Government Debt Bubble is What Directly Precedes Inflation

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Ay yay yay! What a week it’s shaping up to be. The task of today’s Daily Reckoning is to take stock of the 25% rally in the All Ordinaries since March 06th and figure out what’s behind it. Is it “sustainable,” to use a word that’s become so popular with budget deficit runners lately? Also, just how DO you make money in an inflationary boom? And did spiking bond yields pop the government debt bubble on Friday?

First things first. The budget comes out tomorrow. Blah blah blah. What is really left to say? The Treasurer predicts collapsing revenues from the GFC and has cut spending in some places while increasing it in others. The annual deficit could be around $70 billion (we expect it to be lower so it’s ‘not as bad as we expected’) and the government predicts more deficits for years to come until the relationship between falling revenues and rising spending becomes “more sustainable.”

How Australia chooses its social spending priorities is a political question. And who wants to get into the sewer and debate politics on a Monday morning? The effect of financing those priorities/promises, however, is an economic question. And for that we’d say watch out for a steepening Aussie yield curve. This indicates rising long-term interest rates. In other words, big government borrowing to financing deficit spending is going to make borrowing more expensive for ALL Australians. More on the bubble in government bonds below.

What about the stock market though? Australia reported its second-best ever trade surplus last week. Chinese purchases of Aussie exports have surged 80% in the last four months, according to government statistics. China purchased a record $4.4 billion in Aussie goods in March.

Surely that must be the kind of national income that boosts corporate earnings? But whose income? Well, farm exports were up 10%, with wheat exports up about 40%. Imports were down three percent. That would begin to explain some of the surplus. But what about minerals and metals?

Coal and other mineral exports were actually down five and six percent, respectively. But metal ore and mineral exports were up 8% to $354 million. Iron ore exports were up 9%, although in volume terms, exports were up 19% while prices were down 8%.

So wheat and coal held up the trade figures in March, along with a decline imports. That makes sense doesn’t it? Australia has a fair bit of wheat and coal. But we have to confess we find the iron ore export data perplexing. If Chinese demand is being driven by the government stimulus, that might explain it.

But remember, iron ore and coal prices are going to be a lot lower this year than they were last year, once contract negotiations are settled (this also means export values are going to value). Why, then, would the Chinese government pay a higher price for ore now when it could have it at a lower price in the spot market or in a new contract price in just a few months?

Who knows? One possibility is that the surge in ore exports to China is being driven by speculators who are stockpiling. It could be steel-makers could rebuilding inventory. Or it could be what some people seem to think it is: a new boom! We’ll see.

For now, the simplest explanation for the market rally is this: inflation. All over the worlds, fiscal and monetary stimulus packages are kicking into the gear. Their effect in the real economy is dubious. Their effect in the stock market is obvious. Rally! A huge amount of money is being pumped into the global financial system. Stocks are surfing it.

By the way, lest you think we’re against the idea of making money in these rallies, we’re not. The two investment newsletters we publish, Australian Small Cap Investigator and Diggers and Drillers, have each recommended resource and small cap stocks that we think will do well in an inflationary boom.

In fact, that’s probably the simplest way to make big returns in an enormous inflationary boom: owning small and micro cap stocks, especially natural resource stocks. Mind you that is pure speculation. That’s the only caveat we’d add. Can you do it? Yes you can! Is it risky? Yes it is!

What the current rally is NOT is a new bull market rising from the ashes of reasonable valuations and an economic recovery. The boom in government debt issuance is driving investors out of the bond market and into the stock market. The consequences are going to be…not good.

“The government is reinflating the financial bubble,” MIT professor Simon Johnson told the Wall Street Journal this weekend. “The over subsidizing by the government in the financial sector will get us stuck in the same kind of financial bubble that got us into the mess in the first place. Last year, what we saw was a private-sector financial bubble.”

Johnson says this government debt bubble is what directly precedes inflation. “We should look out for inflation as early as the end of the year. The government credit put in the banks makes inflation almost inevitable. It’s a recipe for going to hyper-inflation. Within the next one-to-two years, the government will have to cut back to prevent it from happening…Reality will hit roughly in the next two to five years. What we should watch is the interest rate of 10-year Treasury note. When it approaches 5%, the strategy is in trouble.”

Do you think the government is going to cut back its borrowing?

Meanwhile, 5% on the ten-year note may get here even sooner than Johnson reckons. On Friday, the U.S. Treasury endured what fixed income trader Mary Anne Hurley called a “horrible bond auction.” Uncle Sam’s debt dealer was trying to hawk US$18 billion in 30-year bonds. The auction did not go well, and yields on the 30-year climbed to over 4.25%.

What does it mean for Australia? Well, yields on ten-year Aussie government notes are back over 5%, according to data from Bloomberg. On Friday Bloomberg wrote that, “Australian government bonds fell four days this week with the yield on 10-year notes rising 29 basis points, or 0.29 percentage point, to 4.96 percent.” At the start of the trading week, yields had climbed even higher.

Obviously investors don’t like the idea that Aussie government debt could rise to 15% of GDP by 2012, given the government’s budget projections. So bond investors are demanding higher yields to provide credit to profligate borrowers. The IMF reckons that the four biggest government bond issuers will float nearly $4 trillion in new debt this year.

That is a lot of supply for private investors to absorb. And private investors have a clear choice. They can hitch a ride on the market rally or flee to the perceived safety of the government bond market. But if inflation is really on the way as Simon Johnson suggests, you’d expect falling bond prices and rising yields. You’d expect the bond bubble to pop with a resounding thwack.

That means money flows could pump stocks even higher as equities inflate faster than cash depreciates. We wouldn’t exactly call that a recovery from the bubble excesses of the previous fifteen years. But if you’re a trader, then profiting from an inflationary boom means dipping your toe in the speculative end of the resource market. If you’re an investor? More on that tomorrow.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. So I take it we’re all still freakin doomed?

    As for “market investors have a choice” – they have to buy bonds or invest in stocks… or else what? I know that an obvious third answer is “gold!” (I can already hear gold traders’ hands rubbing together greedily), but here’s the thing – a lot of people don’t want to make bucket loads of cash at high risk on a mysterious market upswing – they want to protect their wealth from inflation. Simply protect it, without buying into a substance (gold) which may or _may not_ be worth anything close to its current value in the future, a thing which generates no income, has no functional use apart from in electronic devices and jewellery, etc.

    In a way it makes me think that for the time being cash is good, real estate is bad (for now), but come inflation time, commercial real estate will be looking extremely cheap and the housing market will gradually approach a sweet point. For people who managed to get out of stocks (and houses) in time and are still dizzy from being so close to the cliff edge (without falling over it), another Ponzi style rally in stocks is not particularly appetizing. Thoughts?

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  2. Cash I reckon is highly under-rated. You can still get some pretty good rates with cash and if inflation picks up rates will head up anyway. It will not make a person rich but it is unlikely to wipe them out either. I would guess there are many thousands of people who would have been better off with more of their investment portfolios in cash, but you know having money in the bank just does not generate those nice trailing commissions so you can guess why some people talk it down a lot.

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  3. Interesting. “For people who managed to get out of stocks (and houses) in time and are still dizzy from being so close to the cliff edge (without falling over it), another Ponzi style rally in stocks is not particularly appetizing. Thoughts?”

    There is actually another group of new investors/humans out there. There are those who over the last few years decided that housing was over inflated and that the market was off its rocker and quietly kept putting cash in the bank.I must say we are a nasty little group that has been urging the sky to fall and bargains to hit the market for some time now. (Makes you VERY unpopular at dinner parties)

    But now, the property market has been propped up and the inflation genie seems to be let out of the bottle – freakin great! Just when you thought the fire sale to end all fire sales was finally here…

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  4. I really enjoyed that article – a good read.

    Haha love your comments Dan. I guess all that money floating around will find its way into all sorts of things…if not bonds then stocks…if not stocks into banks…if not banks into…gold?

    I agree that Real Estate looks dismal. Anyone wanting to actually ‘earn’ money would be wise to stay away from that for the next few years.

    Although picking up some sweet commercial real estate when a recovery actually starts would be amazing fortune. Just unlikely anyone will have the cash for it.

    Had to laugh at your last comment Ren. However I think you shouldn’t stress too much just yet. People who have a decent amount of actual cash in this current environment have more power than ever. Even if you take a small inflationary hit (after interest) on your cash, you still have cash. That is something that a large proportion of home buyers will not have.

    The only real question for you would be – how much inflation is likely? And will cash interest rates offset it for you?

    Not being one to tout Real Estate as an inflation hedge or terribly effective wealth preserver, I am still pro-gold. But if Real Estate is where you want to be, then if you are in this same position within a year I think you will be one of the minorities – those who can buy, when no-one else can.

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  5. Pete: That just about matches my timing. In a bout a year (perhaps slightly longer now because of the FHBG) I’m guessing real estate will be OK if you can buy it without debt.

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  6. I must say the property market will start to worry me if the budget tomorrow props it up any more. It seems the work the RBA did in raising rates last year has been offset by the increased FHBG. When I read about real estate agents reporting a “mini boom” in the sub $500k market then even I start to worry :)

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  7. Cash may well be overrated and that could be why the chinese are doing the counter intuitive and buying both the commodity and the commodity producer’s equity at levels floatinbg on a higher priced consumption clip than what is foreseeably required.

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  8. Ross – apologies for appearing dim (too many beverages last night), but could you please extrapolate on your above comments further.

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  9. Ren, perhaps you could read Dan’s article today on forecast public debt and deficit funding. Monetising causes inflation and in that case you need to find a corner safer than cash and anything else where the bubble hasn’t burst. Anything you buy must have a prospective earning potential or be tradeable while matching or inflating equal or faster than a real world CPI (forget the published b/s basket ones). If you are Chinese you won’t yet wipe your nose with USD bank notes in your reserve but if you thinbk they will be eroding deeply in value you will spend them on something you think will have residual early (like microsoft deciding to borrow to buy back their shares – but like Dan I wouldn’t buy that one).

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