Maybe the yield curve/outright bond yields are anticipating the flipside of rampant credit expansion, a deflationary credit crunch?

Great article Stefan. I have one question. I was having difficulty understanding this paragraph:

The high level of business profits around the world suggests that part of the explanation is that many companies have been unusually reluctant to invest , something which will other things being equal lower interest rates.

What I first thought that you meant was that businesses were reluctant to invest out of their own cash from retained earnings, so they were holding the cash on their balance sheets. Now I think that what you must have meant was that businesses are relucatant to borrow on the bond market and invest. Doesn’t this statement need to be qualified to refer to borrowing? Also, why would business borrow to invest when they had a lot of cash?

I don’t see how investors would be all hyped up about a 20% return over 10 years. That kind of return barely keeps pace with inflation. Then again, everything is distorted by central bank tinkering and fiat toilet paper money.

Robert->”What I first thought that you meant was that businesses were reluctant to invest out of their own cash from retained earnings, so they were holding the cash on their balance sheets. Now I think that what you must have meant was that businesses are relucatant to borrow on the bond market and invest.”

Actually, it means both. What I meant was that corporations have in the aggregate strengthened their balance sheets and had unusually high level of financial savings. This means that the number of corporations paying of debts with retained earnings are relatively large compared to the number of corporations which are borrowing to invest.

This is what The Economist called “The corporate savings glut” in its latest issue.

There is a rationale for buying long term T bonds despite historically low yields. This is the risk of unplanned deflation.

Deflation occurs if the money supply contracts. Since the Fed exists only to inflate, a monetary contraction could occur only in response to events that forced individuals and firms to reduce their borrowing, thereby contracting the money supply. What might precipitate such a series of events? A contraction in what Frank Shostak terms “the pool of real funding”–a phrase that describes real savings, or the goods that people consume while awaiting the completion of the period of production.

In a free market economy, the real pool of funding naturally increases as people save for the future, and as their investments in capital yield income that may partly be reinvested in still more capital. As long as the real pool of funding is on the rise, capital accumulation and economic progress are the norm.

However, when government massively and coercively intervenes in the economy through heavy taxation and regulation, and most especially through rampant money “printing”, at some point the scales may tip away from the accumulation of capital toward its decumulation, or capital consumption. The abnormally low interest rates in Japan over the last 12 or 13 years, and the quite low rates in the USA and Europe over the last 4 years, encourage profligate borrowing for speculation, ramp up consumption, and waste scarce and precious real capital on various investment white elephants, from McMansions to internet sand castles to malinvestments in financial derivatives. Moreover, the low interest rates that result from central bank money pumping greatly retard the further accumulation of savings by depressing the annual returns from existing savings from which additional savings are ordinarily set aside.

Are Americans eating their seed corn these days? Probably they are, and in fact they appear to have been sliding toward capital consumption for the last twenty years. Since the creation of jobs and the payment of wages come directly from accumulated capital, the fact that this economic recovery features job creation at roughly one-half the “average” rate of previous expansions is a sign that the capital fund is in decline. Moreover, real wage rates have been falling slightly for 10 months in the US. In addition, this trend is long running: the economic recovery of 1991-1994 earned the moniker of the “jobless recovery” for obvious reasons, a label that fearful Fed watchers and fretful Wall Street economists are unlikely to attach to our present uncertain circumstances. Finally, I recently read that the percentage of national income attributed to profits is the highest, and the percentage attributed to wages and salaries the lowest, in (as I recall) 24 years.

If the real pool of funding is contracting today in the US (and Europe?), then rising scarcity pushes up time preferences. For those who have difficulty making car, house and credit card payments, making provision for the future is impossible. As such difficulties spread, the saving rate falls as it has in the US since November, 1981 from roughly 8% to a little over zero today.

Rising time preferences raise the average rate of profit in the economy, in spite of the Fed’s frantic attemtps to lower the profit rate by depressing interest rates. As profit rates rise, goods that are more durable, including especially capital goods, must command higher selling prices to adequately compensate producers. But higher capital-durable goods pricing collides with rising time preferences which inspire MORE spending on consumer goods and LESS spending on capital goods. In summary, when the real pool of funding contracts, investment in capital goods declines just as we’ve seen over the last few years. Old line industries that were solidly profitable for years suddenly find that demand for their producer-good products has shriveled, along with their profit margins. Thus, Fed money printing doesn’t fuel a boom in productive capacity, as it used to do; rather it inspires speculation and dramatically rising prices in stocks and real estate, which most people (including many economists) naively believe is solid evidence of a growing economy.

However, if the real pool of funding and the capital base are contracting, then the structure of production in the US will necessarily shorten, as increasingly scarce and costly producer goods make established, once profitable enterprises flow red ink. Vanishing profits force businesses and individuals to default on some debt and avoid the creation of new, additional debt. Despite frantic attempts by the Federal Reserve to “grow” the economy by monetary alchemy, rock bottom interest rates only accelerate the consumption of capital. The result is a contraction in bank balance sheets and the liklihood of monetary deflation.

Under this scenario, long term T bond rates would probably fall to 1% or so. That’s where I think they are headed over the next few years.