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Peter Osterlund
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Peter Osterlund runs a private equity fund in Boston, Massachusetts. He studied mathematics and economics at The University of Chicago and has written about politics and the economy for such publications as The Economist, The Wall Street Journal, and Rolling Stone.
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  • What Price Armageddon? 0 comments
    May 21, 2012 10:16 PM | about stocks: TBT, FXE

    There's a saving grace in writing when no one's heard of you: You can make a fool of yourself and no one cares. Sometimes,one's obscurity can be one's salvation.

    Take last week. Please. While smart money was trampling over dumb money in a pell-mell dash out of the stock market, PO: was writing rally-time stuff like this. And this. And this.

    And writing such bull-ish...ness while equities were doing--how might one best describe it?--this:

    So. What happened? Was PO: delusional? Drinking? Or a bit early?

    Answer: Not drinking, possibly delusional, definitely early. But in the grander scheme, the question is irrelevant. Because last week, something big happened: The financial markets began to price in doomsday.

    Right about the time PO: shared awkwardly-timed predictions about the market's imminent rally, something strange happened in the Treasury bond markets. Money flowed into them, madly. Not foreign money, but domestic money. "Flight to safety" scared money. Huge sums from people--and institutions--who were very worried that something Very Bad was about to happen.

    THE BONDVILLE HORROR

    Have we seen this before? Yes, we've seen big money scramble for the perceived safety of U.S. Treasury bonds in times of trouble. Yes, we've seen yields on Treasury bonds plummet as investor demand for the notes drove up their price.

    But, no, we have not seen demand for U.S. Treasuries spike like they did last week despite the weakness of the dollar. More precisely, we have not seen that particular dynamic since dawn of The Great Financial Crisis of 2007-20xx?, when the Federal Reserve launched a money-minting strategy to keep the dollar weak, interest rates low, and the economy from a civilization-wrecking depression.

    And, no, we have never seen bond yields go as low as they did last week. Yields driven down to historic depths not by nervous overseas investors, looking for the safest haven in an unsafe world. (If that had been the case, the dollar would not have been so weak.) No, bonds were bought like dot-com bubble stocks by big, U.S.-based investors who, judging by their behavior, had lost faith in our economic future. In this, the behavior of the scared money was the scariest thing of all.

    Here's why. Interest rates reflect the market's perception of the future value of money. Higher interest rates mean the market perceives that inflation--and, hopefully, an accompanying robust economy--will decrease money's future value. Lower interest rates, on the other hand, suggest that the market thinks there won't be much inflation in the future.

    Lower interest rates don't necessarily mean that investors expect bad things to come. Investors could be expecting a "goldilocks" economy, where light inflation melts away debt, and economic growth conquers all.

    Except that's not what investors are expecting. No one is. Not when the stimulative policies of the world's central banks all-but-guarantee an inflationary future if the world's economy starts humming again. Which is why the bond market's behavior is so unnerving.

    SO WHAT'S SCARING THE SCARED MONEY?

    When the scared money bids yields down to all-time lows, investors are literally saying they don't believe inflation will be a problem. And when they say this in the face of historic levels of central bank stimulus, they're saying, in essence, that the economy's broken now and for the foreseeable future. And when they say that, and say it in the face of the massive debt these central banks incurred in their efforts to prop up the economy, they're saying, in essence, we're doomed.

    Because if the economy is shot--if businesses aren't thriving, if more people aren't working, creating wealth and paying taxes--then that collective debt sits there, smothering all attempts to breathe air into commerce. In other words, the economy falls and it can't get up. People don't have money to buy things, so the value of those things falls. The result is inflation's evil twin, deflation. Just as inflation reduces the future burden of debt, deflation increases that burden.

    In the best-case scenario, deflation can create economic depression. But with the world awash in oceans of debt--monetary policy's equivalent of global warming--deflation can trigger something worse than any depression anyone's ever seen. One can only imagine what such a nightmare scenario would entail. Suffice it to say, those 20 year Treasury bonds snapped up so eagerly last week probably wouldn't be worth much. Really, if the scared money is right to be that scared, it's better off spending its leftover cash on crossbows.

    THE GUESSING GAME

    Just what prompted this flight to not-so-safe safety? Your guess is as good as PO:'s. It could be Greece's contemplated exit from the Eurozone. Or JPMorgan's tip-of-the-iceberg trading fiasco. Or the impending fiscal policy debacle in Washington, D.C. Or, for that matter, another dust-up over the Mayan calender. Whatever the cause, the result is a spasm of investor illogic that itself sends a eerie signal about the future.

    "Interesting" times ahead.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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