Yes, the credit system is broken now, but if we have a big event that flushes out bad debts and suppresses asset prices (basically more of what we are experiencing, much more), then credit can get flowing again after an episode of rapid deflation.

I think 2-3 decades of slow deflation like Japan is unlikely, considering that every sector of the US is horribly indebted. There, the problem was mainly in large financial institutions. Families were OK, and jobs were available since the rest of the world was still in a credit expansion and buying their exports.

Also, you can’t forget the entitlement problem in the US, which is big enough to bankrupt us many times over, even in the absence of a credit bust with its bailouts and New Deal.

So, yes, if the govt crashes the treasury market by going overboard with monetization, asset prices will collapse as interest rates rise, and even the big NYC banks could cease to function. It is what happens after this event that could threaten the integrity of the dollar, as well as other paper currencies, since the US will not be alone in this madness.

If the govt runs multi trillion dollar deficits after most private debt has been defaulted away, while it monetizes like wild, the currency will lose value, and possibly very rapidly. The key here is that first you have to get through deflation to wash away the debt.

In conclusion, I agree, there is no path around deflation. The question is how long it takes for the debt to be defaulted away. The prices of labor and assets will continue to drop as long as the defaults keep rolling in. This is deflation, and it is today’s reality. The financial markets are just having a spasm, and reflect nothing but people’s misplaced bets on a rebound and a rapid return of inflation.

My guess is deflation lasts until 2012-2015.

There are a couple of things I kind of disagree with your points:

1. “Also, don’t underestimate the impact of increasing government expenditures (which put cash directly in people’s hands) … ”
>> By stimulating and bailing out banks, the net effect is actually taking money out of people’s hands. They may put some money to 1 million people, but with taxing… they take away money from 100 million people or more. Remember that government productivity is near zero. That spending is funded by taxing and/or further debt creation.

Now, about debt creation. We see because of the existence of credit/bond markets, as governments get fiscally mad (keep issuing treasuries)… interest rates soar. This will create huge upward pressures towards mortgage rates, resulting in upshot of delinquencies. So, if you extend this line of reasoning, it will put huge downward pressures to asset prices. It will then blow a huge hole in bank balance sheets (what the FED does not want).

In essence, with the presence of credit market… the market itself can tighten monetary policy, causing all sorts of problems. I guess if the govt forces the issue, the likelihood of political upheaval will rise dramatically.

2. Comparison to Weimar inflation
>> At the time, there was no credit market. The Germans were forced to pay their war debts and they couldn’t. So, they had to (or maybe choose to) inflate their currencies. With non-existing credit market, inflating is easily done. And during those times, unemployment was very low (I think we have to confirm that). In hyperinflation, it will not make sense for people to put money in banks. It will not make sense either for people to save money. What is happening now is exactly the opposite.

As for defaults… I don’t disagree that it is a possibility. But as always, the case is about relative safety: who’s going to default first? Given US’s supreme economic leadership (a bad leader… but still), the likelihood favors most of the others to default before the US. The UK is in significantly worse fiscal postures. European countries in general has astronomical bank leverages & horrific risk posturing (please refer to my Euro Report I posted before), with bank assets amounting to several times their (individual) GDP.

The US can manage to bail banks out. I’m sure it will be much much more difficult for those European countries. So all in all, as much as I hate Obamanomics, Government Sachs, crooked banksters, & how the US is becoming USSA, I still think for now the US is the one-handed man in a kingdom of the blind. For sure, their steps are leading to economic ruins. But I doubt the end is hyperinflation. Perhaps the US is going the Japan way.

To create inflation in a credit-based economy — the world we are in now — rising leverage & debt creation (i.e. ever bigger bubbles) are required. With banks balance sheets blown really deep, that mechanism of leverage & debt creation is broken… that’s what happened to Japan. When the economy recovers, it is likely that there won’t be hyperinflation either… inflation will return but perhaps they are much more limited than most people think.

I am not sure to what degree events like the Lehman collapse have causality, since it is never clear how the market is going to react to them. Sure, something like 911 will be negative, but I think that a few percentage points of the decline afterwards were already baked in, since we were in a strong bear trend when the event happened.

Also, the optimism that produces and sustains a bubble sets the conditions for its bursting. By definition, all bubbles burst, and all such crashes coincide with negative mood, so yes, to some degree, the mis-allocation of capital and excessive debt buildup is a cause of the mood shift. That said, the mood would have changed anyway, since society can’t stay excessively optimistic forever (kind of an identity statement here, since I assume that mood is always changing and can’t move in one way forever).

Ok, so I am not at the moment a pure socionomist or market technician when it comes to the credit cycle, since once a bubble starts to burst, there are mechanics of debt terms and income involved here that trap people in the crash no matter what their mood would be otherwise. However, when it comes to a shorter time scale (less than a couple of years), I attribute very little or nothing of what the markets do to fundamentals.

I am fairly proud of this post from last August (when commodities were still way up and everyone was calling bonds a bubble), where I laid out the reasons why 30-year treasuries could yield under 3% for the first time since the 1940s:

http://sovereignspeculator.com/2008/08/08/that-crazy-crazy-bond-market-a-call-for-sub-3-long-bonds/

They of course went to 2.5% by December (at which point I shorted them):

http://sovereignspeculator.com/2008/12/23/finally-time-to-short-the-long-bond-for-a-trade/

They could go back under 3%, sure, but the wildcard is the likelihood that the US govt is going to default on the long bonds being issued today, and maybe even the 10 years, through excessive monetization or outright repudiation.

Bonds are in the process of making a generational top, so I think going long at this point has to be for fairly short-term trades. There will be bigger money made in going short from super low yields if they are reached again, which I do think is likely when risk appetites subside and equities and commodities crash again. But like last fall, it will only be time to go short when most shorts have tried and failed to the point of frustration.

The faster asset prices crash and flush out the bad debt, the sooner the shadow banking system can get rolling again. That could bring inflation. Also, don’t underestimate the impact of increasing government expenditures (which put cash directly in people’s hands), since that is what brought about the Weimar inflation and the US’s double digit inflation in the 1940s (interestingly, that coincided with the last top in the bond market). With an increasingly socialist and militaristic government and a population brainwashed by Keynesianism and war propaganda, who knows what will happen in the coming years?

For now, until assets crash to historically cheap levels or the feds double or triple their spending as a share of GDP, deflation will continue and bonds should hold up.

In any consideration of the treasury market, you have to look at yields globally, since most major government debt markets are strongly correlated. Because each nation’s credit situation is unique, but its bond market is likely not, you have to look above all at market technicals and sentiment for your trading. Other fundamental considerations are more relevant for assessing the likelihood of unique situations like default.

Is there another piece of the equation that I am missing?

I’ll read the PDF later.

On government bonds, it does look quite complicated. Historical precedents, as Hendry mentioned, favor his views on government bonds. Japan has enormous public debts, amounting to 180% its GDP. In the great depression, the long-term govt bonds also reached extremely low levels. Furthermore, if risk in business environment rises stratospherically high, it makes sense to own government bonds giving yields of 2-3%, instead of losing money. In the worst case, countries that owe in its own currency can always print currencies to pay for those interests. These are all the pro-govt bonds view

Much of the grudge on govt bonds today centers on the argument that the US is the largest debtor nation ever and it is yet to take even more debt. After that, the creditor nations will dump those US govt bonds, and comes hyperinflation… which kills govt bonds. However, I’m confused w/ the notion “debtor” and “creditor” nation. If you look at China & Japan, for example, those two are touted as the largest creditor nations. But aren’t they deep in debt? Those China stimuli & Japan public debts are enormously huge, relative to the respective economies. Is it fair to just view things as extreme indebtedness is pretty much the state of affairs for virtually all nations?

If it is, then it is very natural as the world economic leader & owner of the global reserve currency, the US has the safest (relative) debt compared to all other nations. China recently had numerous consecutive failures in their debt auction. US Treasuries auction has been relatively going well so far (high bid/cover ratios of 2.4, at times 3+). Looking at that comparison, well… is China really a strong “creditor”? The US seems to be a trusted borrower, for now at least.

Excellent points you make there on socionomics. I guess I have to be more careful in drawing lines of causation. However, isn’t it the case that those massive turns in social mood/herd attitude tend to coincide w/ those “credit events” (massive events)? Last year, it was the failure of Lehman, setting off a massive chain reaction in the financial world. While they are not necessarily causation, they at least seem to be very closely correlated & almost coincident. The event and the massive turn may not come simultaneously, but they tend to coincide quite closely — perhaps the degree of intensity also correlates very well.

I also like how he looks at things as all the same market (short dollar and short bonds = long commodities, long stocks, long corporate credit). Along this vane, CNY = oil. I am bearish oil (I own Dec and June puts on futures at the moment) and am looking for a bottom in the dollar before long, so that makes me bearish on the Canadian dollar also, though I’d rather short the Euro.

Speaking of which, yes, there are huge troubles over here and I do expect the Eurozone to fracture, if not the EU itself. As a traveler, I would welcome that, since it is no fun to leave the US empire just enter an equally obnoxious regime over here. As you know, in the old days, you could live your whole life as a tourist in Europe and never leave, by spending 90-180 days in one country, then doing the same in another. Now, it is all one customs zone — no borders within, but so what if you can’t stay for long? There is a lot to be said for a diversity of laws between nations — it adds both color and options.

One thing in your comments that I would take issue with is the assumption that we need an event (or events) to drive the markets lower. I am of the school that says the markets are driven purely by social mood, which creates the events as well as how they are perceived. Thinking that events drive markets is crediting them with some degree of rationality, and I believe they are inherently irrational at all times.

What drives mood? Solar cycles for one, but mostly just rhythms that emerge from our DNA that have existed from before we were human. We are coded to react to others around us in ways that maximize the survival of our DNA on average through generations of bodies, some of which are weak, some of which are strong, some smart, some dumb.

Our reptilian brains are built for humans who are average in every way. I don’t think that there is tremendous variation here, as there is in other parts of the mind. What should an average human do in a crowd situation, to maximize his survival, on average? That is what we are wired to do, and when we all do that at the same time, patterns emerge in the crowd.

Usually, those patterns help us, but in a financial bourse, they are extremely harmful to the average participant. Anticipating the crowd’s next move at any given time is extremely difficult, since the patterns are so complex and we are a part of that crowd and subject to the same messages from our reptilian brains. There are however times at which a self-conscious intelligence can predict with decent certainty the next move of the crowd. Such times are often when the crowd has made a very strong move in one direction, such that few individuals have not joined in, and the majority express with great certainty that they should continue to move in this direction, although they have slowed down.

Fortunately, the movement of the crowd in a bourse, though complex, is restricted to one dimension: up and down.