I generally adhere to the traditional value policy of not allowing macroeconomic events to affect my investing policy. In other words, I attempt to evaluate specific businesses in terms of their underlying value rather than endeavoring to analyze the movement of stock markets based upon economic precepts.
However, as QE2 winds down and the likelihood that QE3 will not seamlessly replace its two predecessors, I have decided to hold more cash than I have since the months prior to Sept. 11, 2001. I still have over 80% of my portfolio in equities although I hope to reduce that percentage in the next months, particularly as some of my winning positions convert into long-term gains.
The subject of today's article is an assessment of the political and economic factors which could lead to a severe market correction. The role of the current worldwide austerity movement, the potential of decreasing purchases of US Treasuries by China and other emerging nations, the eventual end of a multi-decade bull market in US treasuries, and the effects of the potential deflationary wave which could result from a combination of factors will be the major themes today's discussion.
Understanding Bear Markets in Terms of Deflation and a Worst Case Scenario
Most bear markets or severe market corrections are either a result of sudden deflationary pressures or fears of impending deflation. In the case of the four great bear markets of the 20th century, only the bear market of the 1970s, which culminated in 1981, was inflationary in nature. The other bear markets including the Great Depression were all characterized by deflationary pressures (see Russell Napier's exhaustive studies of the four great bear markets of the last century).
The quickest route to unleashing intense deflationary forces on the US and world economies would be a sudden and dramatic increase in the yield for long-term US treasuries. A crash in the government Treasury market would almost certainly trigger a worldwide sell-off in equities, virtually overnight. A sudden popping of the bond bubble would afford investors almost no safe haven. Money would likely search for stronger currencies, but very limited opportunities would be available.
Normally during deflationary periods, US Treasuries would be considered a safe investment. That would not be the case should Treasury yields climb as world economies contracted precipitously. The prospect of stock prices and bond prices crashing simultaneously is not a pleasant prospect, particularly if the scenario involved a rapid decline in the value of US currency. In such a case virtually no alternatives present themselves, although holding stocks for the long term would be a much better choice than permanently losing capital by holding US Treasuries. "Conservative" investors would be crushed as badly as their aggressive brethren, with a much lower chance of long-term recovery.
The recent bear market of late 2008 to early 2009 was a perfect example of a deflationary meltdown which was spurred by sudden credit contractions following the collapse of Lehman Brothers. The Fed monitors deflationary pressures closely and invariably attempts to slow or completely halt deflationary pressures in the hopes of creating a modest amount of inflation to stimulate the economy.
As interest rates had moved to near zero in nominal terms, the Federal Reserve was forced to engage in different attempts to induce inflation in recent years. The most recent attempt being QE2 which amounts to a steady repurchase of US Treasuries by the Fed which has created an artificial demand for the securities; resulting in suppression of their yields even as worldwide demand began to wain.
Prior to the Fed's QE programs, demand for US Treasuries was facilitated by high Chinese demand since their 1994 currency revaluation (the year the renminbi was pegged to the dollar) as well as other emerging market governments with weak currencies or high rates of inflation. More recently, demand was reinvigorated by the credit crisis and the flight to US Treasuries as a safe haven.
One of the major risks to US Treasuries lies in the danger that China and other emerging countries will become disenchanted with the ongoing US central bank policy of initiating perpetual QE policies, thus weakening the dollar and continually raising US debt levels. Such disenchantment will likely become magnified should the credit ratings on US treasuries be downgraded or if the Chinese and other emerging economies decide to control internal inflationary pressures by allowing their currencies to float or otherwise appreciate at accelerated rates.
US politicians who attempt to pressure the Chinese to dramatically increase the value of their currency had better be careful of what they wish for. Thus far the Chinese government has largely controlled the exchange rate of their currency with large purchases of US debt. A sudden surge in the value of the renminbi would almost certainly signal an end to such purchases which would likely result in an immediate crash in US Treasuries and the start of a large market correction.
US Treasury holders did receive some good news last week as Chinese purchases of US debt increased to 1.15 trillion in April. China purchased around 7.6 billion in US debt in April. That figure indicates that the Chinese still have confidence in US debt and are not yet ready to abandon their long-standing approach to controlling internal inflation.
Who Will Buy US Treasuries and at What Price?
The thirty-year bull market in US Treasuries is certain to end at some point. Jim Rogers, Warren Buffett and Bill Gross have all commented upon the lunacy of purchasing long-term US Treasuries at current prices.
Rogers, Buffett, and Gross hold views that are generally representative of private buyers of US Treasuries. Translated that means that in order to encourage private buyers to enter the current market, Treasury yields would have to reset at much higher prices.
If QE3 is not initiated seamlessly, the real question would be at what yield would long term Treasuries prices stabilize? The yield would be a function of the amount of foreign government purchases coupled with the rate at which private buyers feel that US Treasuries offer a value as opposed to equity prices.
Private buyers are going to demand a yield commensurate to the perceived risk between holding equities and Treasuries. Considering the large spread between the current price of S&P earnings yields and current long bond prices, one would have to assume that few private investors would not be interested in purchasing long-term US Treasuries until they approached a 5 to 6% yield. If systemic inflation became involved, yields would likely trend much higher.
The major point to be taken from this discussion is that current treasury yields are a reflection of the artificial nature of government purchases. If the yield becomes a function of private demand then the treasury market will drop precipitously and the yields will skyrocket.
The Role of the Austerity Movement on Future QE
Since the beginning of 2011, the following countries have all raised their interest rates in an attempt to battle inflation: China, India, South Korea, the EU, Hungary, Poland, and Brazil.
The trend in Asia and Europe and some of the other emerging markets is moving towards an attitude of fiscal discipline. The movement is somewhat surprising in Europe considering the high amount of government employees and the vehement protests by workers which have taken place in the face of government cuts.
Bernanke has faced mounting opposition from Republicans in regard to his monetary policy; conservatives have been ratcheting up the pressure to abandon additional QE policies. The pressure has increased significantly since the mid-term elections when "Tea Party" candidates and other fiscal conservatives won majority in the House of Representatives. Many conservatives are now laying the responsibility for increasing inflation and mounting deficits upon the shoulders of Bernanke.
It is not clear if Bernanke will automatically approve additional purchases of US Treasuries by the Federal Reserve at this point. The fact that China increased purchases of US debt in April may also diminish the likelihood of an rollover of QE2 so long as sufficient demand for US debt persists.
Conclusion
The longer-term question remains how long will foreign governments continue to support US fiscal policy which is perceived to be aimed at weakening the dollar and inflating away a large amount of the US debt? Judging from China's recent increase in the purchase of US debt in April, the answer appears to be, a bit longer.
The more important question for the shorter term is how would the abandonment of future QE practices by the Fed, in the form of a discontinuation of future US treasury purchases, affect the price of longer term treasury bonds? The answer to that question is much less clear, although one thing remains certain; When the yield of long term US treasuries become dependent upon private investors rather than government buyers, the yield will quickly increase. When that day arrives, the Treasury bubble will quickly end, likely resulting in a severe stock market correction and a possible bear market in stocks as well as bonds. It's only a matter of time before the bubble in US Treasuries pops. When that day comes the repercussions will likely become extremely unpleasant, particularly for investors who hold those US Treasuries as "conservative" investments.
However, as QE2 winds down and the likelihood that QE3 will not seamlessly replace its two predecessors, I have decided to hold more cash than I have since the months prior to Sept. 11, 2001. I still have over 80% of my portfolio in equities although I hope to reduce that percentage in the next months, particularly as some of my winning positions convert into long-term gains.
The subject of today's article is an assessment of the political and economic factors which could lead to a severe market correction. The role of the current worldwide austerity movement, the potential of decreasing purchases of US Treasuries by China and other emerging nations, the eventual end of a multi-decade bull market in US treasuries, and the effects of the potential deflationary wave which could result from a combination of factors will be the major themes today's discussion.
Understanding Bear Markets in Terms of Deflation and a Worst Case Scenario
Most bear markets or severe market corrections are either a result of sudden deflationary pressures or fears of impending deflation. In the case of the four great bear markets of the 20th century, only the bear market of the 1970s, which culminated in 1981, was inflationary in nature. The other bear markets including the Great Depression were all characterized by deflationary pressures (see Russell Napier's exhaustive studies of the four great bear markets of the last century).
The quickest route to unleashing intense deflationary forces on the US and world economies would be a sudden and dramatic increase in the yield for long-term US treasuries. A crash in the government Treasury market would almost certainly trigger a worldwide sell-off in equities, virtually overnight. A sudden popping of the bond bubble would afford investors almost no safe haven. Money would likely search for stronger currencies, but very limited opportunities would be available.
Normally during deflationary periods, US Treasuries would be considered a safe investment. That would not be the case should Treasury yields climb as world economies contracted precipitously. The prospect of stock prices and bond prices crashing simultaneously is not a pleasant prospect, particularly if the scenario involved a rapid decline in the value of US currency. In such a case virtually no alternatives present themselves, although holding stocks for the long term would be a much better choice than permanently losing capital by holding US Treasuries. "Conservative" investors would be crushed as badly as their aggressive brethren, with a much lower chance of long-term recovery.
The recent bear market of late 2008 to early 2009 was a perfect example of a deflationary meltdown which was spurred by sudden credit contractions following the collapse of Lehman Brothers. The Fed monitors deflationary pressures closely and invariably attempts to slow or completely halt deflationary pressures in the hopes of creating a modest amount of inflation to stimulate the economy.
As interest rates had moved to near zero in nominal terms, the Federal Reserve was forced to engage in different attempts to induce inflation in recent years. The most recent attempt being QE2 which amounts to a steady repurchase of US Treasuries by the Fed which has created an artificial demand for the securities; resulting in suppression of their yields even as worldwide demand began to wain.
Prior to the Fed's QE programs, demand for US Treasuries was facilitated by high Chinese demand since their 1994 currency revaluation (the year the renminbi was pegged to the dollar) as well as other emerging market governments with weak currencies or high rates of inflation. More recently, demand was reinvigorated by the credit crisis and the flight to US Treasuries as a safe haven.
One of the major risks to US Treasuries lies in the danger that China and other emerging countries will become disenchanted with the ongoing US central bank policy of initiating perpetual QE policies, thus weakening the dollar and continually raising US debt levels. Such disenchantment will likely become magnified should the credit ratings on US treasuries be downgraded or if the Chinese and other emerging economies decide to control internal inflationary pressures by allowing their currencies to float or otherwise appreciate at accelerated rates.
US politicians who attempt to pressure the Chinese to dramatically increase the value of their currency had better be careful of what they wish for. Thus far the Chinese government has largely controlled the exchange rate of their currency with large purchases of US debt. A sudden surge in the value of the renminbi would almost certainly signal an end to such purchases which would likely result in an immediate crash in US Treasuries and the start of a large market correction.
US Treasury holders did receive some good news last week as Chinese purchases of US debt increased to 1.15 trillion in April. China purchased around 7.6 billion in US debt in April. That figure indicates that the Chinese still have confidence in US debt and are not yet ready to abandon their long-standing approach to controlling internal inflation.
Who Will Buy US Treasuries and at What Price?
The thirty-year bull market in US Treasuries is certain to end at some point. Jim Rogers, Warren Buffett and Bill Gross have all commented upon the lunacy of purchasing long-term US Treasuries at current prices.
Rogers, Buffett, and Gross hold views that are generally representative of private buyers of US Treasuries. Translated that means that in order to encourage private buyers to enter the current market, Treasury yields would have to reset at much higher prices.
If QE3 is not initiated seamlessly, the real question would be at what yield would long term Treasuries prices stabilize? The yield would be a function of the amount of foreign government purchases coupled with the rate at which private buyers feel that US Treasuries offer a value as opposed to equity prices.
Private buyers are going to demand a yield commensurate to the perceived risk between holding equities and Treasuries. Considering the large spread between the current price of S&P earnings yields and current long bond prices, one would have to assume that few private investors would not be interested in purchasing long-term US Treasuries until they approached a 5 to 6% yield. If systemic inflation became involved, yields would likely trend much higher.
The major point to be taken from this discussion is that current treasury yields are a reflection of the artificial nature of government purchases. If the yield becomes a function of private demand then the treasury market will drop precipitously and the yields will skyrocket.
The Role of the Austerity Movement on Future QE
Since the beginning of 2011, the following countries have all raised their interest rates in an attempt to battle inflation: China, India, South Korea, the EU, Hungary, Poland, and Brazil.
The trend in Asia and Europe and some of the other emerging markets is moving towards an attitude of fiscal discipline. The movement is somewhat surprising in Europe considering the high amount of government employees and the vehement protests by workers which have taken place in the face of government cuts.
Bernanke has faced mounting opposition from Republicans in regard to his monetary policy; conservatives have been ratcheting up the pressure to abandon additional QE policies. The pressure has increased significantly since the mid-term elections when "Tea Party" candidates and other fiscal conservatives won majority in the House of Representatives. Many conservatives are now laying the responsibility for increasing inflation and mounting deficits upon the shoulders of Bernanke.
It is not clear if Bernanke will automatically approve additional purchases of US Treasuries by the Federal Reserve at this point. The fact that China increased purchases of US debt in April may also diminish the likelihood of an rollover of QE2 so long as sufficient demand for US debt persists.
Conclusion
The longer-term question remains how long will foreign governments continue to support US fiscal policy which is perceived to be aimed at weakening the dollar and inflating away a large amount of the US debt? Judging from China's recent increase in the purchase of US debt in April, the answer appears to be, a bit longer.
The more important question for the shorter term is how would the abandonment of future QE practices by the Fed, in the form of a discontinuation of future US treasury purchases, affect the price of longer term treasury bonds? The answer to that question is much less clear, although one thing remains certain; When the yield of long term US treasuries become dependent upon private investors rather than government buyers, the yield will quickly increase. When that day arrives, the Treasury bubble will quickly end, likely resulting in a severe stock market correction and a possible bear market in stocks as well as bonds. It's only a matter of time before the bubble in US Treasuries pops. When that day comes the repercussions will likely become extremely unpleasant, particularly for investors who hold those US Treasuries as "conservative" investments.
