James Ferguson: the scope for bond-market disaster is very real

published 8 October 2021

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Merryn Somerset Webb: Hello and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine. And with me today, I have James Ferguson of MacroStrategy Partners. Many of our long-time readers will know James, everyone indeed. And will know that he's particularly good at telling us what's going on in the monetary system and the banking system. Good news that today, when all we’re worried about is inflation, that we have James with us. Hello, James.

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James: I think what we're actually seeing could easily be transitory. The issue is, when it disappears, when the things which are transitory sort themselves out, what are we going to be left with? At the very beginning, when they were telling us that they were complacently happy about the transitory idea, they were really talking about base effects. And the base effects reached their apogee, or I should probably say nadir, around about June, anyway, this year.

James: Yes. And actually, it's the rebound in energy prices. We had that really sharp drop in energy prices when the world was slammed to a halt. If you remember, in the UK, I think the first lockdown was March 23rd of last year. Most of the rest of the developed world was looking down at a similar time. By the time that the economy had skidded to a halt, it was late April. And then it took a bit of time to work its way up the supply chains.

And if people can cast their minds back far enough, they might remember the news headlines that there was a negative price for oil futures for delivery at that time. That’s when we had a really sharp drop in the oil price. And the oil price has bounded back. And in fact, the oil price now, just recently, top $75 a barrel. That's not too different. It’s only marginally above where it was pre all the COVID stuff. In many respects, the base effect was all about how everything would just bounce back to where it had been before.

And that would look like inflation because it would be up a lot on a low base from 2020. But in actual fact, if you compared it to 2019, we’d be flat. The problem is, that's not what happened. If you look at the CPI index, you'll be able to see that it came back to where it had been and then carried on going. Then the Fed’s story moved on a bit from base effects to supply chain problems, and particularly supply bottlenecks.

Now they’re saying, actually, what's happened is that we've got all sorts of… A lot of ports have been closed down, particularly in China. And this has caused massive backlogs. By one estimate, 6% of the world's entire dry bulk fleet is currently waiting offshore China, because the ports have got such a backlog now. And as far as the US ports are concerned, when you build up a backlog, they are heavily unionised.

It’s very, very difficult. They won't work at night, for example, like the Asian ports do. It’s very, very difficult for the US ports to catch up on backlogs. And the Chinese ports have recently closed because of one or two cases of COVID. And they have big backlogs. By effectively knocking about, I don't know, maybe it's 10 or 20% of the global fleet out of action, because it's inert, this has sent shipping rates through the roof.

And obviously, created shortages of all the things which haven't gone into the port and been distributed yet. We’ve got this new bottleneck problem, but even that appears to now be being exacerbated by other things which are not really bottleneck problems. For example, the massive surge in liquefied natural gas prices, particularly in Europe. This massive surge has really come about because, for whatever reason…

And people have said that Putin's done this deliberately. But for whatever reason, Russia has not sent the gas down the pipelines to Europe this summer and has not therefore allowed Europe to build up its stocks. But in the UK, particularly, because we'd made a very, very foolish decision that since we were going all in green, we wouldn't need any fossil fuels. We closed down our main gas storage facility, therefore, we have nothing to fall back on.

And the gas shortages have triggered panic-buying by the Asians because they're worried that Europe will take all the gas just going into winter. And now suddenly, gas prices have gone through the roof. This is actually a homemade problem that the bad, idiot politicians have made. And it can't really be put down to the supply bottlenecks of the type that the Fed’s talking about. We’re looking at a situation where the huge disruption that lockdown caused is not able to be restarted without some significant shifts.

There are people, for example, who were temporarily laid off, who after a while, got pretty bored with that and went and got another job in another sector. We have all sorts of shifts. For a long time, the UK has been chronically short of HGV drivers. Now this has only been exacerbated by recent developments. But all over the world, you can find all these individual situations where it would appear that the transitory supply bottleneck isn't actually being caused by some temporary delay that should be cured by next Tuesday.

For example, there not being enough petrol in London and South East forecourts. It's actually been caused by long-term, quite structural, chronic problems that have finally come to a head. And this is often, I think, the thing that happens when complacent policymakers meet the real world. They come up against the real world and discover that systems which were just hanging on aren't able to be resilient enough to bounce straight back.

James: The biggest problem, I think… And this actually has interesting parallels with the COVID situation, which is now causing a massive division in the world of science. Because what you had initially was no information. Therefore, the epidemiological, mathematical modellers step in and say, you know what? We can make a model because we know roughly how quickly viruses spread. We know roughly how dangerous they are.

They didn't actually know any of these things roughly, but they were just cherry-picking the R number, for example, out of thin air. They went for something far too high. They would argue that the R number came down only because people started moderating their behaviour. But of course, that's what people do. That’s what they should have assumed. But anyway, the point of the matter is that you have the epidemiological modellers who model what's going to happen.

And then you would expect that as the empirical evidence came in as to what the true effects were, they’d change their models. They’d tweak their models to be closer and closer representations of reality. But they don't do that. And this is very similar to what Fed economists do. In fact, one of the Fed economist broke ranks only just the other day and said, guys, we should admit that most or a lot of the theories that we're basing policy on have been proven to be nonsense.

And they don't make any sense in the real world and that they're abstractions. But we're not doing that. And the Neo-Keynesian academic economic cohort are particularly guilty of just not being that interested in empirical evidence that gainsays their theory. Their theory, it comes first. And if the real world won't behave, then the real world’s wrong. And clearly, we know that’s not the case.

James: Yes. Or you find a way to change or explain away the fact that the real world isn't behaving. A really good example of this would be QE. The Bernanke Fed said that the reason for doing QE is we're going to buy bonds. And if the bond price goes up because we buy them, then the yield will come down. They said, we're helping the economy during a tough time. This after the great financial crisis. We're helping the US economy during a tough time by buying treasuries.

And that’ll push the price up and the yield down. And that'll make it easier and cheaper for people to borrow. That's fine, except that every single time they did QE, the yield went up, went up quite a lot, at least 100 basis points, which is 1%. Which in the world of bonds is a lot. And yet to this day, they don't admit that. If you search online, how much did treasury yields go up during QE, you'll find academic papers sponsored by the Fed saying, it was surprising to discover that yields went down less than expected.

James: There you go. I don't think they even mentioned it in my economics degree. It was so Marxist-leaning, was it? But anyway, the point therefore is that generally speaking, changes in the money supply should impact not real economic growth, but nominal economic growth. However, this is a central tenet of the monetarists. And the Keynesians hate the monetarists. And they purport to say that monetarism has been proven to be wrong.

Whereas the period that they cite and the reasoning they cite, again, it’s like QE, doesn't back up to scrutiny. But what's interesting is that they hate any argument that may be supportive of monetarism. And of course, an expansion of money supply having an inflationary effect is actually a monetarist tenet. And in fact, the Bank of England's own theoretical discussions, which they published to support QE when they started doing QE, actually have this in their diagram.

At the end, it leads to growth and inflation, it says. Mind you, Mervyn King was a monetarist. That probably explains that. Famously, Bernanke ended up after the QE period saying that this funny thing about QE was that it worked in practice, but it didn't work in theory. This isn't actually that funny because what he should have said is, we have to admit that actually, the monetarists seem to have an argument here.

That if we do QE, it expands money supply and that caused bond yields to go up. And the only reason we can cite for that is that the market must have thought that that was going to lead to growth and/or inflation. And they keep wheeling out QE, they keep using it, but they refuse to acknowledge that it effectively destroys their theory and validates the competitor theory. That’s a pretty difficult place to be in because it means that the people who are pulling the levers are suffering from cognitive dissonance.

James: The elephant in the room is a consequence, what they would consider an unintended consequence, of their actions. But before, I would just like to say something about destroying the credibility of central bankers. It’s not just central bankers. There are two theories of the world how we decide on the efficient allocation of limited resources, which we call economics. One theory is that our very clever busybody at the top can just tell us all what to do.

And that clever busybody is never wrong and achieves almost godlike status and runs usually a communist country and he has a few acolytes backing him up. We have something similar in a technocratic West now where we have people like the central bankers who, as I said, with… Two thirds of the US senior central bankers have PhDs in economics. This is a groupthink problem writ large. And these people, their theory doesn't match up to the empirical evidence.

They don't allow it to be tested by the empirical evidence, which if there was a proper scientist, you'd say, you're just nuts. Richard Feynman, the famous Nobel physicist said it didn't matter how beautiful your theory is, how neat and how precise. If it's not supported by the evidence, it’s wrong – end off. And there are no Keynesian economists who obviously read any physics, because they would have moved on some time ago. What I'm really saying is that people…

James: The people at the top don't… And same with, Sage… But people who are experts might give you a reasonable steer, because they spend most of the time looking at this area. But if you really want to know what's going on, you get people to vote. If you really want to know what's happening out in the sticks and what people really feel about you, let them vote. And usually, the easiest way for them to vote is with their wallets.

You look at prices. If you have a free market, the free market will tell you almost everything and will naturally sort things to the most efficient outcomes. And as soon as we start messing around with the free market, then we end up with less efficient outcomes. You may think that's a good idea. You may think that saving the planet from climate disaster is worth destroying the economy by putting politicians in charge of a raft of ideas that no one else is really able to see whether they work or not.

But the point of the matter is, you will not get the most efficient outcomes as soon as someone is pulling levers at the top. When you've got the Fed pulling levers, you're not going to get an efficient outcome. The long-run average interest rate in the UK is 5%. That's the risk-free Bank of England rate. That will make mortgage rates 7%. Just imagine what would happen to you if you wanted to buy a modern house in the UK on a 7% mortgage.

House prices would radically adjust. And by radically, I mean it might be conservative to expect them to half. We have a very weird economy that we've allowed to creep into existence post the GFC… Sorry, the great financial crisis. And this very weird economy is so fragile that we can't seemingly raise rates off the floor. Which means that each disaster that comes along gives us only the option to lower rates into negative territory. Which is what QE is.

QE is doing the same thing as you would do to lower rates, but you continue to do it in the form of QE when rates have effectively reached zero. That's what we keep doing. We keep basically building up the debt and building up asset prices relative to everything else, cannibalising the system, consuming down capital, until we'll have very little of a real economy left, until there's going to be a big reset. And that will be very, very unpleasant, because big resets are unpleasant. But for now…

James: I was going to say, but for now, what is the elephant in the room that will dictate the next stage? And the elephant in the room that dictates the next stage is that in the US, and it's pretty similar here, they considered that maybe a problem with QE last time was that the money didn't get out into the real economy. There's no real ability for the money to get out into the real economy if you give it into the financial markets.

And they figured that this was responsible for an increase in inequality, which has largely been argued and supported by people like Thomas Piketty, the French academic. And if you look at their numbers, they're just garbage. A lot of the inequality argument is predicated entirely on pre-tax and benefit payments, which obviously is pretty silly if you want to know whether there's actual inequality. Because all you're comparing then is people who work a full five-day week with people who work a two-day week or less.

You certainly don't really become wealthy at all until you’ve finished educating your children, finished paying off the mortgage and inherited whatever you’re going to inherit from your parents or both sets of parents, if you’re a couple. You don't tend to have any wealth at all until suddenly, you're okay around about the age 55, give or take. And from then on, you're quite wealthy until you die, whereupon you pass it down to the next generation.

One of the things which increases the wealth disparity is people living longer. As soon as they live longer, then it takes longer to pass the money down. And therefore, you have a bigger, bigger cohort of people who have not yet had that inheritance boost and therefore, don't really have any wealth to speak of. And the other thing that is really important for what we're talking about is that the value of any asset is dictated by the net present value of any asset.

It’s dictated by the discount rate. If you lower interest rates, then the apparent value of any asset, houses, stocks, bonds, goes up. And if you lower interest rates to the lowest for 5,000 years, which is what we've done, then of course, these things, relatively speaking, go up hugely. Again, my analogy with taking interest rates back to 5%, if you took interest rates back to 5%, you would find that the wealth inequality disappeared overnight.

James: I'm sure the plan is the exact opposite. But of course, when do you run out of road? If you do lots of QE, and particularly if you did it because you shut down the economy… And if you shut down the economy, you thought all those people who lose their jobs or their businesses are going to lynch me, I better just send them lots of free money. They did. And in the US, for example, the unemployment benefits paid at the state level in the US and the standard unemployment benefit is $400 a week.

And the state, ie, the federals, up that to $1,000 a week. Meaning that a lot of the people who were unemployed in the US because of COVID were actually earning far more money than they had been earning when they were working. And this basically went straight into their bank accounts. Meantime, lots of firms were given loans that would morph into grants if they promised to re-employ the people they'd laid off later, by the end of the period.

And this is in the US. We had a similar function with us in terms of furlough, with the government paying most of people's wages. And they were really paying the wages in full, because people were not having to have the costs of commuting and eating and dry cleaning and all the rest of it. Basically speaking, at the end of this process, something very interesting has happened. There has been a massive increase in household and business bank deposits.

It's normal for household bank deposits to stay up during the recession, because what they do is they stop spending. What you normally see in a recession is a collapse into negative territory of business bank deposits. But business bank deposits have gone up this time and household bank deposits have gone up at a record amount. Here we are, these are these guys who are looking for transitory inflation, who are expecting everything to bounce back to normal.

And they're discovering that prices are sticky or at least the easy supply is sticky. Which means that the prices are going up and they're not coming down nearly as quickly as they wanted. We should probably get some good news on inflation, i.e., lower inflation prints, into the rest of this year. Because some of these supply bottlenecks will be getting fixed. But the inflation isn't going to disappear. And then we're going to get hit with this big wave of money coming from these bank deposits. How much money…

James: The first thing to bear in mind is that… We were talking earlier about the Fed and its Neo-Keynesian theory. According to the Neo-Keynesian theory, there are two types of money, endogenous money and exogenous money. You already know people are starting to crank up the bullshit when they start using silly words that you don't really use in day-to-day life. And what this basically means is that new money supply that’s created by the normal process of bank-lending, that will go into people's bank accounts and be spent.

Therefore, it moves. And it moves off into either investments or consumption until the money supply is back in sync with the economy. The theory is that basically, for any given size of an economy, you will have a given size of money supply. But Keynesian theories explicitly says that if it's exogenous money, i.e., if it's money created by the central bank, then that money isn't spent effectively. Either that's because it's totally inflationary or assumed to be totally inflationary.

And therefore, the inflation means that everybody now has to hold more money in their bank. But then that wouldn't marry up to that money relative to the size of the economy. This is what economists call velocity. If anyone hears anyone talking about the velocity of money, this is what they're talking about, the relationship between the stock of money and annual GDP activity. The whole argument that the central bankers are absolutely resting their entire case on is that we gave everybody extra money.

You can see how large that extra money is in people's bank accounts. In the US, it equates to something like 20 or 30% of GDP. And even if we got only a partial resetting… Because we're talking about potentially 10 or 12% of GDP shift if people spend the money. And if they don't spend the money or invest it, then it just sits there forever. People have way more money in their bank accounts. Keynes talked about this as people having precautionary money in their bank accounts.

Merryn: I thought they might. James, here we are in an environment where central banks may think this is all transitory. You make an excellent case that it's not. And I agree with you. But what does that mean for MoneyWeek readers? What’s going to happen to our investments? What’s going to happen to our bond holdings? What's going to happen to our equity holdings? And how do we prepare for it?

James: The first thing is that if you look at the financial markets… And I think I'm going to concentrate particularly on the bond market here. Because although the bond market is the boring market, it is also the daddy of all markets. If you know where the US treasury market’s going, you can pretty much work out what everything else is going to do. And there are two very interesting things about the US treasury market or the yield on US government bonds.

The first one is that they have historically no predictive power whatsoever when it comes to inflation. In fact, the closest mathematical relationship between US ten-year government bond yields is with the past ten-year history of US government bonds. This is an absolutely classic case of driving with the rear-view mirror only. But it would appear that the bond market doesn't rate itself as being any good at predicting what the inflation rate will be.

It finds it safer to say, what was it last time? If it's a ten-year bond, I’m buying. What was it over the last ten years? It was 2.5%. I'm going to assume 2.5%. And that's pretty much what it does. And if you look more closely, over the last few years, the five-year US treasury has been very close to the CPI rate, the inflation rate. But when the inflation rate dropped down to zero in 2015, because there was a big sell-off in the oil market back in 2014, 15, the bond yield ignored that because it said that's going to be transitory.

And sure enough, inflation came back 12 months later, back up to where it had been before. This time, we've had inflation shoot up to extraordinarily high levels, by recent standards, 5.5% or so. And the bond yield is actually lower than normal. It's still maintaining its downward trend. The ten-year yield is about 1.5% and the five years are a bit lower than that. There’s this massive gap. The bond market is telling you that they've listened to the Fed and they concur that the inflation is going to be transitory.

Having said that, don't forget the bond market has no track record of predicting inflation. It does tend to take these things as they come. It tends to think that an erratic inflation figure, up or down, will correct itself. The Fed’s telling us this will happen and the bond market’s assuming it’ll happen. But of course, the longer we wait and it doesn't happen, the more tension is going to build up. And there's a very important point about the bond market as to why maybe the bond market hasn't sold off more and sent yields higher to meet up with inflation.

And if you look at the issuance of US treasuries’ net of what the banks were buying, i.e., the Fed and the other banks, then we actually had a huge drop in the pool or float of US treasuries. And it's only just back now to the pre-COVID level. Maybe it's no surprise that treasury yields are down, despite the inflationary backdrop, because we've had this massive disruptive hit to the economy. And yet the supply of treasuries, which is the safe haven asset of choice, the supply of treasuries has actually been held artificially flat for this entire period.

But that's going to change. We already now have the treasury more and more steadily moving these bills over to longer-dated, what they call, notes and bonds, at that issuance. And we're also about to get hit with a withdrawal of money from the economy by the treasury because it has a bank account which it maintains at the Fed. And it tends to take money into that bank account and out of the economy or vice versa, depending on circumstance.

And right now, it's just run those bank deposits at the Fed right the way down. They've been injecting money into the economy and the markets. But we're all now having discussions about debt ceilings and problems like that, which tend the treasury, to be on the safe side, to build its bounces back up, so they can cover at least a month or two of outgoings in case we hit debt ceiling problems in the future. We can be fairly certain that we're going to see a big, probably three month-long extraction of funds from the real economy by the treasury.

This is them either taxing people and not spending the money immediately, but holding some back or increasing their borrowings, as I said. And we can be fairly sure we're also going to see quite a significant increase in the supply of long-dated treasuries into the market. You take away money that would be potentially used to buy these bonds, whilst increase the supply of bonds, that does not look like a pretty picture with very high inflationary backdrop.

That does not look like a very pretty picture for the treasury market. And the likelihood is that you're going to see quite a significant increase in treasury yields, a delayed but obvious increase in treasury yields. How much they go up is anyone's guess. In the old days, treasury yields used to be 3% higher than the underlying rate of inflation in order to create a buffer for treasury investors to protect them against inflation.

Because in the pre-great financial crisis days, that's what people remembered. They remembered that the great risk to buying bonds was inflation. Nowadays, since the great financial crisis, on average, bond yields have had no premium to inflation. And right now, they're trading at about 400, 450 basis points below. You can see that the scope for a disaster in the bond market is very real. If the bond market…

James: Everything I've said applies to the gilt market as well, except for the treasury general account shifting. But everything else accounts. In other words, your inflation had better be transitory. Because if it's not transitory, bond yields have to go to meet the inflation rate. And if the bond market then starts to fear that the problem is inflation, it could go back to demanding the 3% premium as its protection that it’s always historically used to, right up until the great financial crisis.

That would mean that if we have treasuries at 1.5% and inflation at 5.5, even if inflation comes down to, say, 4… Which is really what the official consensus is, that it'll come down to about 4 and then next year, 2.5%. Even if that's right and if the bond market demanded a 3% premium to the 4% inflation rate… That's bond yields of 7% and at the moment, they're 1.5. We’re talking proper crash potential here.

That's a worst-case scenario. But let’s dial it back and say maybe the truth, it’s going to be somewhere between the 1.5%, where we are now, and the 7% that is not unreasonable based on the last 50-year history. What are we going to call it? A bond yield of 3-plus percent? Bond yields were there only four years ago anyway. This is in quite modern memory. And that would be a very devastating impact on all bonds.

Because of course, that would then spill over into all the other bonds, corporate bonds, etc. And then what would that do to equities? The 1987 crash was caused by a very similar readjustment in the bond market. There was nothing wrong with the economy in 1987. The thing that caused the crash was that bonds had reset to 10% yields from, I think it was around about 6 the beginning of the year. And that resetting suddenly made other assets like equities look too expensive.

James: I think the way to protect… Because history doesn't repeat itself. It rhymes. Nothing that worked in the past will work exactly. But gold has been incredibly quiescent throughout this period, which seems very odd. Again, makes sense only if the inflation is totally transitory. And silver is at a big discount to gold. I think you double up your insurance by buying silver or Fresnillo, which is obviously the world's biggest silver miner. And in one minute, that's all the heavy thinking I can think about doing.

James: Assume bond yields are now 4% and go through everything you've got, that means that you have to have a 4% earnings yield on your equities. Which means that any P/E over 25 is going to get crucified. And you won't make money unless you buy things with a P that's half 25. I think that means a big switch out of growth in tech into value and cash generation. I think it means a really big portfolio shift. And people talk about these things and insuring their portfolios and dealing with these shifts a lot.

Merryn: Hopefully, MoneyWeek readers have been thinking about this for a while and already have started to make their switches. James, thank you so much for joining us today. That's James Ferguson of MacroStrategy Partners, who I think long-term MoneyWeek readers will know very well. As you can't hear more from James, unless you were to buy his research or read more of his work in the magazine or listen to more podcasts with him that we may well do in the future.

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