I just want to highlight something that I discussed recently when talking about monetary policy. Recently, I wrote about why ‘Permanent Zero’ is toxic and leads to depression, saying that low nominal rates that fail to spur a sustained recovery are toxic due to declining interest rate expectations flattening the yield curve and robbing savers of yield.
PIMCO, the world’s largest bond fund call this suppression of yields financial repression because it means savers and bond investors get negative real returns. However, John Hempton pointed out that in Japan, where this monetary policy is well-advanced, deflation has set in and real yields are positive despite the zero-rate interest policy (ZIRP).
So it is telling that US real 10 year yields a record 225bpt discount to JGBs as Andy Lees of UBS proclaimed today:
The attached chart, highlighted in the daily, shows the differential between real US 10 year Treasury yields and real Japanese 10 year JGB’s. As you can see it is a record 225bpts at the moment. Something has to give; either the currency, economic policy or the state of the economy. Clearly the end of QE2 points to this being resolved through a massive deflationary burst. If not it will be through policy of the US entering monetisation 3. (Let’s not kid ourselves that the Fed is going to shrink its balance sheet. The only way it would is if its own assets collapsed in value!)
If we look back 1997 was an even bigger extreme, but that time it was real Japanese yields being at a discount to US. That resulted in the Tigers bubble and the resultant Asian burst as these massive capital distortions unwound.
The question is when? That’s a cash flow situation in my mind. Unfortunately M2 is being distorted at the moment with the end of regulation Q but www.shadowstats.com data shows M3 growth starting to slow again. The funding of the US deficit will become increasingly difficult, or rather it will suck money from other assets causing the European debt crisis to blow up again etc etc. Having thought Jackson Hole would be when monetisation 3 is announced, that now looks increasingly unlikely with people saying the dissent within the Fed is now looking as bad as within the government. Everything is increasingly pointing to a big deflationary burst.
