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Tuesday, May 05, 2009


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john walker


Isn't there a contradiction between your bond and currency outlooks? In the Currency post, you wrote that "the bet to make right now is deflation". If so, bond prices could easily rise, since deflation raises the real interest rate on any fixed coupon.

For bond prices to fall during a period of combined deflation and a contracting economy would be historically unprecedented (counter-examples most welcome).


john walker, historical analogies an be tricky. From 1873 to 1896 we had a long but mild deflation, but the economy expanded (quite a lot actually) rather than contracted. Bond prices rose, but the analogy is imperfect to today. From 1837 to 1842 we had severe deflation and a huge contraction, and that is more like today; but we had just gotten rid of the central bank, so lacked a Fed to try to drive rates down. Again, an imperfect analogy to today.

From 1929 to 1932, we had a horrific deflation, and bond prices rose. After that it is hard to generalize, as we went off gold, but paradoxically gold flowed back into the US as a safe haven, so the money supply expanded. We didn't need to raise rates to attract investment.

From 2007 to 2009 we have dropped rates, and deflation has arrived, and so far bond prices have risen. My contention is that they will now fall as rates will go up in order to finance huge deficits. Interesting is that from 1929 to 1931 the Fed dropped rates from 6% to 1.5% very quickly, almost a mirror of our last two years. Then in 1931 the Fed raised rates to 3.5% to stem the outflow of gold, somewhat analogous to having to raise rates to attract foreign buyers of Treasuries today. Bonds fell. But in late 1931 Austria defaulted, then England defaulted, and we had a huge baking crisis worldwide. This prompted the Fed to start dropping rates again, back down to 1.5% in 1932.

One of the most influential diagnoses of the Great Depression was Milton Friedman's Monetary History of the United States, which argued that the Fed failed to flood the market with money. In retrospect, it is much less clear today that he was right. The Fed dropped rates as fast as Bernanke has, but was overwhelmed not by a contraction of money in a narrow sense, but by a huge write-down of debt. For example, by 1933 most nations were defaulting on their foreign debts, most notably Germany, which repudiated the WWI war reparations, and England, which tried to get out of debt owed the US. Hard to see how the Fed could have put enough fingers in the dike to hold back that flood.

My argument is that the Fed has already driven rates down to really low levels, and it is hard to see how it can keep them there. With deflation, real rates are destined to rise, but nominal bond value should drop.



I think you have raised a very pertinent doubt on the continuation of the Bond rally. The sheer amounts of deficit financing required world over could easily steepen the yield curves with the short end subdued by the liquidity and long end stressed by the largesse of the debt burden. This fits in with the logic of weaker USD in the last downleg
The steepening of Yield curve can thus resolve the contradiction pointed out by JW

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