The recent sell-off in the U.S. government bond market provides an early warning that a crisis of far greater magnitude will befall investors in 2002. More than anything else, the recent severe decline in bond prices and the long-term drop in interest rates proves beyond a doubt that the U.S. economy is undergoing a severe deflation and should sufficiently dispel any argument that inflation will soon rear its head.
The steep decline in March bond futures is only the beginning for what should be a very bad year for bond investors as the cycles and chart patterns all suggest falling prices throughout 2002. But the crashing bond market will influence far more than just bond investors' portfolios; the sell-off in Treasuries represents the beginning of a massive, large-scale repudiation of U.S. government debt that will have an impact on the entire country. Moreover, the collapsing bond market suggests that the very foundation of the U.S. government is cracking and on the verge of imploding from the monstrous weight of its debts.
The long-term decline in U.S. interest rates and the recent drop in bond prices is as instructive as it is premonitory. There is no greater instrument for measuring economic inflation and deflation than the interest rate. Even gold itself for all of its latent qualities and intrinsic value cannot measure deflation and inflation quite so accurately as the interest rate, especially considering gold's tendency to go against the general current during hyper-deflation and explode in value. An extremely low rate of interest essentially proves that deflation has been underway for some time, for it reflects the falling demand for loans in the face of a shrinking money supply.
Properly defined, the interest rate is the cost of borrowing money. But more than that, the rate of interest reflects the demand for borrowing money. A low rate of interest is a product of low demand for borrowing money; a high rate of interest reflects high demand for loans. "But," someone protests, "would not a high interest rate, such as the double-digit rates the U.S. experienced in the late '70s, deter many from contracting debt obligations?" Answer: Not if the rate of inflation keeps ahead of the rate of interest, as it did during the latter half of the 1970s. During the late '70s it was financially prudent to make investments on borrowed money as the money supply was being inflated at a rapid pace and money was easily available. Loans could be paid off with cheap dollars and many fortunes were made during this time of inflation by borrowing money and paying off those loans with debased dollars.
Today an opposite condition exists to that of two decades ago. For now we are the opposite end of the K-wave spectrum where deflationary pressures dominate and the money supply is rapidly drying up. This is shown in overall tendency toward falling prices and interest rates. As the used car salesman must lower prices on automobiles in order to attract buyers in a slow market, so too must banks lower rates of interest in order to "sell" loans to businessmen and consumers. Deflation produces falling prices, rents and rates, and this is a phenomenon that we must get accustomed to in the months and years ahead. To get a true sense of the extent of inflation or deflation in a broad economy we must repair to the bond market and survey the going rates of interest on debts. Consider the following current rates on U.S. Treasuries: 3-month, 1.6%; 6-month, 1.71%; 2-year, 3.06%; 5-year, 4.34%; 10-year, 5.04%; 30-year, 5.48%. When was the last time you saw interest rates this low? These rates positively scream "Deflation!"
One prominent financial analyst has suggested that the coming years of severe deflation will produce extremely high interest rates on most government bonds. To argue this, however, would completely nullify any claim that deflation could exist, for as we have already established, a very low rate of interest can only occur in an economy where the money supply is shrinking (viz., deflation) and where the demand for taking on debt obligations is correspondingly low. After all, even with attractively low rates of interest, who would be foolish enough to go into debt at a time of general depression when the odds of being able to repay the principle on the loan are low.
Some point out that the past four years have been times of unprecedented inflation with respect to credit, and this is true. There is a distinction, of course, between money and credit and while the general money supply has been contracting on a rate of change basis for several years, the availability of consumer credit in recent years has virtually exploded. This accounts for the "abnormally high" interest rates on credit cards in recent years. While the bank rate of interest has fluctuated in the low single digits in the past four years, interest rates on most bank credit card has been as high as 18%! Some have suggested that this is a form of usury on the part of banks issuing the cards, and while this may be true in some respects, it reflects more than anything else the vociferous demand for consumer credit in recent years. In short, the high interest rate on credit cards has been a response to high demand and not, as some suppose, a purely arbitrary number concocted in the minds of the bankers issuing the loans. But even rates on credit cards are rapidly falling as consumers lose interest in borrowing money and are intent on trying to get out of debt. Banks seem to be bending over backwards with appeals to suddenly debt-conscious consumers to resume the frenzied installment buying of the late 1990s. But as we shall see, those heady days of unlimited installment buying are forever over. One observer has made the following comments, which summarize very well the current thinking on Wall Street concerning the bond market, "Treasury bond futures just had one of the biggest one-month collapses in United States history. Bonds should be going up when rates drop, not down. That could be major foreign selling of all U.S. Dollar-denominated assets but whatever it is, it is not good for stock prices. If bonds must be liquidated at any price then stocks will be next." This comment underscores a common belief within the financial community that there is a inverse correlation, or a "coupling," between bond prices and inflation rates. But in reality no such correlation exists, only a seeming one.
There is nothing quite so fearful as a bond market collapse because of what it implies. As fearful a specter as a crashing stock market presents, it simply does not compare with the utter ruin brought about by a debt market implosion. When stock prices collapse, as they did in the early 1930s, there is always the hope that the country will survive the ensuing business depression and emerge prosperous once again in time, provided that the government remains sound. But when a country's bonds collapse it means the government itself is unsound and bond holders no longer view with trust and confidence the government's guarantee to pay back their principal with interest. A bond market sell-off is essentially a repudiation of a Government's debt by the debt holders themselves.
Gold will perform extraordinarily well in the deflationary years ahead. In fact, even as stocks, bonds, currencies and most commodities are falling victim to deflation, gold will be practically the sole beneficiary of runaway deflation as gold prices will begin to take off this year. Gold will soar as we near the K-wave deflationary bottom in the middle of the decade. Franklin Sanders of "The Moneychanger" newsletter correctly points out that "Gold and Silver are not commodities like all other commodities. They are money by their nature. However vociferously tyrants and inflationists may scream that gold and silver have been "officially demonetized," their monetary essence remains." He goes on to point out the discoveries made by Roy Jastram in his books "The Gold Constant" and "Silver the Restless Metal" that gold and silver both tend to appreciate in value during times of extreme deflation much more so than in times of extreme inflation. For instance, Jastram demonstrates that in Great Britain at various times over a 200-year period between 1658-1933, when times of economic deflation prevailed, the purchasing power of gold rose by an average of 94.2%. During the deflation of 1920-1933, the purchasing power of gold rose by an astonishing 251%. During the present unprecedented deflation gold should perform even more admirably. For at no other time in U.S. history has a 55-year K-Wave peaked along with a 120-year economic "Master Cycle," thus falling hard simultaneously in the later portion of the present decade.
The ideal financial safe haven this time around, far from being the bond market, is the yellow metal.
January 1, 2002
Clif Droke is the editor of the weekly Bear Market Report, a combined forecast and analysis of U.S. stocks and indices and international precious metals stocks, and is the author of numerous books on trading and technical analysis (most recently Gann Simplified, published by Traders Library). For a FREE COPY of the Bear Market Report send e-mail to: firstname.lastname@example.org or write: The Bear Market Report, Clif Droke, P.O. Box 3401, Topsail Beach, N.C. 28445-9831.