Posted by: Ravi Saraogi | August 7, 2011

The Spooky Times

Friday (5 August) was an eventful day. One that has provoked me enough to write. So here goes….

First and foremost, a quick update on the horror unfolding before us.

Lets look at the US 10 year government bond yields and the S&P500 index,

US 10 year bond yield (Blue) vs S&P 500 Index (Red)

Quickly recall (refer previous post) the story behind the curves. Fear of a double dip in the US pushed the bond yields down in Q32010. Faced with a slowing economy, investors switched money from risky assets (like equities) to bonds, driving up bond prices and lowering yields (price and yield is inversely related). In a desperate attempt to shore up the markets, Ben Bernanke announced the second round of quantitative easing (QE2) in November 2010. Bond yields hardened on the prospects of the monetary stimulus giving a boost to the US economy. Investors were shifting from bonds to risky assets to ride the wave of economic optimism. Bond prices fell (driving yields higher) and the S&P500 equity index soared.

Now, everything seems to be falling apart. Look at the S&P500 index over the past 10 days,

S&P 500 Index

After a 2.56 per cent fall on 2 August, it crashed by 4.78 per cent on 4 August. To put it in perspective, this was the worst day on Wall Street since December 2008 (the peak of the sub prime crisis). The US 10 year yields had a similar story to tell,

US 10 year Government bond yield

The mad rush into bonds has pushed down the yields by over 50bps in the past one month. Such is the frenzy to exit risky assets and park money in bonds and bank deposits, that Bank of New York Mellon is now going to charge large clients for keeping their deposits. Put another way, the bank is offering a negative interest rate. Really absurd? I thought so too. But it makes perfectly good sense. The bank has been receiving huge cash piles from its institutional clients afraid to deploy their holding given the rise in uncertainty. The bank cannot deploy these deposits for giving loans as they can be withdrawn anytime. For the same reason, it cannot invest them in long term bonds which offer a positive rate of interest. The only option is to churn these deposits in very short term debt instruments, which offer (no prizes for guessing) zero yield. (The intraday yield on 1 month US government bond turned negative on 4 August. Read here)

Near zero yield on 1 month US government bond

So, why the sudden panic? This can be the subject of a new blog post all together. But lets try and summarize the glut of problems.

Look around you. What do you see? Start with the land of the rising sun – Japan. The problem with this economy is that everything apart from the Sun seems to be falling or has been in a state of falling. A stagnating economy for the past 20 years has put the phrase ‘the lost decade’ to shame. Debt to GDP ratio in excess of 200%. Double whammy of an ageing and shrinking population. The glimmer of hope in Japan is its export industry. But with the Yen strengthening like it has, even the export industry is feeling the squeeze. The previous week, when the Yen was threatening to breach its all time against the dollar, the Bank of Japan was left with no option but to intervene in the forex markets to pull the currency down. If the all this wasn’t bad enough, the Tsunami in February caused severe supply side disruptions in the economy. And kindly add the bill of reconstruction to the already inflated government debt. All in all, here is an economy with such deep structural problems that you just tend to wonder – how in earth did the patriotic and hard working Japanese land in this situation?

Japan GDP growth rate

Move over to the sick man of the world – Europe. Well, there is just one word to describe the problem here – PIIGS. Portugal, Ireland, Italy, Greece and Spain. Debt problems in Portugal, Ireland and Greece has already caused quite a furore. Yet, these economies summed up are a minuscule part of the European Union. Spain and Italy, unfortunately, are not a small part of the European Union, and definitely not when summed up.

Greece 10 year bond yields

The Greece 10 year bond yields are at 15%. How will a debt laden economy refinance its debt at those levels? It will send its already strained finances into a complete tailspin. So expect Greece to be perpetually dependent on aid and bail outs. Similar is the story for Portugal and Ireland.

Greece, Portugal and Ireland are oldies in the bail out club. The newest kids on their way to join them are Spain and Italy. Look at the bond yields below and you will see that the debt market is already beginning to frown at Spanish and Italian debt.

Italy 10 year government bond yields - past 3 months

Spain 10 year government bond yield - Last 3 month

Germany and France are the only saving grace in European Union. And hence, the tax payers in these countries will bear the brunt of the bail outs being given to the countries in the periphery. All in all, Europe continues to be ‘the sick man of the world’.

Coming to the US of A, well what can we say. Standard and Poor’s has cut the sacrosanct AAA rating on US government bonds to AA+. The ISM survey for manufacturing is falling. GDP growth is falling below 1 per cent. The S&P 500 is correcting. Bond yields falling. Consumer spending shrunk for the first time in June since the last two years. Household budget is still very leveraged. Housing prices are showing tepid rise if not falling. The political gridlock over the raising of the US debt ceiling ended in a debt deal that speaks volume about the willingness (or unwillingness rather) of US policy makers to address the debt issue. Unemployment refuses to budge below 9 per cent.

The Fed Chief, the hirsute Bernanke, does not believe an economy which runs on paper money can ever deflate. Because as he very succinctly put in 2002, in a system of paper money, it is easy to generate inflation by simply printing money. Any surprise then that we had a QE1 and then a QE2. Yes they help in lifting sentiments, but without any corresponding changes in policy to address structural issues, such monetary stimulus only adds to the glut of dollar sloshing around the global economy.

Below I am quoting Bernanke in his famous 2002 “printing press” speech,

” Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation”.

After reading the above lines, one would not have any difficulty in visualizing Bernanke as below,

Bernanke and his printing press

What Bernanke is basically saying is that the US can never have deflation. Because the moment the economy shows sign of going into a deflationary spiral, the Fed will open the flood gates of its printing press. Imagine what the Chinese must be feeling. They are the single largest foreign holder of US bonds. Rampantly printing dollars will eventually lead to a severe debasement of the US dollar and force the Chinese to book  forex losses on its holding of US treasuries. Not a thing to look forward to when your forex reserves total 1.8 trillion dollars.

If problems in the developed world is not enough, what the emerging markets are going through is equally frightening. But I am so tired that lets just stop here with the solace that the problems in the emerging markets are cyclical and not structural. And in that limited sense, the global economy will start to rely increasingly on emerging markets to deliver growth.

To conclude, I am spooked. And it seems the markets are too. What if all this is just the tip of the iceberg? When all the band aids and short term bailouts and printing money and accumulating more debt is over, and they fail to get markets out of their miseries, where does that leave us? Was the sub prime mess just prelude to a mega crisis in coming? A crisis where the PIIGS default on their debt bringing a sever contraction in Europe. Where the deflationary fears in the US leads the Fed to print so much dollars that they devalue by 50%. Where such a devaluation in the dollar devastates the export industry in China and other emerging markets. Think about what will happen to commodity prices and oil when turmoil in the global economy causes the Chinese economy to slow down. And what those low commodity and oil prices will do to countries like Brazil, Russia, Australia and the middle east.

Spooky times indeed.



  1. where do we stand, the indian markets? how spooked should common man here be?

  2. Nicely done Ravi !

    It seems that there is hardly anything positive to look forward to for the markets.

    Given that inflation is still stubbornly high (and an increasing fiscal deficit), it is improbable that the government will undertake a fiscal stimulus. If the US were to slow down (the chances of which seem high), we could see Crude and Commodity prices falling (and perhaps leading lower inflation in India)

  3. Good Read Ravi..
    Given all this, how the indian markets look? I feel that the Indian market should be able to come up soon. Should we invest at these levels?

  4. The common man does not have much to be spooked, at least in the short term. If anything, slowdown in global growth will lower oil and commodity prices and help the inflation to come down. Already there is news that petrol prices may be cut by Rs. 1.5/litre in the coming weeks. Lower inflation will also allow RBI to cut interest rates. This will lower the burden on car and home EMIs. This is the short term. In the long term however, if the global crisis deepens and causes India to grow below its potential, per capita income growth will decline, affecting all of us.

    For investors, there are two scenarios which can play out. 1) India decouples from the global misery – This is the “growth in short supply” theory. As growth in the developed world stagnates, capital will flow to structurally attractive markets like India, and benefit equity markets. So, in this case, the investors benefit. 2) The global crisis deepens to such an extent that they cause a sell off in emerging markets too. In this case, driven by fear, markets can tank further.

    So, the bottom line, should we invest in Indian markets? I would put my guess that scenario 1 plays out. Indian markets are at attractive valuations. Inflation is peaking, and it will be helped by lower oil and commodity prices; we are also nearing the end of the RBI’s tightening cycle. The only concern I have is that stock specific risk has increased substantially because of opaque government policy making. Apart from that, things are looking fine.

  5. Conditional Credit Easing in the US till Mid 2013 🙂

  6. @ anand… yup.. dont know how much this will help apart from being a sentiment booster.. the problem is not interest rates.. they are already so low.. the challenge is how to get people to invest and create jobs..

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