Executive Summary

• Expect a bond market bloodbath as rates rise
• Municipal, corporate and sovereign defaults will soon follow
• Liquidity suffers as necessary goods prices rise, but securities prices fall
• The new, nuclear risk of a derivatives market collapse

If you have not yet read Part 1: The Global Credit Market Is Now A Lit Powderkeg available free to all readers, please click here to read it first.

You may remember that what caused then Fed Chairman Paul Volcker to drive interest rates up in the late 1970’s was embedded inflationary expectations on the part of investors and the public at large. Volcker needed to break that inflationary mindset. Once inflationary expectations take hold in any system, they are very hard to reverse.

A huge advantage for Central Bankers being able to “print money” in very large magnitude in the current cycle has been that inflationary expectations have remained subdued. In fact, consumer prices as measured by government statistics (CPI) have been very low in recent years.

When Central Bankers started to print money, many were worried this currency debasement would lead to rampant inflation. Again, that has not happened for a very specific reason. For the heightened levels of inflation to sustainably take hold, wage inflation must be present. I've studied historical inflationary cycles and have not been surprised at outcomes in the current cycle in the least, as in the current cycle, continued labor market pressures have resulted in the lowest wage growth of any cycle in recent memory. But is this about to change at the margin?

The chart below shows us wage growth may be on the cusp of rising to rate of change levels we have not yet seen in the current cycle on the upside. Good for the economy, but not so good for keeping inflationary expectations subdued as has been the case since 2009. And what is most important is expectations change at the margin:

You may be old enough to remember that bond investments suffered meaningfully in the late 1970’s as inflationary pressures rose unabated. Does anyone remember the term “certificates of confiscation?” This was exactly how bonds were characterized in the late 1970’s.

I'm not expecting a replay of that specific environment, but the potential for rising inflationary expectations in a generational low interest rate environment is not a positive for what many consider “safe” bond investments.