Cascading Crises. Can The Evolving Sovereign Debt Crisis Be Avoided?

October 21, 2022

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Inflation is a problem, but it is also the only viable long term solution.

“Willing acceptance – now at this very moment – of all external events, that’s all you need.” ~ Marcus Aurelius

Events are developing quickly and volatility keeps rising across all asset classes.

There seems to be a combination of crises, but really there is a universal singular crisis with different parts. It is worth being clear about how they all fit together and which element is about to become the new focus.

The chart below shows the astonishing rise in the US 30 yr Government Bond Yield. From an all time low of 1% in 2020, the yield has now broken out above 4%. What started as a repricing to reflect higher inflation, is evolving into a sovereign debt Crisis.

Central Bank Dogmatic Serial Failure

The current predicament falls on the central banks. During every crisis they have adopted temporary and very often experimental solutions which have become increasingly used to new excesses and imbalances.

Keynesian debt financed government spending was added as a new tool for the future after the 1930s depression. Under the gold standard the debt capacity was limited so it was abandoned in 1971, to enable further deficit spending, which combined currency devaluation with deficit financing.

It was a long hard slog to contain the resulting 1970s inflation but by the early 1980s it was finally achieved. Debt took off again from the 1980s.

There was little concern that over the 70 or so years following the second World War that debt had continued to rise and long term growth had continued to decline from 5% down to below 2% by 2019. So, concerned by the weakness of world growth, the central banks announced that they would employ policy to the maximum with every tool available, in the BIS annual report in 2019. The Covid crisis provided the opportunity to go to record levels of stimulus. Now this has evolved into an inflation and sovereign debt crisis and the world economy is very weak and growth is declining.

Where do we go from here?

Mohamed A. El-Erian put it well in his twitter account about how comprehensive has been the failure of central bank policy:

An independent #FederalReserve is critical to the well-being of the US #economy. Having said that, it is getting harder to justify such independence when four big operational errors (of analysis, forecasts, actions and communication) are accompanied by a lack of accountability.

In addition, while the Liz Truss UK era was short and poorly executed, it became the scapegoat for the chaos developed over several years by Bank Of England policy and, in addition, direct involvement in leveraged bond positions in pension plans! Blaming this on just a month of unexecuted policy proposals seems like a stretch. The core issues have still not been addressed.

Daniel Lacalle explains:

The only lesson for the United Kingdom is to remember that if you follow Greece’s economic policies, you get Greek debt, unemployment, and growth. The UK government should do everything to avoid the seventies’ elevated inflation and economic stagnation, not try to replicate them vigorously.

The current economic problem is intensifying with the new extreme tightening policy of the Federal Reserve which is immediately following the most recklessly stimulative policy settings in its history. Instability is directly linked to complete and sudden reversals in central bank policy.

The chart below shows that by any reasonable historical measure the Fed is still nowhere close to ending its tightening. The Fed has never “pivoted” to easing while the Fed funds rate was below the sum of core inflation plus a measure of the unemployment rate. This would currently require a minimum interest rate of around 6% or an unprecedented reversal of policy.

Relief from current trends does not appear to be an option for the Fed.

The new inflation target will likely evolve in a new direction

The debt, growth, inflation, asset purchase, interest rate policy is becoming harder and harder to reconcile into an acceptable economic situation and debt is likely to become a growing key problem. So much so that it is likely that negative real yields will become an implicit policy in the hope of inflating away some of the debt over time. This is covered in a great research note by Russel Napier.

The room for manoeuvre, and the stability of the current system should not be taken for granted. Volatility has increased and is likely to continue to stay high. The outlook has rarely been this uncertain. Investment management needs “Best Investor” metrics and techniques as never before.

Market and economic events are moving fast at this stage. If you need a quick review of the issues that you may need to know about for your own circumstances, schedule a FREE consultation today.

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