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Deflation and Bond Bubbles - Outside View by Nitin Gregory
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Deflation and Bond Bubbles
Nov 3, 2016

Developed nations today are struggling through a period of low to no growth. The reasons are deleveraging and demographics. The average consumer is saddled with large debts and is looking to pay them off. Meanwhile, the number of retirees continues to increase. This means a lower outlook for growth. This low growth scenario is one of the reasons for all the scrutiny we see over interest rates.

Is My Capital That Cheap?

Today, we are in a low - and in some cases, negative - rate environment. This implies that people are ready to provide their capital at cheap rates. My view on the price of capital is here.

An alternate view is that the 'equilibrium rate' is now permanently lower because the demographics have changed. More retirees mean lower capital requirements. You don't need as many computers and machines if there are no employees to man them. This means more savings and less demand for capital.

But - what about capital for innovation? Does this mean there is no capital requirement for productivity improvements? We have discussed how total factor productivity can be a key driver of growth. You might have a great new idea for a robot that can take care of the elderly, but it needs a lot of research and development (capital). What about increased consumption from retirees? People out of the job market usually end up consuming savings - this means further spending with no output. This has the tendency to drive inflation

The current demand for capital is low because artificially low interest rates have clouded the environment.

Inflation or Deflation

The debate continues. Inflation bugs (including me) have been proven wrong. All the new money in the system did not create inflation. Large scale fiscal stimulus is one way to bring about inflation. The current sovereign debt levels are preventing governments from continued large scale stimulus.

Does this mean deflation is possible? We've already seen decades of deflation driven by productivity improvements - e.g. robots and a globalised workforce. These deflationary forces will be even more prominent in a low growth/inflation scenario. (More on this soon)

Short-Term Bubbles

Central banks are setting low interest rates. There is a prolonged outlook for low growth and a strong case for a deflationary spell. The similarities to Japan are many. Does this mean another 2007-style bubble is off the table?

Bubbles are usually associated with the go-go years of spiking demand and inflation. However, disconnects between price and value can take place in a deflationary environment too. I have been writing about the elevated bond markets. Some of the typical dimensions of a bubble are high prices, low risk aversion, and a belief that this can go on forever. The perception of low risk drives investors to higher yields.

When we look at the 'junk' bond market, we see very high prices. This section of the bond market has run up nearly 15%. The difference between treasury yields and junk yields has dropped to historic lows. This means the risk premium is very low.

Howard Marks talks about the 'pendulum of price'. When the pendulum swings towards higher prices, negative outcomes become more likely. Risk and uncertainty are high. But it is at this point that investor perception of risk drops. Nothing can go wrong, they think, so prices keep climbing.

Then, one day, the pendulum pauses and starts to swing back. This flight to safety can result from a unexpected yet probable trigger - say, corporate defaults. This could then cause a panic and an outflow of funds from the junk bond market. This would result in high interest rates for many poor-quality companies. The spillover to the rest of the economy could be catastrophic...

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

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