.
Already, financially challenged governments with record peace-time debt-to-GDPs are about to find their financial obligations go into hyperdrive.
Yet, US treasury bond yields do not reflect these difficulties.
We have to look at other G7 economies to see the emerging financing crisis, and nowhere is this more obvious than in Japan and Germany, whose manufacturing bases will be most exposed.
Japan’s 10-year JGB yield is shown below:
Japan’s impending financial crisis is the most obvious.
With a debt to GDP of about 230%, government finances depend on the lowest possible borrowing costs.
With the Bank of Japan still suppressing its short-term policy rate at only 0.75%, the yield on the 10-year JGB is at its highest level since September 1995.
Clearly, the coming supply shock will disrupt the entire basis of Japan’s high debt and ultra-low-interest rate environment.
The rise in bond yields to the highest levels this century is just the beginning of a bond market discounting a debt trap.
This has negative consequences for other G7 currencies because the low-cost yen is the basis for a carry-trade supporting their debt markets.
Furthermore, Japan’s pensions and insurance companies are the largest source of capital exports into global private sectors.
Germany is the other G7 member which has a saving tradition and manufacturing base.
Similarly to Japan, its 10-year bund yield is heading higher into new high ground:
French OATS’ yields are also hitting new highs, as are those of UK gilts.
The only G7 nations whose yields have yet to break out on the upside are the US, Canada, and Italy but their yields have begun to rise as well.
Even with Japan, Germany, France, and the UK leading the way into a global bond crisis, investor sentiment has yet to appreciate the implications of an oil crisis which comes at a time of ultra-high government debt.
Last time round it led to an arithmetical average of 15% inflation when government debt-to-GDP averaged 27%.
Today’s debt-to-GDP averages 124% across all G7 nations.
We need to consider the consequences of today’s oil shock, which arguably is greater than during the mid-seventies.
The loss of downstream products such as fertilisers today are due to additional refining capacities in the Gulf having been built since the mid-seventies.
Furthermore China, and doubtless other nations are protecting domestic industries by limiting their exports of the commodities and products directly affected.
It is obvious from the table above that G7 inflation and bond yields do not currently reflect the outcome of today’s oil crisis.
This being the case, both metrics face considerable increases in the coming months.
Being so mispriced, there is likely to be a sudden shock with consequences for equities, G7 economies, and government finances.
The average level of G7 indebtedness relative to GDP is 4.6 times that of the mid-seventies, and the Rubicon of peace-time debt at over 90% whereby the situation becomes irretrievable was crossed long ago.
For a glimpse of what this will mean for bond yields, the long-term chart of the US 10-year treasury note is truly alarming:
It can only be a matter of a short time period before the long bond yield, currently at 4.96% and only 12 basis points below the break-out point completes the pennant formation and rises into new high ground.
We can then expect it to rise considerably and relatively rapidly.
Conclusion
The consequences of America’s war on Iran and the continuing blockade of the Persian Gulf will prove to be too severe for governments to manage.
Not only do markets underestimate the economic damage, but they are blind to the debt problem.
Since the 1970s G7 governments’ debt-to-GDP has multiplied nearly five times.
Consequently, they all face inescapable debt traps, will be unable to finance the deterioration in their own finances, and also the implied extra spending in their attempts to prevent a global slump.
The only possible outcome is a collapse in all confidence in government finances which will become unfundable — that’s the implication of a debt trap.
And if governments cannot fund themselves, their credit simply collapses.
And by definition, that credit is the purchasing power of their fiat currencies.
Being true money without government-counterparty risk, gold is the only safe haven from this impending crisis.
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