Given what’s unfolded in DM bonds over the past week, and considering all the talk about “Japanification” in Europe, you might be wondering if SocGen’s Albert Edwards is feeling emboldened with regard to his famous Ice Age thesis.
Of course Albert isn’t ever really “deterred”, per se, when it comes to that thesis, so maybe “emboldened” isn’t the right word because that would suggest his conviction had waned at some point, which I don’t believe is the case. So, maybe it’s better to just say that, in light of recent events, Edwards is all set to champion the Ice Age thesis anew.
“Ten years since the start of the QE experiment, the Fed has failed in its objective to drive up CPI inflation, merely inflating asset prices instead”, Edwards writes on Thursday, before proclaiming that “the next phase of the Ice Age is unfolding as US (and eurozone) CPI inflation rapidly falls towards zero, and central bank liquidity continues to rotate out of risk assets into the last game in town – government bonds.”
While it might be a stretch to say that US and eurozone inflation are “rapidly falling toward zero”, there’s no question that folks have flooded into DM bonds over the past couple of weeks amid acute fears that global growth is grinding to a halt and as central banks pivot (hard) to the dovish side in an effort to reflate before it’s too late.
Although the bond rally appears to be taking a break on Thursday, Wednesday saw 10-year yields in the US push to their lowest since December 2017 while bund yields fell below 10-year JGB yields, making the Japan comparisons poignant indeed.
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Before diving in, Edwards reminds everyone that while the media habitually castigates him as a “permabear” whose “views can be safely ignored”, context is critical.
We’re going to use a fairly lengthy block quote here that finds Albert rehashing the main tenants of the Ice Age thesis. Although some readers can likely recite this off the top of their heads, given the current environment, a refresher for those not well-versed is probably in order. To wit, from Edwards:
As regular readers will know, my bearishness on equities sits within the context of my Ice Age thesis. I have long used the Japanese experience from 1990 onwards as my template, having watched each successive economic cycle in Japan grind out lower highs and lower lows for inflation and nominal GDP growth until they slid into a sub-zero deflationary hell. When I first framed my Ice Age thesis back in 1996, I envisaged the US and Europe experiencing a Japanese-style secular de-rating of equities, both in absolute terms and, more importantly, relative to government bonds. Meanwhile, bonds would also re-rerate in absolute terms. I believe this Ice Age process will end with US 10y close to minus 1%. My consistent über-bullishness on western government bond markets never seems to attract as much attention as my extreme bearishness on equities. Yet the thesis supporting both is the same. Take a look at the performance of 10y+ world government bonds since the inception of the Ice Age (i.e., from end-1996). A balanced fund following my strategic advice to buy and hold bonds over equities would have only marginally underperformed even at the end the fantastic bull run in equity markets over the last ten years. The contrast in volatility is also striking as is clearly shown in the chart below.
So, there’s that – and again, you can see why this is highly relevant at the current juncture.
That relevance isn’t lost on Albert who on Thursday says that “the recent explosive rally in bond markets and inversion of the US yield curve” may well mean that “the next phase of the Ice Age is arriving.” That, in turn, means you should “prepare for huge market moves.”
Edwards does express a bit of skepticism with regard to what exactly the yield curve is “saying”. That’s by no means to suggest that he doesn’t think you should worry. Rather, he reminds you that while the 3m-10Y has inverted, the 2s10s hasn’t (we’ve talked about this on any number of occasions over the last week) and in any case, history suggests a relatively long lead. Here’s a handy table from Goldman:
(Goldman)
“Many commentators are getting way ahead of themselves in predicting an imminent recession as we have yet to see 10y-2y inversion let alone renewed steepening”, he writes, before noting that all caveats aside, “a recession is still likely”.
Next, Albert delves back into the “shadows” (so to speak), citing his colleague Solomon Tadesse’s work comparing the current Fed tightening cycle to previous cycles in the context of QE’s effect on the shadow rate, which was pushed to ~–3% at one juncture. Here’s Deutsche Bank with a breakdown on that:
Our model suggests that between 2008 and 2015, each $1 trillion expansion of the Fed’s SOMA portfolio helped lower the shadow fed funds rate by 62bp, while a 12-month extension in SOMA’s WAM reduced the shadow rate by another 29bp. Put another way (and generalizing the findings somewhat), the Fed had achieved the equivalent of a 25bp rate cut with every $400bn of asset purchases or with every 10 month of maturity extension for SOMA during QE and Operation Twist.
When you calculate the amount of tightening using that -3% nadir as the baseline, you end up pondering the following chart which shows that, to quote Edwards, “the increase in Fed Funds rate has not been from 0.25% to 2.5% currently but from minus 3.0% to 2.5%, i.e., a much more punchy 5.5 percentage point increase, as shown in the chart below – the green line depicts the end of QE and start of QT.”
(SocGen)
This is something else we’ve spent a ton of time talking about in these pages and the bottom line is that when couched in the terms laid out above, we’ve seen “considerably more aggressive tightening of interest rates than meets the naked eye” – as Albert puts on Thursday.
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The implication – i.e., the reason Edwards cites this in his Thursday note – is that even if the Fed hadn’t slammed it into reverse in January, bonds would have likely rallied hard. He puts it as follows:
With the US economy and equity markets beginning to suffer from a severe dose of indigestion in the wake of this 5½ percentage point hike in rates, no wonder the bond market rallied so hard. It would probably have done so in a few months in any case, even without the Fed’s panic U-turn on interest rate guidance.
After that, Albert proceeds to suggest that a “very sharp” drop in core CPI may be in cards thanks to a plunge in the shelter component.
“Back in the early 1990s, a similar decline in new home inflation saw CPI rent inflation slide from above 4% to 2% (as circled below)”, he writes, on the way to warning that “a similar outcome now would see core CPI move closer to 1% than the current 2%.”
(SocGen)
Needless to say, if Albert is even halfway right about that, it would likely embolden bond bulls even further or, as he puts it, “given the market’s current mood that would be like throwing gasoline onto a government bond market that is already on fire.”
Ultimately, Edwards comes back to a theme we’ve pushed pretty hard here lately, although we would note that we never set out to champion even more unorthodox policies. Rather, it increasingly seems as though the current landscape (where DM central banks have reached the limits of accommodation and populist politics means fiscal largesse is en vogue) makes unorthodoxy inevitable.
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Edwards, citing Russell Napier, writes the following in that regard:
Should the bond investors’ view on deflation be confirmed, it paves the way not for more QE, as the inequality that QE has caused has lost the Fed (and the ECB and BoE) the support of the public and politicians alike. Rather, new policies will be tried, [as] trial balloons have already been floated by the Fed in recent speeches, ready for use in the next recession.
