So far, the storyline was simple. As a result of the global meltdown, risk aversion had risen and investors made a beeline for US treasurys, which they considered the safest haven in the world. Bond prices had accordingly soared, while stock prices crashed.
But that scenario might be changing. In a 22 January report titled Choose your poison: stocks or bonds, Bespoke Investment Group points out that while stocks have got off to a rocky start this year, US treasurys (as measured by the US long bond future) were down almost 6%. “With the recent break below their 50-day moving average,” said the report, “bonds are hardly looking like a ‘safe’ alternative in the current environment.”
Back home, 10-year government bond yields are well off the lows they hit earlier in the month on worries over the increase in government borrowing. That’s also the reason why yields on government long-term bonds have risen in the US, as the new administration readies a massive fiscal stimulus plan.
Also Read Manas Chakravarty’s earlier columns
Many have said that the end of the boom in US treasurys is in sight. Ditto for global bonds. Concerns about sovereign ratings rise as fiscal deficit widens. As global fund data monitor EPFR points out, “The latest source of pressure on global bond funds is the uncertainty about the ratings implications of stimulus plans in key sovereign markets.”
But if money is flowing out of bonds as well as stocks, where is it going? Gold could be the answer, with the metal’s prices rising above $900 (Rs44,010) an ounce, a level last seen in October. International gold prices tend to ebb and flow with changes in the US dollar index and it’s interesting that the recent spike in gold prices has occurred in spite of a stronger dollar.
Why are investors flocking to gold? The market is worried that the huge monetary and fiscal push to the economy being arranged by central banks and governments around the world will, sooner or later, result in higher inflation.
Manish Chokhani, director at Enam Securities Pvt. Ltd, is among those who believe that inflation will rebound later this year. He sees oil and precious metals as stores of value in this environment. But with global growth increasingly being seen as near zero this year and with commodity prices getting crushed, isn’t deflation rather than inflation the major worry?
Inflation depends on what economists call the “output gap” or the gap between potential and real output. The availability of finance on easy terms could have been a reason for higher potential output and its withdrawal may therefore have lowered it.
Morgan Stanley’s Manoj Pradhan writes: “Our model suggests that potential output may also have fallen sharply so that the slack in the economy may be smaller than many believe. As a result, the fundamental downward pressure on inflation may not be as strong. If monetary and fiscal stimulus is successful in stemming deterioration in economic growth, and we believe that this will indeed be the case some time in 2009, then a return to inflation worries may be on the cards earlier than expected. We believe that inflation markets are far from pricing in this view.”
But is the amount of new money being created enough to offset the destruction of “money” by the “shadow banking system” of derivatives combined with excessive leverage? As mentioned in this column a few weeks ago, the computations of Eric Fishwick, head of economic research at CLSA Asia Pacific Markets, show derivatives and securitized products together add up to 93% of global liquidity.
If that estimate is correct, no amount of money creation by central banks will restore the liquidity that existed prior to the crash.
Legendary investor Jeremy Grantham, in his recent quarterly newsletter, says deleveraging still has a long way to run. He points out that the write-downs in asset prices also leads to a rise in debt ratios. Moreover, bankers have become more conservative and loan to collateral ratios have been increased.
Grantham estimates the net result of all this in the US would be to “halve the level of private debt as a fraction of the underlying asset values. This implies that by hook or by crook, somewhere between $10 trillion and $15 trillion of debt will have to disappear.”
How can we overcome such a horrendous amount of deleveraging? Author and commentator Satyajit Das has been arguing since the crisis began that an easy way for a government to lower the debt burden is to inflate its way out of trouble.
American poet Robert Frost wrote: “Some say the world will end in fire/Some say in ice.” So how will the financial meltdown end—in the fire of inflation or the ice of deflation? Perhaps we should let the policymakers talk.
In a 2002 speech, the current chairman of the US Federal Reserve Ben Bernanke said: “If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.” The markets are realizing he might have meant what he said.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at email@example.com