The thirst for yield has compressed spreads across high grade to high yield bonds, and bid up the prices of sovereigns and loans and just about any security that threatens to pay an income stream. Yield junkies a.k.a investors have even bought unrated, first loss securities, paying an uncertain coupon and with infinite duration, a.k.a equities, in their quest for yield. The usual intermediaries have of course been quick to meet this demand by offering all manner of income funds.

Given the state of the global economy, weak but for some pockets of strength such as the US, credit has become overpriced, particularly in investment grade but now including high yield as well. Even, or some would argue especially, emerging market bonds, are overvalued. Almost globally, credit is overvalued and the risk of the bubble bursting grows day by day. The market consensus, not bereft of moral hazard, believes that central banks will be able to sustain the credit bubble for longer if not indefinitely. What might confound this thesis?

Short term rates are mostly determined unilaterally and arbitrarily by central banks. It is hard to see the developed markets’ central banks raising rates any time soon given their desperate efforts to suppress their respective term structures. Some emerging markets may already find themselves at the foot of stagflation as global growth slows while inflation rises. Control over the longer term interest rates is not so simple, generally involving intervening in otherwise free and open sovereign bond markets. The Bank of Japan’s latest QE efforts are illuminating. Their stated objective of 2% inflation has had the unintended consequence of causing a selloff in JGBs.

Inflation has thus far been absent from the weak, developed markets, where demand is deficient. Instead it has manifested in emerging markets where growth has been robust. Now even emerging markets seem to be slowing. Yet inflation may be persistent, if sufficient money is printed globally. Witness Brazil‘s predicament of slowing growth and rising inflation. The situation that the major central banks have put us in is one perched between inflation and deflation, an unstable equilibrium.

If inflation should prevail, the ability of central banks to maintain flat term structures will be challenged. Given the low levels of interest rates, debt service is highly nonlinear in rates and could prove problematic. Also, the dependence on almost all asset markets on the level of interest rates in their derivation of value makes them vulnerable to a treasury selloff. Fixed income would be most sensitive, but so would highly geared investments such as real estate and REITs.

Deflation would allow rates to be held low but this would be a Phyrric victory since real rates would have risen.

It is academically appealing to seek causation in market moves but experience has shown that while causation matters, underlying fundamentals can be held back for long periods of time, all the while building unhealthy pressure. Catalysts are more difficult to identify. Often the catalysts lie in the same inscrutable animal spirits that policy has strived to revive. Pressures build in fundamental imbalances and in the collective psychology of the markets as well. Sometimes the catalyst for unwinding a fundamental imbalance or mispricing is purely a turn in the balance of sentiment. Aided by accumulations of gamma at key market levels, such reversals can be quite violent and mark the establishment of a protracted new trend.

The policies that Japan has embraced in an effort to revive its flagging economy are indeed desperate measures. To be clear, I believe that they will work in at least boosting asset prices and reviving the economy for a period of time. The long run prognosis is not so good.

Abenomics is like a swimmer trapped under water who must get to air quickly enough before he passes out. Unfortunately, to do that, he has to swim faster and burn more oxygen thus quickening his drowning. His fate rests on reaching the surface before his lungs give out.

Much of Japan’s fortunes and ills have come from its demographics. Given its current aging and shrinking population, economic growth will be hard to sustain and government budgets will be difficult if not impossible to finance.

The current spurt of asset purchasing by the BoJ coupled with fiscal expansion will only hasten the process of cash flow insolvency. The BoJ’s policy has already become hostage to game theoretic paradox, a curious manifestation of the Lucas Critique. If successful, the BOJ’s 2% inflation goal must make JGBs less attractive and so investors must shed JGBs wholesale. To be successful, therefore, the BOJ must become the sole bidder of JGBs, accelerating a demographical eventuality.

This is a vast acceleration of a dynamic that I had described in my last comment about Japan and it has surprised me. Be that as it may, I expect the BOJ to be able to control the term structure at least for the near future, and thus for the equity market rally to continue at least for about a year as animal spirits are revived. We can already see some optimism among domestic investors and corporates which is a very good sign in an economy which has this far been skeptical about all previous efforts to resuscitate the economy.

The longer term prospects are poor as savings dwindles with the population. Japan needs to reach oxygen before its lungs burst.

10 Year JGB Yields. Source Bloomberg.

The credit infused growth of the last twenty years has allowed many an inefficiency to persist undetected or un-addressed. The EUR is one such inefficiency. Unless national factor prices are flexible or factor productivities converge between countries in the Eurozone, a single currency must impede market clearing leading to inefficient allocation of resources leading to underemployment or unemployment. Only the acute dearth of credit has exposed this systemic weakness, at least to some. Many economists and central bankers continue to focus on the financial markets effects of the EUR without addressing its impact on the real economy. A point will be reached when the real economy issues will demand resolution.

The area most likely to demand attention is the labour market. As long as national level wages do not adjust to reflect differing levels of labour productivity, and without national currencies to effect that adjustment, unemployment must result in some markets, and shortages in others. Productive capacity may be shifted to reflect total factor productivity. This may hollow out manufacturing in some parts of the Eurozone to the advantage of others.

How does this micro structural inefficiency impact he UK and Switzerland? The answer is not simple. It is not clear if the EUR is over valued or under valued and thus if the Eurozone is beggaring its non EUR neighbours. Strictly, any distortion to relative prices is suboptimal for market clearing, so the region as a whole suffers. That said, there can be localized winners and losers. Many companies in Europe, both within the Eurozone and without, are global companies. Europe has a very open economy and so a weak currency helps Europe’s terms of trade and improves its balance of trade. Unfortunately, the weak currency strategy is not unique to Europe, Japan has recently begun to depreciate the JPY in an effort to get its exports going, and trade partners and competitors may not countenance more currency weakness as they too try to boost exports. Also, the common currency impedes price adjustments within the region creating intra European trade imbalances. Were intra European trade less significant the problem might be less troublesome but Europe does considerable trade with itself.

Even if The Eurozone does manage to boost exports, the distribution of profits will be unbalanced, precisely because of the internal misallocation of resources. Based on current observations, the owners and generators of intellectual property and brands will continue to thrive and the rest of the region will continue to struggle. For a more precise analysis of the fortunes of the Eurozone’s economies one would have to ask more specifically what each part of the world wants that The Eurozone can supply.

What must be apparent to observers who are not too close to sovereign bond and currency markets is that the cost of the EUR is not just financial sector stress and banking crises but more importantly a failure of the market in goods and services as well as factor markets. Yet it is the financial markets which have drawn the most attention and policy response. The recent actions of the ECB have removed much of the default risk from the banking system. Calls for closer banking union are misguided because they treat a tangential symptom. At he heart of Europe’s problems is that a common currency cannot serve a region with inflexible labour markets. The realization and the call to action will likely come from a chronic inability of the labour markets to clear.

The trouble with gold is that it has long derived its value as an alternative  to fiat currencies and paper assets whose values are derived from collective trust or faith and little else.  Gold has very little use except as a supply constrained store of value. As trust and faith are restored in paper assets, it is reasonable not to be surprised that gold should lose its value as an alternative. It is ironic that gold, by being an alternative to fantasy, should find its value hostage to the whims of fantasy.