Can bond yields rise on "sovereign risk" even as core prices grind lower towards deflation? Yes, they can, and this baleful possibility is not in the textbooks.
Ben Bernanke made a fatal error by launching QE2 too early, with an incoherent justification, by dribs and drabs for fine-tuning purposes. The QE card cannot easily be played a third time. If he now tries to print money on a nuclear scale to crush all resistance and hold down Treasury yields, he risks exhausting Chinese patience and invites the wrath the Tea Party Congress.
Alas, my neck-sticking predictions for 2011 must be as grim as ever. This does not exclude further bear rallies over the Spring on Wall Street and Euro-bourses as institutional mammoths seek to extract themselves from bonds. Europe's insurers have as little as 5pc of assets in stocks, against 15pc or more in the 1990s. Yet it is a double-edged sword if big funds switch en masse into shares. Bond dumping has economic consequences.
Japan will slip back into technical recession. It cannot keep raiding its foreign reserve fund to pay bills. Public debt will spiral up to 235pc of GDP. Interest payments will approach 30pc of tax revenues. Fresh debt issuance will outstrip fresh private savings this year. Dagong, Fitch, and S&P will have to act. Downgrades will come thick and fast. This time they will hurt.
Yes, I thought Japanese bonds would buckle in 2010. The obsolete paradigm survived another year. The longer it takes, the worse it will be.
China and India are over-heating, faced with a 1970s choice between choking credit or the onset of stagflation. If they choose the latter to buy time, the politics of food will turn on them with a vengeance.
Vietnam will have to rescue its banking system, kicking off the Asian hard-landing of 2011-2012. The Aussie dollar will come back to earth.
Dylan Grice's rule of thumb at SocGen is that regions coming off a "good crisis" -- Japan in 1987, the US during East Asia’s 1998 blow-up, Chindia this time -- typically pop about two and half years later. The reason they have a good crisis when others bleed is because momentum from credit follies and/or hubris overpowers the external shock, but that contains the seeds of its own destruction.
Speaking of rules, the Atlanta Fed’s law is that every year of debt-based boom is roughly offset by equal years of debt-purge bust, which means a Lost Decade for the old world. I doubt the West will recover soon enough to pick up the growth baton before the East hits tires. We may then have a "sub-optimal equilbrium", that modern euphemism for a trade depression.
Europe is hobbled by its Delors Error. The region makes things that world wants to buy. Its external accounts are in balance. Fiscal policy is more responsible than in Japan, America, or Britain, yet the whole is less than the parts. A dysfunctional currency union engenders chronic crisis at a lower threshold of aggregate debt.
Frazzled investors will seize on China’s foray into Iberian debt markets to thin their own holdings, denying the Portugal and Spain much interest relief.
Lisbon may last unit on until March before being forced by yields above 7pc to accept its debt servitude package. At that point the EU will order its €440bn rescue fund to buy Spanish debt pre-emptively, hoping to draw a final line in the shifting sand, with half-hearted solidarity from the European Central Bank.
As usual, Frankfurt will fall between two stools, failing either to satisfy Germany by immolating EMU on an altar of Bundesbank purity, or to satisfy everybody else by blitzing QE to save the system.
Bond yields will not fall enough to stop to the vice from tightening in every EMU state south of Flanders. It will become clear that Europe’s scorched-earth rescues cannot work because they offer no means by which victims can clear debt and claw their way back to health.
Ireland's Fine Gael-Labour coalition will take its revenge on Europe for imposing such ruinous terms under Berlin's Diktat. It will restructure senior bank debt, setting an irresistible precedent for the PASOK backbenchers in Greece, the Left wing of the Partido Socialista Obrero Espanol, and America’s insolvent cities. From bank debt to parastatal debt is a hop, and from there to quasi-sovereign debt is a skip. Nobody will utter the word default. They never do. Bondholders `volunteer'.
Pudding bowl haircuts will set off the next wave of distress for Europe’s banks as they try to refinance $1 trillion by 2012, in competition with hungry sovereigns. Gold may slip at first as casino funds cut leverage to meet margin calls, before punching higher to €1300 an ounce as investors seek gold bars in a precautionary move. Talk of capital controls will grow louder.
Year III of the Long Slump is when we confront the Primat der Politik in tooth and claw, the phase when states become erratic, victims fight back, and dissident intellectuals start to inflict damage on failed orthodoxies. The dog that hasn't barked yet is the jobless army in Spain, the 43pc of youths without work. Bark it will when the €420 dole extension expires in February.
The cruelty of Europe’s `internal devaluations’ will become clearer. Wage cuts are tectonic events. They set off the protests that forced Britain and then France off the Gold Standard in the 1930s, and smashed Argentina’s dollar peg a decade ago. What we need is an iTraxx European Wage Index to navigate EMU's treacherous waters from now on. Spain’s Jose Luis Zapatero has barely begun to cut, yet he has already had to impose the first state of emergency since Franco to keep airports open.
Certainly, this is the year when Europe's unions will remember their own warnings twenty years ago that EMU was a "bankers’ ramp", a scheme for the convenience of elites. They will ask louder why crucifixion on a Deutschmark cross is in their interests.
Those few and reviled Iberian economists who dare to suggest that monetary union itself is the reason why Spain and Portugal cannot take action to fight the slump, will find a voice in the press at last. Once debate is engaged, it will be impossible to contain.
It would be a mercy if the German constitutional court brought this unhappiness to a swift close by ruling in February that Europe’s rescue machinery is a breach of EU treaty law, and therefore of the Grundgesetz. But it cannot happen, can it? A court order forcing Berlin to suspend payments would drive a stake through the heart of German foreign policy, and for that reason the eight judges must recoil, and the law be damned. One presumes.
Alas, there may be no neat solution, no division into two currency blocs with the South keeping the euro and the North launching the euro-plus, no brave decision by Germany to get out, revalue, and let others recover. Instead, there will be month after month of catfights, and flashes of hatred.
The EU will do just enough to prop up the edifice, but too little to restore lasting confidence. The German bloc will not confront the elemental point that either they agree to pay subsidies – not loans – on a scale equal to Versailles reparations, for year after year, or the South with stay trapped in slump until electorates blow a fuse.
Norway will sail on serenely.
Happy New Year.
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