Saturday, 26 January 2013

Lies and Damned Lies

A slippery slope
It is somewhat shocking that the cost of borrowing for the US has fallen steadily since global financial liberalisation began in earnest in the early 1980s. Despite a few hiccups during periods of boom and credit binges as in the late 1980s, mid 1990s, and mid 2000s.

This graph [thanks to Abnormal Returns] truly does sum up the continual disequilibrium in the global economy. In financial economics, treasury yields have long been considered as the base to measure the all important risk-free rate of return; a rate which determines the riskiness of all others in relative measures to it, as in the standard CAPM framework. Lacking a better alternative in Europe or China, these bonds are still apex predators.

Nevertheless, it is a worrying sign that many investors, though individually concerned over the sustainability of such a system where cheap borrowing sustains intragenerational excess spending, collectively act, from pension funds to SWFs, as if there is an indefinite need to sustain allocation towards low-yielding treasury bills. Assumptions reliant on the supposed future nominal growth of the American economy and the ability of future generations to carry the burden of the current.

What is more concerning is the Fed's sustained asset purchases in the past five years will slowly inflate the US economy in a few years, not reflected in the present due to the negative output gap. If this occurs, the risk premium would be certainly higher than the last period of prolonged and deliberate debt reduction: following WWII in Bretton Woods.