Credit Spreads Expected to Narrow

This Time Is Not Different

The business cycle is alive and well. If you read the blogs and mainstream media you'll see a lot of bearish sentiment about the destruction of the American economy. Certain things won't be exactly like they were, but the interesting thing we see often is those bearish pessimists keep trying to discredit the optimists by pointing out the fallacy of "this time it's different", meaning this bubble isn't going to thrive any more than the last one.

Well, they're right on one count. The bubble won't thrive better than the last. But the one guilty of clinging to a fallacy are the bears. The "this time it's different" fallacy really points back at them. See, the bears are trying to sell us on the idea that "this time" the business cycle isn't going to happen. No sir, this time we've really shot ourselves and the stock market is just going to go right back down until the entire economic system of the world resets.

Well, maybe we exaggerate their point of view a little, but the essence is there. We contend the business cycle is alive and well and the prudent person will plan accordingly.

So how then do we interpret the budget deficits in light of the business cycle? For background on the business cycle of boom and bust one should go dig around at some of our favorite economic sites:

The Mises Institute
The Foundation for Economic Education
Cafe Hayek

Budget Deficits For Fun and Profit

Budget deficits necessitate a rise in interest rates. To attract money to Treasuries, the price has to fall since people will be competing for better returns in riskier assets. A lower price for Treasuries will attract that money to that instrument along some continuum of risk/reward which differs from one person to another. Meanwhile, the supply of Treasuries is going to be growing. To attract buyers then, the market has to push down the price of Treasuries.

On the off chance (slim as it is) that the government can’t attract buyers from the open market, the central bank will have to monetize the debt to prevent failed auctions. Hence, gold would be a good buy against U.S. dollar dilution by the central bank. This is not only true because of the recent past liquidity measures, but even more so for potential future liquidity efforts, if they arise.

Nevertheless, even if there are no more waves of quantitative easing, the last stimulus will be enough to create a wave of price inflation in the next five years. The recent sell-off in gold was simply profit taking and flight to cash on fears of Euro defaults, accentuated by program trading on the momentum and short term hysteria. Now that has subsided, we can get a wave of movement back toward long-term fundamental expectations based on centuries-old historical expectations of the boom-bust business cycle.

The beauty of this setup is that it implies higher risk in Treasuries than historical norms. Higher risk between Treasuries and corporate bonds means the spread between Treasury and corporate will narrow to the extent that businesses still know how to run a sound business. This translates to basic business-cycle fundamentals acting in opposite directions on the two sides of the spread.

Even though Keynes may not have had the big picture well understood when it comes to long term health of the economy, he was not wrong that government deficit spending stimulates demand for goods and services in the marketplace. Demand for goods and services in the marketplace is good for “business”, which translates into improving business credit default risk as cash flows improve for them.

Given then improving business credit default risks with degrading government credit default risk, we have a nice scenario that translates into narrowing credit spreads between so called "risk free" Treasuries and business risk corporates.

We're not trying to sell the value of the business cycle, or suggest it's a good thing. We simply want to point out it is alive and well. The fundamental factors that create it in the first place aren't gone. Names change and leaders switch places, but the same system that brought us all the other booms and bubbles is going to give you another one. We happen to think the global Q/E policies of every modern nation on the planet is going to make this next one a doozie. The good news is you have plenty of time to prepare for the pop and chaos that ensues from the bust.

For a more entertaining perspective, check out the viral video "Fear the Boom and Bust".