Media’s focus is now on the losing spree of gold which coincided with Donald Trump’s victory. Meanwhile no attention is paid to an elephant in the room – bond market crash. An elephant because the value of the global bond market is higher than the capitalisation of all equity markets. If we talk about the value, here we can find plenty of it.

Investors are closing their positions and selling bonds. Quick. Many of them understand the fact of higher inflation being only beneficial for central banks. It is only a matter of time when the smarter part of the market leaves before it is too late. What was sold first? Bonds with very low-interest rate or negative interest rate. Drop in price of bonds (i.e. higher yield) is visible all over the world.

This capital flight from debt market is only the beginning. Yield of bonds all over the world is correlated. In the chart below you can see interest paid on 10Y UST throughout 6 decades.

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The cycle of increased prices (dropping yield) was supposed to end in 2008. This was the moment when most economies were indebted enough for investors to realise that giving money to the government in exchange for a very small return is not worth the risk.

To regain control of the system, central banks entered the stage. Printing unleashed at a scale unknown before. Fresh currency was used to buy government debt no one wanted to touch. Even though the share of debt market owned by central banks was only in single digits, investors realised that the new buyer with an endless supply of cash can drive the price up. Fundamentals? Who cares? Definitely not those who are caught at the peak of a speculative bubble with their portfolio value about to disappear.

The secret of central banks’ success lies in restoring optimism thanks to which lavish bulls continued buying bonds. Central banks achieved what they wanted. Demand for bonds drove their yield to record lows – with the price being very high.

After 8 years of boom, the trend which pushed the bond market to absurd levels seems to shift to reverse. If you were clever, you put your money somewhere else – somewhere safe.

What we see today is a market slowly waking up to a huge hangover. Global debt market on every level: government, corporate and household was never that high. Record low yield does not help either.

Today the world is 180 trillion USD in the red or 300% of world’s GDP. Imagine, in 1980 it was only around 100% GDP.

Where is this heading? This crossroad has two paths. Both are very dangerous for anyone who put their money in ‘safe’ government bonds.

 

Deflationary scenario

Failure of a significant institution (DB or Unicredit) creates a cascade of bankruptcies. First, everyone who held bonds of aforementioned institutions loses their money according to the bail-in procedure. Their assets are transformed into shares of bankrupted institution. The bankruptcy gets viral and soon capital flight is seen not only in corporate but also state debt. Yield spikes and at some point government announces insolvency wiping out 50-70% of money invested in it. After few months of financial tsunami, new currencies of already deleverage states are pegged to new global coin – SDR issued by the IMF.

This scenario has a small chance to materialise due to virtually non-existent trust in the banking sector and consequent inability to eliminate cash. Elimination of cash seems to be the overarching goal.

 

Inflationary scenario

To reduce the real amount of debt, central banks have to change their tactics. Until now, 80% of the capital was retained in the banking system as fresh QE was used to monetise government debt, acquire toxic assets from commercial banks and equities around the world. However, the desired level of inflation is still far.

To artificially create it, governments will increase their spending, be it infrastructure, basic income experiments or others. Deficits will be covered with more printed money and as a result, the rate of inflation is bound to climb. One of the growing economies of Europe – Poland – saw its M3 money increase by 9.6% y/y.

With low-interest rates set by central banks and relatively low yield of debt (thanks to central banks acquisitions), interest on the debt can stay at levels much lower than the real rate of inflation. In an environment like this, the real value of debt can be reduced at a rate of 5-6% each year. It can only take a decade to get rid of over 40% of it.

This scenario is much more probable as 95% of society does not understand the consequences of QE or inflation that follows. In the US, debt has been reduced with success between 1960 and 1980.

For over two decades, Washington was spending like mad. Since 1954 the US unofficially participated in the Vietnam war, resembling Syria’s involvement. After officially joining the fight in 1964 and after introducing the Great Society, the deficit literally exploded. The US debt ballooned from 300 to 900 billion USD.

 

How is it possible that in USD the debt triples while debt/GDP ratio dropped from 56% to 32%?

There are two explanations. First, a very quick growth which indeed we witnessed. Second, high inflation. ‘High’ may not be the right word. The rate of inflation has to be much higher than interest paid on debt. This is when bondholders will be paid back to the last penny. The problem is that even after adding interest to the capital (face value of the bond), this sum is worth less than back in the day when the bond was bought.

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I used an example from 45 years ago on purpose. Evidence points out that we are approaching the same path. After 8 years of printing spree, the monetary base of the biggest central banks nearly tripled from 6 to 17 trillion USD. Now compare it with the turn of the 60’s and the 70’s.

Inflation hit with a few years’ delay and we can assume that this time it will be similar. Important is the fact that first manipulations with inflation rate calculation started during the 80’s. This is why presented charts manifest the real situation. However, if there are still people believing in attested by the authorities CPI measures simultaneously ignoring data published by the Chapwood index or the Shadowstats then I will share this:

“In 2006, brokerage company owned by Credit Agricole published results of their research according to which inflation in the US was equal to 6.7% which is corresponding to an increase in M3 money supply. The official rate of inflation was 2%.”

 

Why the analogy to the 70’s is so important?

For a dozen of years, we were conditioned to think that government debt is the safest asset on the market. People who like to enjoy low volatility and a lot of safety should, according to mainstream propaganda, focus exclusively on bonds. How surprising is that in this period bonds were one of the worst investment assets?

Parallels with the 70’s are plenty. The important difference is the debt level. Today the debt piles much higher. Bonds are also more expensive. In my opinion, bonds are a guarantee of

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