Enzio's Clock

Background

1. The Economic Time® and the  yield curve

At its simplest, the Economic Time influences primarily the short end of the yield curve: that is because our Economic Clock® is based on how Central Banks control (demand pull) inflation.  If there is an excess supply of goods - deflation - they loosen; and if there is an excess demand for goods - inflation - they tighten. Central banks  control only the short end of the yield curve.

Investors  correctly have been scrutinizing this short end of the curve and the consensus is that short- term rates are going to stay low for a long time. The market believes that they will stay low through 2010; my own conjecture, based on past cycles, is that Fed Funds actually will stay low until 2011.

That's the easy part.  But what happens to long-term rates during the course of the economic cycle, over the Economic Time?

Whenever there is an excess supply of goods, the government loosens monetarily and it stimulates fiscally: it spends more money.  But yields stay low because there is an excess supply of money: governments can borrow without this driving-up long term interest rates. Nobody is competing for capital, so there is no "crowding-out".

Readers know that we believe in a recovery in "L", i.e. in a jobless recovery that will keep the economy on its back for a long time. So this suggests that despite more government spending next year, long rates stay low. All of which results in a slightly upward-sloping yield curve.

 

2. Where the action is

The only problem with this purist view is that I am assuming that the government has no debt, i.e. that when it borrows, its creditors can assume smooth repayment.

We all know that this is not the case in the G3. That is why their bonds' yields have been rising since early October. (Indeed, in America, we read that nine states now have the Californian disease of budget deficits. So these state governments have to raise taxes and cut spending. But because these nine states account for about one third of American GDP, their domestic deficits further impede a U.S. recovery of her Economic Time.)

Indeed, what is happening is that people either are getting scared of

• inflation rearing its head,
  
• the government having to borrow more money, or
  
• the government not being able to repay its borrowings. 

The latter two scenarios will become 2010's realities. The discounting of these realizations very well could trigger a market crash by year-end, the reason being that the market (finally) decides that

• the Economic Time has to stay in a funk for a long time, and,thus, that 
• profits will disappoint, and that
  
• budget deficits have to rise

The implication for the yield curve, then, has to be that it steepens, but for "bad" reasons: 

• when the government issues record amounts of debt next year, it has to increase the price, ie the coupon, in order to attract (warier) buyers, and
• leery buyers stop focusing on that old mule, inflation, and understand that their "store of value" can be destroyed by something far more pernicious than rising prices: bankruptcy, or the threat thereof.  You see this with junk bonds time and time again.

Next to higher bond yields, another interesting implication is that even when dollar yields rise, the dollar's exchange rate  won't necessarily: if people start disbelieving the dollar's function as a store of value, then you could have higher dollar rates AND a weaker dollar. Look at what happened to the Italian Lira before the ECU came along!

3. How to Make Money Off This Idea

1. Always consult your financial adviser first.
2. If you feel like shorting the U.S. long bond, have a look at the ETF, TBT:US.  For the sake of transparency: I own this instrument.