Expert Commentary

Deflation Expectations Rising

Government bonds are benefitting from a flight-to-safety. But their days are numbered.

Global capital markets have started to fall apart over the past few weeks. Junk bonds have crashed, leveraged loans have imploded and the bubble in BBB-rated investment grade bonds is deflating. It seems that, all of a sudden, confidence has evaporated.

Of course, EWI has been warning subscribers of this impending danger for many months. Followers of our Bond Market Monitor will know that the measured trend of the Global Aggregate Credit index yield spread has been up (indicating underperformance) since April 2018. In that time, the spread has advanced from 97 basis points to 142 basis points (a 46% movement of underperformance.) That trend has accelerated since October.

This loss of confidence in credit markets has prompted a flight-to-quality into government bonds. Due to a government's control of the currency printing presses, its bonds, issued in its own currency, are considered to be "risk-free." Err...right. In the real world, of course, governments can and do default on debt, even in their own currency (Argentina anybody?) Nevertheless, "high-quality" government bonds are considered to be default-free.

Thus, U.S., German and Japanese government bond yields have all declined significantly in recent weeks. However, our Elliott wave analysis suggests that, once this decline is over, the trend towards higher yields should resume in the U.S. and Japan. In Germany, this decline in yield is probably the final wave down of a multi-decade trend. Once it is complete, a significant up-move should occur.

Some people ask us why we expect bond yields to rise as U.S. and European stock markets drop. The answer is that we don't cloud our judgement with correlation bias, because correlations wax and wane. We analyze each market on its own merit and let the correlations fall out of that. It's perfectly normal, of course, for credit yields to rise as stock markets fall. What's especially interesting about this cycle, though, is that our wave analysis anticipates rising government bond yields along with declines in equity markets. What does that tell us? Well, one explanation could be that this negative trend in social mood will be so intense that confidence will not only be lost in the private sector, but also in the public sector. We would not be surprised to see a number of governments (societies indeed) collapse.

This negative trend in mood is highlighted by the chart of "inflation" expectations for the G7 economies. Turn this chart upside down and the collapse since October is an indication that deflation expectations are rising across the globe.

190103 - Deflation