Is Real Deflation Friendly to Bonds?

The change it had to come
We knew it all along
We were liberated from the fall, that's all
--The Who

In our current fiat money system, the primary source of new money is credit creation. Central banks lend money to big banks and others privy to the central bank window. Those entities turn around and lend to other banks who then lend to other borrowers.

When risk appetite is high, original credit money can pyramid 10x or more thru the system.

Problems arise when lenders (beyond central banks, of course, since CB's assume no risk given the printing presses at their sides) don't want to lend and/or borrowers don't want to borrow. Risk aversion slows fiat money creation to a crawl--and could even cause money supply to decline if loans are paid back or defaulted on.

This is ebb and flow provides fodder for credit/money cycle theory--which is really a theory of business cycle boom/bust. The ramifications that this cycle has on stocks and bonds seems clear to me but misconstrued by other. But perhaps I am mistaken.

Here is my conceptualization and assessment of supporting empirical evidence:

Inflation phase (credit money expands). Stock prices go up as borrowers buy equities with some of their credit money. But bond prices also rise. While conventional wisdom posits that bonds fall during inflation, it does not jibe with theory or evidence. Large numbers of risk seekers, particularly banks, who obtain low cost funds from central banks, will use those borrowed funds to buy bonds that yield more than the cost of borrowing from banks (central or otherwise). As long as a positive spread is perceived, bonds are likely to be well bid as borrowers engage in classic carry trades.

This is precisely what we saw in the 1980-2000 period of massive credit money creation. The greatest bull market in the history of stocks. And the greatest bull market in the history of bonds.

Transition phase (credit money flatlines). When risk appetite starts to wane, it is first likely that those borrowers who purchased assets deemed as relatively risky (e.g., stocks, real estate) will first move down the risk spectrum into the perceived 'safety' of bonds. Borrowers will not close out their debt projects. Instead, they will initially seek to temper their risk profile. As such, stock prices will be under pressure during this period, while bond prices will continue marching higher.

This is what we have been seeing from 2000-present. Stocks have been sideways/lower. Houses are lower. Investment grade bonds (Treasuries, high grade corporates), have been well bid. In fact, long bonds recently touched all time highs.

Deflation phase (credit money declines). When risk appetite turns negative in earnest, carry traders will no longer pursue spreads of any size--spreads which btw have been narrowing as bonds were being bid higher during the previous transition phase. When deep risk aversion sets in, stocks and bonds will both be sold as investors shun all risk. Borrowers pay back or default on loans. Little new borrowing occurs. Money supply contracts in earnest.

While this has yet to occur in earnest in the US during the present cycle, it is happening in Europe. After decades-long inflation, European countries are drowning in debt, and credit markets are shutting down. Policymakers are trying to extend the transitionary phase that has been tracing out since 2008 or so, but interventions are providing temporary respites at best. Moreover, the marginal effectiveness of successive interventions appears to be decreasing.

For those countries at the leading edge of the tide (e.g., Greece, Ireland, Spain, Italy), we are seeing stocks and bonds both slaughtered. Credit money is contracting, and risk assets are getting sold.

From where I sit, the US is still in the transition phase. During this phase, bonds have been a good place to be. But, in my view, many pundits are confusing this transition phase with the deflation phase. They are advising positions in bonds as an antidote to deflation.

But deflation has yet to arrive (check out charts of total money/credit supply if you need proof). If/when deflation materializes in earnest, those who view bonds as a safe haven may be in for the surprise of their lives.

As I see it, the one 'out' that policymakers may elect to avoid outright deflation is to take the monetary system off a credit money basis and put it on a pure printed money basis. If policymakers indeed elect this approach, then they might circumvent the problems of risk aversion that impair credit creation during deflation. Essentially, this approach involves sending money directly to people in boxes--or in today's world, sending people checks.

Imagine those 'stimulus checks' done by recent administrations. These checks would be larger, of course, and more frequent.

I must say that I am factoring this 'nuclear option' increasingly into my probability spectrum. Should this occur, then we would be in the world of Zimbabwe, Argentina, and Weimar. It would also be the world of gold blasting off toward Pluto.

position in SPX, BOND, gold