Why I’m not worried about this bubble

As I write, the FTSE looks like it’s got 6,200 in its sights.

There’s been plenty of talk of pension funds moving out of bonds and back into equities. About time too – low yielding government bonds just don’t make a lot of sense today.

Over in Japan, it’s the same. Talk of government induced inflation is pushing pension funds to rethink bonds. Not only is the stock market on the up, but gold has hit new highs in yen terms. The pension funds are said to be actively seeking out the yellow metal. At last Japanese investors may have to consider inflation and what it means for their investments.

Now, if the clever money’s draining out of bonds, should we be concerned about the bond bubble popping?

I’m not so sure. I know many investors are expecting a crash. Something that will bring on another financial asset implosion – just like the dotcom bust or the 2008 financial crisis.

But a lot has changed over the last few years. And I don’t think there’ll be a crash. In fact I think this will all end quite differently.

Why? Because different bubbles lead to different busts. Let me explain…

There’s nothing like a centrally planned bubble

The dotcom crash and financial crisis of 2008 were typical credit boom and bust affairs. If you have an interest in the Austrian school of economic thinking, you’ll be well aware of how these credit booms turn to bust.

Here’s how it works. Private credit gets funnelled into, say, dotcom stocks or subprime housing. As the bubble grows, it suckers in more investors. The banks create money, lend it to investors and the bubble inflates.

Then all of a sudden, there’s a collective re-think – an eye-opening moment. The money makes a dash out of the asset bubble. Either the cash goes into other investments or it’s destroyed as loans go bad.

But the current bull market is a different affair. For a start, it’s not a typical-looking crazy bubble. I mean, we haven’t see crazy valuation multiples like at the dizzying heights of the dotcom peak. And neither do we see the lunatic antics that went along with the subprime boom. And that included lunacy both in the financial markets that created the subprime debt and the flip-flopping of houses and condominiums on Main Street.

When these bubbles burst, they created a downward cycle of asset destruction. As investors lost faith, the wealth literally disappeared. Privately created money disappears even quicker than it appears during the bubble formation.

But the bull market we see today isn’t fuelled so much out of private bank credit creation, as it is central bank credit creation.

And there’s a big difference.

This time there’s nowhere for the cash to go…

Yes, the central banks have created a lot of new money over the last few years. And despite what they may say, I’m sure they’re going to create plenty more too. And there’s no doubt in my mind that this new cash is propping up markets worldwide. Frankly, that’s what it’s supposed to do.

The more I think about it, the more I’m starting to believe that this asset inflation won’t necessarily lead to the classic bust.

As I say, for starters, we’ve not seen the classic bubble delusions. The bond market has been largely driven by the money printers themselves. The Bank of England, for instance holds well over a third of government gilts today. These guys are not like ordinary investors. There’s no way they’re just going to dump their holdings because they somehow lose faith in the investment.

And anyway. They’re the central bank. They don’t need to worry about losing money – they literally make the money!

If they don’t want a major bust, then they can probably keep us from one.

But all of this doesn’t mean that we can rest easy. It’s just we need to adapt the way we protect ourselves…

What happens next?

It’s kind of easy to protect against private credit booms. If you see what looks like a bubble building, then just put your money elsewhere. Cash is typically a good place!

But in a central bank induced boom, the bust calls for a different approach.

What we’re seeing today is the formation of bubbles in many asset classes – and worldwide.

And what’s more, with the central banks willing and able to print unlimited amounts of currency, this could well be QE to infinity.

Now, in this scenario, arguably the best thing to do is to stay invested. Especially in assets like commodities (particularly gold) and equities. If it’s central bank induced inflation that we have to fight, then it’s the inflation hedges that we need.

Remember, it’s darned difficult to destroy central bank paper money – but create it – well, that’s a different matter…

Don’t fight the Fed is the old adage. It’s an adage you’ll do well to remember.

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  • SteveH

    Yeees, except if the bank goes bust….
    Thank heavens Mr Brown saved the banks I say (seriously)

  • MikeP

    Aah, Bengt, you’re always worth reading – always a different twist to the ongoing story from you. So, if bonds won’t burst, will they simply deflate? Can the central banks always deflate a bond bubble in a ‘controlled’ fashion; i.e. will the bond market (slowly) deflate of its own accord, simply if the CBs maintain a status quo; or in other words, will the CBs be able to turn off QE at some point, start ‘normalising’ interest rates towards 5%, and not create a ‘burst’ at some point on the way. Or, will they be caught out by an unexpected rise in inflation – the basic question: can CBs really and truly keep inflation under control?

  • laehc

    There’s also China’s belligerence. From my searching and surfing, investors don’t care much, so I won’t go on about it as it will look off-topic.

  • JimW

    What about the effect on the pound?

    If british bonds look dodgy wouldn’t that affect the value of the pound?

    Unlike Japan where bond ownership seems to be held by the Japanese (that’s loyalty for you). They do not seem to give a toss for what markets think and are going to sort there problems in there own way.

  • AdamI

    I have a simple view that MikeP points to, and that is INFLATION.
    Inflation will ultimately be the moderating factor that brings QE infinity to heal along with its mentor the Bank of England.

  • china watcher

    Imagine Britain’s inflation tops 6 or 7%, its economy is still in recession, and its government debt keeps rising, plus its AAA rating being stripped.

    Also imagine hedge funds start to attack UK bonds by sitting on massive positions of credit default swaps, driving UK bond yields substantially higher putting UK to a crisis mode, just like what they did to the PIIGs.

    Unfortunately, the Bank of England has lost its fire power to fight off the hedge funds given inflation is dangerously high.

    Two scenarios here, 1) BOE prints money anyway, sending inflation and interest rate to double digit level, everything in sight crashes; 2) The government decided to ask for help from the IMF, and the sick man of Europe returns.

    That means if inflation keeps rising, it’s possible for Britain to face its Greek moment.

    But then this may not be bad, because it can bring about decent dileveraging which can bring back life to this economy.

  • Colin Selig-Smith

    Kyle Bass’s point (on Japan but it applies elsewhere) is you won’t see the bond bubble bust because nobody in their right mind would go up against a central bank’s sovereign bond acquisition programme.

    So the problems will play out in the currency markets first and central banks will lose control of interest rates there, which will then cause a bond crisis only after domestic inflation is pushed up by imports. Funnily enought this seems what the Japanese government are trying to do, deliberately… Some sort of weird suicide cult thing I suppose.

    Of course in terms of being bullish on Japan, that would only make sense for companies which,
    1. Primary market is an export market.
    2. Raw materials are locally sourcable, not imported. I think this rules out almost everything.

  • aff

    “there’s no way they’re just going to dump their holdings because they somehow lose faith in the investment.”

    but might there be other reasons they would decide to crash the system ?

    “If they don’t want a major bust, then they can probably keep us from one.”

    but what if they do want a major bust?

    These people are not like you and I, they are not out there to help the public, they are there for power.

    Who gave them this power they hold over us? I didn’t vote for it. Lets not waste this crisis, lets end central banking.

    Buy silver

  • StephenL

    Colin Selig-Smith is right on the money: we are watching the second heats of a race to the bottom among the major currency crosses. Japan has an early lead in this round, after sterling trounced them all in round one. I see a series of currency mini-collapses. The FX markets have been eerily quiet and range-bound in the past four years but that may all be about to change…