With most commentators now of the view that the 35-year secular bull market in government bonds is over and that US yields will rise further, financial markets are reeling, he said.
“This is already apparent with the dollar’s surge and resultant weakness in emerging market currencies, most particularly the renminbi. At some point very soon the bond sell-off will even adversely impact equity markets!”
According to Edwards, while little will happen on the fiscal side in the US over the next 12 months, he expects the price of oil will drive a mechanical pick-up in headline US CPI to between 2.5% and 3%. This should force wage inflation decisively higher, which in turn could persuade Bond vigilantes that the Fed is way behind the tightening curve. Should this occur, he said, the current bond rout could then extend all the way to the long-term trend line.
“A move in US 10y yields to 3¼% is entirely plausible and would still not negate the long-term bullish trend. Indeed in the next recession I still expect 10y yields to ultimately fall to minus 1% as helicopter money is adopted to finance Trump’s double-digit fiscal deficits.”
Another impact of this shift in bond yields will mean that the “fragile, highly indebted US economy will suffer a traditional end of cycle acceleration in consumer prices, and more importantly wages, which the Fed simply cannot ignore.”
And, while he believes it entirely plausible that the Fed’s hand will be forced by the bond market, he said: “Even if the Fed refuses to tighten, monetary conditions will tighten dramatically anyway as bond yields and the dollar surge, exacerbating the profits recession. This very long economic recovery will then suffer a very traditional death.”
I should have seen it coming
Having called an end to his secular bullish call on long-term government bonds a month ago, Edwards admitted that he should have seen the recent rout coming.
“The engine for the surge in bond yields was already in place before Donald Trump’s victory,” he said: “First Japan and then the UK governments strongly intimated that it was time to switch towards a more fiscally active regime…The reason rates are now so low is that one of the biggest credit bubbles in history burst in 2007 while central banks, especially the BoE, were asleep at the wheel. QE has undoubtedly made an (admittedly deteriorating) situation for inequality much worse.”
Howvever, he added, what is unusual about the recent leap in inflation expectations is that it has come in spite of an increase in the price of oil.