State of the Nation

Trouble in the Treasury Markets and High Inflation

Friedrich Hayek, the prominent Austrian economist, believed that normal business cycles are distorted by cheap credit and monetary expansion. These distortions send false signals to investors, leading to malinvestments and asset price bubbles.

When the money supply expands rapidly, a boom becomes apparent at the outset as investment drives economic activity. Meanwhile, rising asset prices create a wealth effect, increasing spending (i.e. consumption) further. Unfortunately, this cannot last forever, as the boom is not sustainable, leading to the inevitable boom-bust cycle.

Why? Because the boom itself is driven by an increase in artificial credit, with no backing from any savings or real resources. The cheap credit creates conditions where certain projects are profitable, but only under these specific conditions (more on that later), leading to malinvestments in real estate, lending, and the corporate sector.

Treasury Markets

This brings us to the treasury markets, and what represents the main way Government's raise cash to fund their spending. Since the Fed and the BoE have stopped buying bonds, the treasury markets have been weak. Coupled with all time high current account deficit spending, has resulted in

The prevailing market narrative is that interest rates are due to be cut soon.

We are in unprecedented times and the challenges facing the economy are greater than ever. Despite a consensus from the Bank of England and the Federal Reserve that cuts are coming the treasury markets are not pricing in any.

Government issued debt is the cornerstone of the financial world. It acts as the de-facto risk free rate in all markets. For many years Gilts and Treasuries were, and this was because central banks purchasing bonds to hold directly on their balance sheets. However, once inflation reared its head in 2021/2022, central banks had to engage in quantitative tightening. Essentially letting bonds mature and roll of their balance sheets. With this (major) buyer no longer participating, the yield quickly rose. US Dept. of Treasury (Janet Yellon) and the HM Treasury had to quickly price bonds higher to attract buyers. A la higher rates permeating throughout the investment world.

Chart of US and UK Treasury / ECB. Possibly Japan.

In the above it is notable that Japan is the outlier, and that is due to them continuing their programme of QE. However what the chart tells us is that cuts to the base rate are unlikely to impact the price of debt.

Inflation

The challenges facing the global economy are severe. None more so which we believe is continuing effect of rising prices. Although the value of these goods is unchanged as such. An apple is always an apple, however does it increase in price? Yes supply and demand has short term effects such as weather or transport issues, but in our current society prices never go down. The apple here being a metaphor for the entire economy.

The answer lies in inflation, and an excess supply of Pounds / Dollars / Euro(insert any other currency in the Western world) being created. Simply speaking, when too many dollars chase to few goods, the price of the goods must increase to reach an equilibrium with the new level of money supply.

M2 Money Supply - Comments / Lessons

When money is plentiful and 'easy', it as we mentioned earlier creates distortions in the economy. However, as inflation increases and prices rise, previously profitable projects lose profit margin or worse still become completely unviable.

There is a close connection between debt and cash. Cantillion effect

Conclusion

Going back to Friedrich Hayek and his description of asset price bubbles, we must ask ourselves what happens once a monetary bubble over inflates. The answer, is precisely what happens to physical bubbles. They eventually become too big, and the weight of the bubble causes it to collapse in on itself.

The key implication being that the current asset price bubble, in this case being the bond markets (government & corporate), stocks and real estate are all primed for a fall. Given what this therefore portends, it is essential to insulate oneself. In a debt deflation environment it is better to own direct economic resources than financialised assets whose values are based on inflated debt.