The Bondfire
I am sure some of you have enjoyed the great Netflix series “The Gentlemen”. If not, I would highly recommend watching this Guy Ritchie-directed epic.
The 8-episode features the rather poignant and memorable phrase "non sine periculo," which translates to "not without danger." This Latin expression captures the inherent risks and consequences of the character's actions and decisions, often underlining the precarious balance they must maintain to navigate their complex world. I would argue that this concept extends beyond fiction into the very real dynamics of political, fiscal and monetary policies over time. Everything has its price, and there is no free lunch. If you belong to the camp thinking that ever-expanding fiscal deficits will just make everyone better off, think again. History should act as a guide.
Modern fiscal and monetary policies are not without their own dangers. Governments and central banks worldwide engage in various strategies to manage economies, such as adjusting interest rates, implementing quantitative easing, and undertaking significant public spending. These actions are aimed at stabilizing economies, fostering growth, and preventing recessions. However, the underlying risks of these policies are often overlooked or underestimated.
Central banks, particularly the Federal Reserve, have employed unprecedented measures to stimulate economies, especially in the wake of the 2008 financial crisis and the economic disruptions caused by the COVID-19 pandemic.
One of the most significant risks in the current economic landscape is the potential unravelling of the bond market. Bond vigilantes are getting louder again, eyeing up government bonds, which are traditionally considered safe investments. They have become a focal point of monetary policy. Whether the mini-gilt crisis provided by the short-lived leadership of the UK’s Truss government or more pronounced bond sell-offs in emerging markets came as a stark lesson, the bond market will hold our fiscal and monetary leaders equally responsible.
Now, there have been attempts to call the end of bonds. Take Japan, for example, where people were calling for JGBs to be the fly that is looking to hit the windscreen of a fast-approaching car. They all sunk a big hole in their PnLs. Why? Because Japan’s bond market is pretty much owned and financially suppressed by the BoJ. Needless to say, however, what would a scenario of a severe bond market tantrum do to the financial system as a whole?
The consequences of such an event would be dire. The sharp increase in bond yields would lead to higher borrowing costs for governments, businesses, and consumers. This could result in a cascade of defaults on debt obligations as entities struggle to meet their nominal commitments. The interconnectedness of global financial markets means that the fallout would not be contained within one country or region but would have widespread ramifications.
To understand the potential gravity of the current situation, we can look to historical precedents, such as those detailed in Adam Fergusson's "When Money Dies." This book chronicles the hyperinflation in Weimar, Germany, in the early 1920s, a period marked by the collapse of the German mark and the devastation of the economy. Fergusson's account highlights how the unchecked printing of money to meet government obligations and stimulate the economy can lead to catastrophic inflationary spirals.
Fergusson writes, "The mark was becoming more and more a scrap of paper. Its depreciation was evident to everyone, yet the government’s principal concern was how to pay its way in the short term." This short-term thinking, driven by the need to fulfil nominal obligations, ultimately led to the destruction of the currency. The parallels to today's policies are striking, as central banks continue to print money to sustain economic activity, often ignoring the long-term consequences.
This is an excursion into the possibilities of the time when government liabilities, including its money and money-like instruments such as bonds, will face their moment of truth. Ironically, those events were closer to the low and negative-yielding world we found ourselves in not too long ago.
I will especially dive into the somewhat silly arguments hyper inflationists make when comparing our Western fiat system to the fall of the Weimar Republic or Zimbabwe. Further, we shall look through historical examples where the combination of powerful monetary and fiscal policy coordination helped get us out of the zero money trap, similar to what we are still seeing post-Covid. To end, I am posting one of my favourite strategists’ 2016 essays, which encapsulates the dangers of overindebtedness and monetary experiments all too well. The future he describes might not be far away.
Let’s dive straight in.