By Ethan Penner
Since I graduated college nearly 35 years ago the yield on the 10-Year U.S. Treasury bond has declined from near 16% to today’s 2%-2.5% trading range level. This tells an important story. The massive decline in yields on all financial instruments during this period, which I will call a “Financial Supercycle”, and the concurrent expansion of multiples and thus valuations, has led to massive wealth creation which has served to bolster the overall economy by literally infusing trillions of dollars in the form of both found money (gains) and loans (recycled savings). In that same time, the field of finance and investments were red hot, growing dramatically in size and expanding in a multitude of ways, spurred by an abundance of creativity that spawned new ways to borrow and new ways to invest. Innovations that were introduced during this time and had heightened and broadened access to capital include entire financial markets such as the junk bond/high yield bond market, the residential mortgage-backed securities market, the asset-backed securities market, the commercial mortgage-backed securities market, and the various swap and options markets; loan products like those for subprime home borrowers, home equity, and adjustable rate; and many types of structured finance investment products such as ETF’s, REIT’s, CMO’s, CDO’s, hedge funds, and CLO’s. During these 35 years borrowing and investing have both ballooned, as have employment and compensation levels in the finance industry.
That trend, which originated in the U.S. but became global, is now dead. Easy profits will no longer be available to investors as yields either remain historically low or trend higher and thus diminish the value of their financial assets. Employment opportunities as well as compensation levels for the finance sector have long ago peaked, and will continue to be under siege – falling victim to the deadly combination of the low yield environment, technological efficiencies, and the already record high levels of indebtedness that will continue to stymie governmental efforts to stimulate the borrow-and-spend formula that has been employed for so long to produce what has passed for economic vibrancy.
The ramifications of the death of this Supercycle will be many. There will be micro-effects such as the impact that will be felt in the New York area housing market and others like it that have long been dependent upon legions of high-earning financiers and traders. Those effects will harm some, but it will be the macro-effects that we’ll all care a lot more about. Mostly, economic recoveries will likely be tepid at best, weighed down by massive debt burdens and population levels that are disconnected from the realities of gainful employment opportunities. In past times recoveries could be easily manufactured by the Fed – either by managing rates lower or by allowing easier lending policies in the form of increased bank leverage (remember the CDO squared?). Today, with financial assets already at peak prices, debt at historical high levels, and rates about as low as they can go, the Fed doesn’t have too much left in its arsenal.
Deflation is a force that is natural, but in a world filled with debtor nations addicted to borrowing it is a force that is dreaded and one that governments have used all their powers to fend off. However, natural forces are inevitable, and it would not be surprising to me to see deflationary forces appear once again in the coming years, if only for some period. I can imagine tax reform, if it ever passes, giving the economy a boost. However, I cannot imagine that having a longer-term positive impact given the fiscal imbalances which exist and seem politically intractable. The same is true for any boost that might result from governmental infrastructure spending.
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