The central concept of this post assumes that the US is and will remain in a deflationary trend for sine time to come, regardless of outspoken calls of hyper-inflation or severe inflation from many. If deflation ends sooner than expected, than the consequences of the investment thesis described here will end in losses.
During times of deflation there are few investments that prove suitable for long-term investment, but among them are government bonds. The two examples illustrated here are the US during the 1920's through 40's and Japan from the late 80's until the present.
If you were a buy and hold investor in the 1930's and your investment happened to be long dated government bonds, you made money:
The spike in yield in 1932 corresponded to the bottom in the stock market, but US government bonds still proved an excellent investment for many years to come. The DJIA on the other hand, tested the emotions of investors with opportunities and tragedies throughout the same time frame.
The yield curve grew steep from 1930 to 1932, signaling the end of the plunge in markets.
What's most interesting is that the action in the yield curve was dominated by changes in the long end of the curve. In other words, the shortest end of the curve never recovered to normalcy, confirming a new bull market had not yet been sparked, but only short cyclical bull markets within a bear.
Notice the shorter term treasuries didn't recover significantly until the late 40's at the onset of a new secular bull market in stocks and bear market in treasuries. What is even more significant is just how long rates remained very low, a deflationary trend.
US Government bonds remained bullish for a long time despite persistent and large deficits and stimulus programs.
Just as now, US public debt was growing at a rapid pace at the same time.
Before presenting how this compares to today, let's consider Japan's deflation as well.
During times of deflation there are few investments that prove suitable for long-term investment, but among them are government bonds. The two examples illustrated here are the US during the 1920's through 40's and Japan from the late 80's until the present.
If you were a buy and hold investor in the 1930's and your investment happened to be long dated government bonds, you made money:
The spike in yield in 1932 corresponded to the bottom in the stock market, but US government bonds still proved an excellent investment for many years to come. The DJIA on the other hand, tested the emotions of investors with opportunities and tragedies throughout the same time frame.
The yield curve grew steep from 1930 to 1932, signaling the end of the plunge in markets.
What's most interesting is that the action in the yield curve was dominated by changes in the long end of the curve. In other words, the shortest end of the curve never recovered to normalcy, confirming a new bull market had not yet been sparked, but only short cyclical bull markets within a bear.
Notice the shorter term treasuries didn't recover significantly until the late 40's at the onset of a new secular bull market in stocks and bear market in treasuries. What is even more significant is just how long rates remained very low, a deflationary trend.
US Government bonds remained bullish for a long time despite persistent and large deficits and stimulus programs.
Just as now, US public debt was growing at a rapid pace at the same time.
Before presenting how this compares to today, let's consider Japan's deflation as well.Richard Koo Presentation
Fast forward to slide 15 within that document. Japan spent up huge deficits for nearly 20 years and grew its debt to GDP to now almost 200%, yet an investor in 10 yr JGB would have profited nicely.
Recently, Japan's credit ratings were downgraded, but there was no panic sell off as yields on the 10 year were recently quoted at 1.43% and the yield curve remains normal.
Let's fast forward to today. The situation is not exactly the same for the US, but many similarities co-exist. Recently there has been a large sell off in the long bond as equity markets rallied. Also, similar with the other two examples, the yield curve steepened throughout the equity market sell-offs. In this case, the yield curve has remained steep throughout, a bizarre phenomenon that may be sending a false signal.
The main difference between America post 1929 and Japan post 1990 is the public debt starting point and deficit spending starting point. Referring back to Steve Keen's chart above, you can see the US has a much higher starting point now than in the two preceding cases. Also, the US has large amounts of unfunded liabilities and has been deficit spending for some time. The deficits are expected to grow for 10 years +.
The fear is the US is next in line to lose its triple A rating, and soon. All in all, its a non-event that will trigger a knee jerk reaction in probability.
The question is, will the deflationary trend remain intact sparking investors to seek safety in return and capital of US treasuries? The evidence presented above is compelling and suggests the answer is yes regardless of an equity market bottom. Fundamentals of the economy and the equity markets remain impaired and show no signs of improving, just declining at a slower pace.
On a final note, please read Bob Hoye's recent article Great Depressions Are So Methodical. Bob is a market historian of sorts and has interesting parallels of 1929 to 2008. It sort of hints at another year and a half of severe contraction in the economy and equity markets.
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