We have had central banks telegraph their intentions to us for years now, and mostly those signals have been dovish. Recently, however, there has been a backup in bond yields and some uncertainty around what central banks want and what they can achieve.

Is the current correction in bonds similar to the taper tantrum of 2013 when the Fed signalled an end to quantitative easing, or is it a shorter, shallower correction, or is it a more durable reversal in the one way market for bonds since the crisis of 2008?

Let’s explore a slightly cynical view of the world, that central banks are in fact not independent of their political masters and that the government uses all the apparatus at its disposal in the management of the economy.

Global debt levels have risen from 87 trillion USD (246% of GDP) in 2000 to 142 trillion USD in 2007 (269% of GDP) and to 199 trillion USD (286% of GDP) in 2014. Despite deleveraging of particular sectors in the aftermath of 2008, aggregate debt levels did not drop but instead accelerated.

A plausible strategy for dealing with excessive debt would run as follows:

1. The first order of business is to ensure that the holders of the debt are strong and do not attempt a market sale which would bring about price discovery.

2. Market rates of interest need to be contained to facilitate the refinancing of existing debt towards longer maturities. This involves suppressing two elements, the first is the underlying government bond curve, and the second, the credit spread.

3. A strong holder of debt is the government since it pursues objectives beyond economic and commercial ones.

4. The government needs to finance debt purchases with the issue of government debt. This will lead to an increase in the national debt, from in most cases already elevated levels. A strategy needs to be found to reduce the cost of government debt.

5. Central bank purchases of government bonds are an efficient means of financing the government’s debt purchases and moderating financing costs. In the case of more determined programs, central banks may buy corporate debt to suppress the credit spread as well as the base interest rates.

6. A pool of investment capital sufficient to finance and refinance the debt needs to be maintained and developed.

7. Excessive savings are to be encouraged as they are another source of cheap funding. Inequality of wealth supports excessive savings and may therefore be tolerated.

8. To channel savings to fund government debt, banks need to be encouraged to buy government bonds. Under Basel III, government bonds have a risk weight of zero, making them highly capital efficient investments despite their low yield. The zero capital consumption of government bonds makes banks demand highly inelastic. In the US, in the 12 months to Oct 2016 the holdings of US treasuries and agency MBS by banks has risen from 2.16 trillion USD to 2.43 trillion USD.  Western and Southern European banks’ holdings of government securities has more than doubled from 627 billion EUR in Sep 2008 to 1,422 billion EUR in mid-2016. This has been aided by credit lines (LTRO) for which government securities are eligible collateral.

9. The slower is economic growth and corporate profit growth, the lower must financing costs be maintained in order to prevent the excessive growth of the total debt. Ideally, the objective is to at least attain steady state if not shrink the stock of debt.

If the above conjecture is true, then interest rates will be capped over the long run. The current rise in interest rates would be a short term (3 to 6 months) phenomenon.

On this basis, while we would be tactically short the 10Y UST at 1.8, we would be long the 10Y UST between 2.0 – 2.3, and the 30Y UST between 2.84 – 3.06.

10 minutes into the future…

Growth remains positive but slow, equities are expensive, credit spreads are tight, and interest rates are low. High quality assets are even more expensive leaving only lower quality, less liquid, more esoteric or clearly troubled assets with any value.

A significant contributor to the current state of affairs is central bank policy which has included suppressed interest rates and competitive demand for assets. The only hope for traditional assets such as equities and bonds to appreciate is further central bank purchases or a sudden spurt in economic growth and productivity.

On the risk side of the argument we have, in addition to expensive valuations and slow growth, monetary policy being close to or at its limits, a dip into negative growth even if cyclically and short lived, social tensions from inequality and most pressing of all, political tensions from Europe to America to the South China Sea.

Governments may mitigate some of these pressures with fiscal policy but sovereign balance sheets are already heavily indebted. China’s growth has been supported only by a significant expansion of credit. The US has had contentious debates about their debt ceiling and Europe is constrained by fiscal rules which most of its member countries have been in protracted breach of.

If fiscal stimulus becomes widely adopted it will provide a lifeline to economies and markets for another 3 to 5 years, depending on how determined the effort. However, the world has experienced 8 years of recovery since the financial crisis of 2008, and a cyclical downturn can be expected soon.

That the monetary policy lever has not had a chance to be reset or restored is a serious concern. In the next downturn, monetary policy will have no room to act. The parachute has been deployed, there is no spare, and we haven’t packed it back in the bag.

The fate of fiscal policy will likely be the same as that of monetary policy. A slippery slope from which there is no return. Slowly, the wisdom of austerity has been pushed back, first in the fringes and then in the centre of academic orthodoxy. The biggest challenge for fiscal stimulus is not how it will be deployed but how it will eventually be rolled back.

Eventually, debt will have to be repaid or repudiated. The first step to debt forgiveness is to place the debt in friendly hands. This stage has already been done. The Bank of Japan, for example, owns over a third of Japan’s national debt. Were it to convert this debt into perpetual, zero coupon debt, the debt burden of the government would fall dramatically. If this debt was written off, it would reduce the leverage of the sovereign balance sheet to facilitate new issuance.

The mockery that such a debt restructuring would make of the concept of money and debt will have unpredictable consequences. Either interest rates go down with the leverage, or up as the internal (inflation) and external (exchange rate) purchasing power of the currency is questioned.

For the investor, this scenario is depressing. The only strategy is chicken. In the game of chicken, two cars drive towards each other at speed. The first to flinch, loses. If no one flinches, both die. The winner is the one who flinches as late as possible. For the traditional long only investor trafficking in equities and bonds, the runway is short. For less constrained investors, the runway is longer, slightly, but still finite.

Markets in asset backed securities, structured credit and leveraged finance may not be as accessible to fast money retail investors and their proxies such as mutual funds and exchange traded funds and may retain value for longer. However, it is a matter of time before the relentless pursuit of yield finds these niches and squeezes the value out of them. Regulation, complexity and tax structure may present barriers but not for long as the collective intellect of the financial industry is turned towards circumvention.

Shorting. If assets are expensive, then perhaps it makes sense to hold a short exposure to these assets. However, shorting is not a mirror image of ownership. The risks to shorting extend beyond the economics of the trade to the mechanics, regulation and legality of establishing and maintaining a short position. Shorting is an unpopular strategy particularly when it works.

What is an investor to do in this environment? If Lord Keynes’ observation that in the long run we are all dead, then chicken is a viable alternative. But do choose the longer runway, which means eschewing conventional, accessible assets and strategies.

In the long run, however, average returns have to be low, since growth is moderate and assets are expensive. The problem is most tangible in the pensions and savings industry where liabilities are chronically underfunded. The individual or individual institution may attempt to navigate the temporal distribution of returns, i.e. market timing, but for the industry as a whole, the problem is chronic.

As the memory of war fades and technology allows us to fight wars from long distances we become distanced by time and space. The more time passes and when wars are fought in faraway places and fought with detachment the more likely we are to engage in it.

Capitalism leads to inequality of wealth.

• Capitalism is based on competition. Capitalism incentivises competition and the maximization of inequality at the micro and macro levels.
• To maximize profits companies have to maximize revenues and minimize costs. Minimizing costs implies indirectly minimizing payments to resources, labour included.
•  Labour’s share of GDP has shrunk consistently for at least the last 60 years. The relentless accumulation of intellectual capital and innovation results in greater efficiency and productivity of resources and capital. To the detriment of labour.
• Individuals supply labour. Individuals can only store a small and finite amount of knowledge in their lifetimes.
• Business entities like corporates are able to accumulate intellectual capital. As the share of returns to innovation increase, enterprises’ share of GDP will increase.
• Capital is scalable whereas labour is not. Intellectual property is an inexhaustible resource whereas labour is not. Individuals do not generally licence their intellectual property, they sell it as an integral part of their labour, rendering the intellectual property of the individual an exhaustible resource.
• Ownership of businesses allows the individual to accumulate more wealth than supplying labour.

· Inequality of wealth leads to slowing economic growth and carries political risks.

• The potential for inequality promotes greater effort, enterprise and innovation.
• Past a certain point, inequality impairs growth. The rich save a greater proportion of their income than the poor and thus greater inequality translates to more saving and a slower rate of circulation of money leading to slower growth.
• When the perceived probability of advancement from the lower strata to the higher strata becomes sufficiently small under the current economic and social system the lower strata will find it unacceptable.

· Slow economic growth has wide ranging risks.

• Humans have evolved social behaviour as an economic expedient. Sufficiently weak economic growth can threaten faith in the social compact.
• Slow growth can therefore encourage less cooperation, more competition, trade protectionism and other anti-trade practices, disintegration of economic and political unions, civil and martial conflict.

· Slow economic growth coupled with high levels of inequality imply that the majority of households experience negative growth.

· Central bank policy has limits and limitations.

• Central banks make policy while having imperfect information about and imperfect understanding of the economy. This leads to oscillations in later time periods. The probability that policy is suitable and adequate is extremely low.
• The more activity, the more potential imbalances are accumulated. The cost of policy is cumulative.
• The engagement of fiscal policy introduces the same theoretical instabilities as monetary policy but adds complexity and the political dimension.

· Low interest rates have multiple effects.

• Low interest rates make it cheaper to borrow and therefore boost consumption and investment.
• When lower interest rates stimulate growth they are inflationary.
• Low interest rates can encourage over-investment and over-capacity which in an economy suffering from weak demand can be deflationary.

· Firms versus Individuals:

• A highly knowledge based economy encourages labour specialization which can lead to loss of flexibility and diversification in the labour force.
• Firms are able to accumulate a diversified portfolio of intellectual capital and even trade in intellectual property. Individuals find it more difficult to do so.

· Globalization and open factor and goods markets increase competition in specific segments of the labour market.

• Segments facing the most immigration face unemployment and wage pressures.
• Segments which face outsourcing also face unemployment and wage pressures.
• For the other sectors, the increased efficiency and productivity is a positive development.

· Technology and Human Ingenuity

• Technology can either augment or substitute human ability. So far the ability for technology to substitute human ability has been limited.
• When labour is abundant the need for and the return on investment in human replacement is low. Efforts turn to augmentation instead of replacement. When labour is limited or inadequate, the reverse is true.
• Low unemployment, rising wages, tight labour markets and low participation rates indicate a mismatch between supply and demand for labour, namely, a labour shortage, an environment which might drive investment in human substitution.
• If human substitution increases in incidence social questions about the ownership of automatons may arise. Apart from technological and practical questions, the advent of human substitution technologies will generate many questions in the legal and ethical domain.

· Time and technology blunt the memory of the cost of war.