Putting the Deflationary Mindset to the Test

Impact of Rising US Treasury Yields

Authored by Louis-Vincent Gave via Gavekal Research blog, this article explores the effects of rising US treasury yields. Initially, the increase affected the yen, won, euro, and British pound. Now, it appears to be causing havoc among high-value technology stocks. This shift has led to a significant rotation in equity markets, with the Nasdaq falling by over -2%, while the Russell 2000 rose by 1%. This is a change from previous trends, leaving investors wondering what the rise in yields will impact next. Could it be the gold bull market? Or the emerging market boom? Or perhaps the new bull market in industrial metals and energy? Or even economic growth in general?

The Deflationary Mindset

The belief that rising yields will eventually self-correct is a testament to a fundamentally deflationary mindset, a mindset that most investors share due to the world's fundamentally deflationary nature over the last 40 years. This mindset is based on the belief that government bonds remain the ultimate risk-free asset, despite long-dated US treasuries losing half their value in the last four years. This belief is partly based on the ability of governments to tax their citizens to pay off their debts. However, in a world where capital and individuals are increasingly mobile, is the government's ability to tax its citizens limitless?

Testing the Concept

Canada is currently testing this concept by significantly increasing capital gains taxes, which will likely result in a lower actual capital gains tax take than if the increase had not occurred. This is not an isolated incident. In France, tax receipts have risen from about a third of GDP to over half in the last 50 years. Despite taking a larger slice of the economic pie in each cycle, the French government has not run a budget surplus since 1974. As a result, France's debt has grown from about 20% of GDP to 112% today, placing it on the downward slope of the Laffer curve.

US Commercial Real Estate Meltdown

Consider the US commercial real estate meltdown. Office buildings in high-tax states like New York, Los Angeles, and San Francisco are selling for a fraction of their price five years ago. In contrast, low-tax states like Florida and Texas seem to have fewer commercial real estate problems. This suggests that high-tax states may have reached a point where increasing taxes results in citizens and businesses moving to lower-tax jurisdictions.

Future Scenarios

Given the current state of affairs, three possible scenarios emerge. The first scenario involves government spending continuing to outpace tax receipts, leading to larger budget deficits and debt-to-GDP ratios. In this scenario, government bonds may lose their default risk-free asset status to risk assets like gold and equities. The second scenario involves increasing taxes to control budget deficits and stabilize debt-to-GDP ratios, which would restore government bonds as the ultimate risk-free asset. The third scenario involves governments selling assets to control debt-to-GDP ratios, which could cause all asset prices to fall.

Conclusion

Given the current direction of government policies and the migration from high-tax to low-tax states, it seems likely that the coming years will provide an answer to these questions. What do you think about these scenarios? Which one seems the most likely to you? Share your thoughts with your friends and sign up for the Daily Briefing, which is every day at 6pm.