The Bond Wave Mapping on Price & Inflation Cycle

BOND WAVE MAPPING： CASE STUDY 2
Price & Inflation Cycles
Along the Bond Wave

Originally published July 23, 2016
Last edited January 2, 2022
By Michio Suginoo

This section reviews transformations in the relationship between price behaviours and the bond wave (sovereign bond yields of a leading economic and political powerhouse).

Sidney Homer left us a notion that the state of money has something to do with the evolution of the Western civilization. And it extends to a scale of one life cycle of civilization. In studying the bond wave, I intend to contemplate Homer’s notion in a shorter horizon, say secular time frame. In other word, we can use the bond wave to observe a long-term transformation in the relationship between bond yields and other metrics. My attempt is to capture a notion that the state of money mirrors a broader socio, political, and economic reality.

Bond wave mapping provides a heuristic approach to apply historical analogy to make relevant questions about our present and future based on our past.

Overview

In general, the following components constitute bond yields:

real risk-free rate
inflation premium
default premium
illiquidity premium
maturity premium and
tax premium.

And in this reading, we only focus on the relationship between the bond wave and inflation rate, presuming the variability in other components being non-material in a secular scale: this assumption needs to be tested in other readings.

Chart 3.2.1 illustrates the relationship between the bond wave (bond yields of the UK Console) and price cycle (the cycle of the log of price level) in the United Kingdom. The chart demonstrates a couple of salient features:

these two metrics demonstrated a high correlation (77.7% during the period of 1737-1981) until the 1980s;
they started decoupling around the 1980s (with a negative correlation of –90% for the period 1982 to 2009).

In other words, something triggered a drastic change in the behaviours of the price level in relation to the bond wave somewhere between the 1970s and 1980s.

As a precautionary footnote, throughout this reading, the term 'cycle' refers to irregular dynamics, not regular ones, in terms of both magnitude and duration.

Below, Chart 3.2.2.b illustrates the relationship between the bond wave and inflation cycle.

From these two charts, the following two observations can be made.

Prior to the 1970s, the bond wave had exhibited a remarkable synchronization with the general price level for more than two and a half centuries: this notion is known as Gibson’s Paradox.
After the 1980s, the bond wave started exhibiting a new behaviour, to synchronize with the retrospective inflation experience, which is measured as the trailing average of inflation rates: this notion was illustrated by Professor Robert Shiller.

Two Paradoxes
Gibson's Paradox and Shiller's Paradox

As a reminder, the recent five bond waves are defined as follows:

the Victorian Wave from 1798 to 1897;
the International Gold Standard wave from 1897 to 1920;
the Vacuum Wave from 1920 to 1946;
the Reconstruction Wave from 1946 to 1981; and
the Globalization Wave ongoing since 1981.

A more detailed definition of the bond wave is described in Secular Rhythm of the Bond Wave.

The change in the behaviour of the bond wave might be a product of some structural changes in the international currency system taking place during the post–WWII period—the period of gradual shift towards fiat money (the floating currency exchange rate system) that extends from the introduction of Bretton Woods System (1944) to Nixon Shock (1971).

Price behaviours along the bond wave

Why would we care about such things, the relationship between the bond wave and price cyle?

As we observed in CASE STUDY 1-- Paradigm Transformations in International Monetary System Along the Bond Wave, a paradigm shift in international currency regime took place during the period of an extreme monetary condition: either within a top range or a bottom range of the bond wave in terms of yield level. Now, we are positioning near the bottom of the Globalization Wave (in terms of the yield level, but not of the timing, which remains uncertain at the time of this writing). In this context, our better understanding about past price behaviours along the bond wave might illuminate our present and future.

Toward the end of the previous bull bond wave, the Vacuum Wave (1920 to 1946), the New Deal Programs, a massive government intervention in the form of fiscal expansion, took place in the United States. As a comparison, in the most recent bull bond wave (1981-today as of 2016), a new type of government interventions (in the form of monetary policy) has been conducted at an analogous location (a low range of bond yields) along the bond wave. Both cases were triggered by periods of deflationary environment and underemployment (1929-1931; 2008-the 2010s). These two periods can be seen as products of excess supply capacities that had been created during the preceding bubble economies on one hand and ensuing deployment of cost-reduction innovation during the aftermath of the systemic financial crises.

The contrast in the form of government interventions, fiscal expansion in the former case and monetary expansion in the latter, raises a question about the difference in their price consequences.

Price Paradoxes:
Gibson's Paradox and Shiller's Paradox

Chart 3.2.1 illustrates that the secular relationship between the price cycle and bond yields has transformed drastically towards the end of the Reconstruction Wave (1946 to 1981). In this reading we will observe this transformation through two prominent paradoxes: Gibson’s Paradox and Robert Shiller’s Paradox. The conventional notion embraced by economic theory is that bond yields reflect, among multiple factors, the market’s expectations for the future inflation rate. In this theoretical view, bond yields are expected to contain an element that serves as a leading indicator for future inflation rates. However, those two paradoxes present alternative views of this conventional notion.

Gibson Paradox

Gibson’s Paradox used to represent a widely established empirical notion prior to the 20th century: bond yields had demonstrated a high correlation with the general price level, rather than with inflation expectations.

This notion that bond yields reflect price level breaches a conventional notion that bond yields is a forward looking indicator of the inflation expectation among other factors. Keynes described this paradox as “one of the most completely established empirical facts in the whole field of quantitative economies.” (Keynes, 1965, vol 2, p198) Chart 3.2.1 confirms this notion until the 1970s.

However, after the 1980s, the price kept rising while yields started declining, demonstrating a negative correlation between the price level and the bond wave: this breached the notion of Gibson’s Paradox.. As a matter of fact, from 1737 to 1981, the log of general price level and bond yields demonstrate a high correlation (77.7%): this supports Keynes’ view, described above. However, as the chart illustrates, after 1981 or so, the two metrics show a negative correlation (–90%) for the period 1982 to 2009. This demarcation point nearly coincides with a drastic change in monetary policy demonstrated by then-FRB chairman Paul Volcker.

Ironically, one of the most completely established empirical facts for two and a half centuries, which John Maynard Keynes advocated, lost its validity towards the end of the Reconstruction Wave (1946 to 1981). What are usual suspects that accounted for the price hike and destroyed the validity of Gibson’s Paradox?.

In hindsight, among many possible factors--explosive population growth, monetary expansion, various causes for supply destructions, etc--fiat money was emerging during this period.

Shiller's Paradox

Another paradox associated with price cycle and bond yields was addressed by Robert J. Shiller (2015), a Nobel Laureate and one of preeminent pioneers of behavioural finance. Shiller suggested a paradoxical relationship between inflation rate and bond yields. Shiller posited a revisionist notion that bond yields might better serve as a rear-view mirror to reflect past inflation experience, rather than a forward-looking inflation expectations. (Shiller, 2015, pp. 42-43)

Shiller’s illustration contrasts with the conventional notion embraced by economic theory that, in a nutshell, bond yields should reflect, among multiple factors, the market’s expectation for future inflation rates, but not past inflation experiences.

Chart 3.2.2.a illustrates Shiller’s Paradox over UK Consols historical data for about three centuries; Chart 3.2.2.b illustrates Shiller’s paradox using US data. Along bond yields, Shiller projected two sorts of 10-year average inflation rates―one retrospective and the other prospective―and empirically illustrated that bond yields have a higher correlation with the retrospective inflation average than with the prospective alternative. (Shiller, 2015, pp. 42-43)

The UK Consols’ long data suggests that for the period 1703 to 2009, spanning three centuries, the bond yield has a reasonably high correlation (66%) with the retrospective 10-year inflation average (CAGR: compound average growth rate) versus a lower correlation (44%) prospective 10-year inflation average (CAGR). Since the turn of the 19th century, the retrospective metric for the case of the United Kingdom demonstrates a remarkable synchronization with the bond wave, with 71% correlation. On the other hand, bond yields demonstrate only a 46% correlation with the prospective metric for the same period of time. The differences in the correlations confirm that bond yields better reflect the retrospective than the prospective inflation experiences.

The notion of the two historical paradoxes

Overall, what would be the notion of those two paradoxes?

First of all, both paradoxes suggest that the bond wave reflects our past price experiences—whether at the price level or at the inflation rate level—but not future inflation behaviour. These two paradoxes seem to invalidate human predictive power regarding future inflation.

Second, is Shiller’s paradox a better fit than Gibson’s? Or it is just that the bond wave, after having danced with the general price level (Gibson's Paradox) for more than two and a half centuries, changed its dancing partner at some point to the inflation memory, or the retrospective inflation average (Shiller's Paradox)? Reviewing the US case in Chart 3.2.2.b, Shiller’s Paradox demonstrates its validity from somewhere in the middle of the Reconstruction Wave (1946-1981). This observation over a long time horizon would suggest that the latter notion of changing its dancing partner is more relevant than the former. In other words, Gibson’s Paradox is still “an established empirical fact” prior to the 1980s as Keynes conceived (Keynes, 1965, vol 2, p198). But something drastically changed to transform the notion during the 1980s.

In a way, a historical lesson from this story is that the future can be very different from the past. This lesson teaches us that in the future we could experience another drastic change in price behaviours in relation to the bond wave. In other words, Shiller’s paradox can also be challenged in the future.

Extraordinary period toward the end of the bull bond wave:
political manipulation of the bond yield

Between the 1940s and the early 1960s, the US chart demonstrates a material diversion between the trailing 10Y inflation average and the bond yields.

The period from 1931 to 1967 corresponds to the period between the middle parts of the Vacuum Wave (1920-1946) and the Reconstruction Wave (1946-1981). During this period, the United States went through the New Deal Programs, WWII, and Vietnam Wars. When we measure the correlation between the two metrics only during this period, the US data exhibits negative correlation (-41%).

Especially WWII was a period of extraordinary government interventions in yield curve. A legitimate question is whether a series of governmental interventions affected the behaviour of the correlation between these two metrics.

Franklin Roosevelt (FDR) was inaugurated as the US President in 1933, a year that marked the beginning of massive fiscal expansions known as the New Deal Programs[1]. Then 1941 to 1945 was the period of WWII. During WWII, the US Treasury controlled yields to shape a stable rising slope in the yield curve. The Federal Reserve Banks purchased the securities in order to achieve the fixed yield curve schedule. This guaranteed that bondholders would benefit from “riding the yield curve”: towards maturity, the bond price increases as scheduled. In this way, the US Treasury promoted investment in US war bonds. (Homer & Sylla, 2005, p. 354)

As a comparison, in an analogous location in the bond wave, toward the end of the Globalization Wave (1981-today as of 2020) of our time, FRB has been conducting historical monetary expansion and maintaining the interest rates low. Although the measures taken are quite different between our time and the war time, we can see some resemblance in the presence of substantial government interventions in interest rates toward the end of these two bull bond waves.

Other Issues:

Inflation cycle and Hegemonic Wars

Joshua Goldstein studied a historical relationship between hegemonic wars and major inflationary periods [2]. According to Goldstein, “From the seventeenth century on, most of the major inflationary periods appear to be connected to wars.” (Goldstein, 1988, p. 249)

Based on empirical studies of hegemonic wars since 1790, Goldstein demonstrated a statistical inference of causality relationship (Granger Causality Test) that war serves as a likely cause for inflation—but not the other way around (inflation causes a war). (Goldstein, 1988, pp. 252-253) Chart 3.2.2.a confirms his view. When we trace the trailing inflation average, we can locate major hegemonic wars during inflationary periods: the French Revolutionary Wars, the Napoleonic Wars, WWI and WWII.

As an additional remark, the notion of the one-way causality relationship from war to inflation presents a question regarding demand: whether war is a special form of employment that immediately activates consumer spending, therefore, boost the money multiplier effect and causes inflation? There is no quick and straight-forward answer. It is because war also causes supply-demand imbalance in consumer products from the supply side in multiple manners: shifting the use of productive capacity from ordinary production to war supply production, blocking cheaper competitive imported products, and introduction of price controls.

Inflationary Period

Moreover, Chart 3.2.2.b illustrates that historically prolonged inflationary periods, whether war-driven or not, coincide with the top range of the bond wave, except WWII. Only during WWII, we observe divorce between the bond wave and inflation behaviour.

As stated earlier, during the WWII, the US Treasury managed the yield curve of Treasury Securities in collaboration with the Federal Reserve Banks: it is intended, for the sake of special war funding needs, to secure the profitability of “riding the yield curve” for investors. In this context, the bond wave is manipulated and suppressed downward in spite of the presence of inflationary pressure during WWII. Therefore, the particular divorce between the bond wave and inflationary behaviour during WWII is the product of government intervention.

Deflation

Another salient feature of price history can be illustrated in Chart 3.2.2.c. This chart illustrates the behaviour of inflation/deflation cycle. Small yellow dots circled in red represent annual inflation rate. Annual inflation rates alternate between the positive and the negative territories until the outbreak of WWI in 1913.

In 10Y compound average, deflation and inflation periods alternated one another prior to the unification of Germany in 1870’s. This earlier period in the post-Napoleonic war Europe represents plurality in monetary regime across Europe: the United Kingdom was the only state under the gold standard; the German speaking states were under the silver standard; a majority of others, including France, were under the bimetallic standard.

During the remaining of the 19th century after the 1870’s, 10Y compound average inflation remains in the negative territory floating around the zero line, indicating minor but persistent deflationary pressure. This deflationary period coincides with the integration stage of international gold standard, where major advanced economies are consolidated into the gold standard regime. This suggests a hypothetical monetary view that monetary gold supply was in a chronic shortage to account for deflationary momentum.

Then, an international convergence toward the gold standard emerged during the period of 1870-1900. Thereafter, since the turn of 20th century, 10Y compound inflation average surfaced to the positive territory and remained around a near zero level (in terms of 10Y average). This indicates that the international gold standard era gave rise to a price stability with low inflation. Overall, since the last quarter of the 19th century, prices has come to stabilize around near zero level until the outbreak of WWI.

The outbreak of WWI broke this relative price stability. Inflation surged until 1920 when it registered 10.19%.

Thereafter, the trend reversed. It entered a deflationary environment which lasts throughout the Great Depression, registering -3.72% in 1930 in the 10Y compound average of inflation rate. In 1931, the Bank of England announced the first peace-time suspension of gold convertibility.

In the sphere of the currency exchange rate, hereafter, through the “Vacuum Wave” (1920-1945) until the adoption of the Bretton Woods System, the GBP collapsed against the USD. Along this line, the deflation is tempered toward 1939 in the United Kingdom. As mentioned earlier in the CASE STUDY 1—Paradigm Transformations in International Monetary System along the Bond Wave, the Vacuum Wave (1920-1945) is a transition period from a metallic regime to a fiat money regime.

Since the beginning of the Reconstruction Wave (1945-the1970s), the de facto USD standard of the Bretton Woods System has gradually unfettered the international monetary arrangement, shifting it from a gold convertibility regime into a fiat money system.

In this backdrop, deflation has disappeared from the scene and inflation has become rampant. Inflation culminated at the end of the Reconstruction Wave (1946-the1970s), accompanied by two oil shocks in the 1970s. The behaviour of inflation transformed along with the transformation of the international monetary regime. As a consequence, its relationship with the bond wave has fundamentally changed towards the end of the Reconstruction Wave.

The bond wave mapping captures the transformations in these two dynamisms—the behaviour of deflation and the paradigm shift in the currency regime. It contrasts the differences in price behaviours between two currency regimes—the fixed exchange rate regime under the metallic system and the floating exchange rate regime under fiat money—with gradual transition during the period between these two regimes.

In Chart 3.2.2.c, the contrast is salient in the behaviours of inflation rates between the metallic standard era (the Victorian Wave and the International Gold Standard Wave ) and the period of gradual transition (the Vacuum Wave) to fiat money era. During the metallic standard era, inflation and deflation alternated one another, cancelling out each other to neutralize the long-term inflation/deflation implications at the near-zero level.

Inflation Volatility

Chart 3.2.2.d adds the 10-year trailing volatility of inflation to Chart 3.2.2.a. The declining volatility between 1870 and 1913 reflects the stabilising inflation risk environment for international commerce during the late stage of the Victorian Wave and throughout the UK peace time of the International Gold Standard Wave. After 1865, the volatility of inflation settles below 5%. The stabilization in inflation volatility comes into reality near the year 1871, the beginning of the international convergence towards the gold standard, the year in which the newly Unified German Empire adopted the gold standard. In this volatility sense, the Victorian Wave can be divided into two sections—one before and the other after 1870 or so. These two periods are contrasting in terms of inflation volatility characteristic.

The Victorian Wave ends as it makes a success in stabilizing inflation volatility. The new era of Edwardian time opens with price stability.

However, the outbreak of WWI ends the period of the great prosperity, the dividends from Victorian Splendid Isolation, and introduces a new inflation cycle into UK price history. This accords with Goldstein’s one way “from war to inflation” relationship. In Chart 3.2.2.d a large swing in inflation volatility can be observed between the outbreak of WWI and the end of the Vacuum Wave (1920-1945).

Looking to the Future

Now (2020), sitting at a near-bottom yield level of the Globalization Wave (1981-today as of 2020), we are still surrounded by threats of deflationary pressure for the first time since the Great Depression during the Vacuum Wave (1920-1945). How would our past illuminate our present and future?

The 10-year retrospective inflation average (geometric compound average) might cast a similarity in inflation behaviour among these three bull bond waves—the Victorian Wave, the Vacuum Wave, and the Globalization Wave. Toward the end of each bull wave, deflationary pressure persisted:

for the last quarter of the 19th century (the Victorian Wave: );
during the post Wall Street Crash of 1929, the late part of the Vacuum Wave (exclusive of WWII); and
during the post–Global Financial Crisis in the late part of Globalization Wave.

Are these similarities merely a coincidence?

Or is there any underlying force exerting deflationary pressures to complete the bull wave (noting that in the United States, the most recent case did not result in deflation per se due to inflationary pressure arising from its prompt massive monetary expansion)? This question is explored in the bond wave mapping of private debt cycle.

In the case of the Globalization Wave (1946-today as of 2020)—the most recent bull bond wave—among advanced economies, there have been new developments brewing—the counter-response against deflationary pressure by central banks with quantitative easing, a series of massive monetary expansions that did not take place during its precedent during the Great Depression. For the previous case during the Vacuum Wave, it was fiscal expansion, the New Deal Program, for the United States, and currency devaluation for the United Kingdom (the latter is a monetary adjustment, therefore, some might consider it as monetary policy).

Deflationary pressure--which does not necessarily result in deflation per se (especially when there is a counteracting force such as inflationary pressure arising from a massive monetary expansion)--can be caused by several factors:

decline in demand,
excess supply,
monetary contraction,
mobilization of innovation (cost reduction and job destruction) or
a combination of multiple factors above (the most likely scenario).

Therefore, questions need to be addressed from a perspective of all these factors. When deflation is a compound by-product of all of them, it cannot be resolved only by monetary response alone.

Moreover, price behaviours vary among price categories—general price categories (CPI, PCE, etc.) and asset price categories (e.g. productive assets, real estate, land, equities, etc.) and commodities (e.g. energy). This naturally leads to a monetary policy paradox: while conventional monetary policy is designed to manage general prices, it fails to control price behaviours in other price categories.

In the aftermath of the Global Financial Crisis, the post-crisis response adopted across advanced economies—a series of monetary expansions by central banks—has been rationalised by the notion of the wealth effect. However, it primarily triggered asset inflations without making a material intended improvement in demand.

Asset prices, from asset reflation to asset inflation, could theoretically penetrate general prices through rent cost. With its unprecedented scale, it could yield an unparalleled evolution in price behaviour: namely, hyper-inflation or even stagflation. In reality, deflationary pressure has been persistent after the Global Financial Crisis.

Furthermore, monetary policy fails to address some non-monetary consequences such as:

Innovation is one example. Deflationary environment, pressurizing the profit margin, compels business to mobilize innovation to cut down fixed cost that includes labour cost. In this context, newly introduced innovation impairs job creation mechanism. With deteriorating income prospect in the asset bubble environment, consumers are forced to spend less. Overall, demand hardly can rebound.
Another factor is an excess of supply capacity in the system. One aspect of deflation is the excess supply capacity created during the preceding finance-fed bubble period. Say, bubble is caused by excess demand fed by finance that was made possible with easy monetary conditions. The resulting supply-demand imbalance results in the psychology of the scarcity of supply. Supply capacity expansion, although delaying in catch-up, when it completes, ultimately transforms the psychology into the perception of the abundance of resources (Jarvis, 2009).

In these ways, the non-neutrality of money changes long term non-monetary reality drastically. These long-term non-monetary consequences in a deflationary environment present a limitation in the ability of monetary expansion to increase demand that hinges on the long-term prospect on job and income. In other words, this presents the necessity of implementing other measures, such as fiscal expansion, to stimulate job creation.

Easy money led to an excess demand; that led to an excess investment; that led to an excess expansion of supply capacity; that led to excess leverage in the system. In this chain, supply appeared to be scarce. The notion of scarcity rationalized expansion of supply and the employment was guaranteed. In this setting, easy money proved to be so effective in boosting money multiplier. Money exerts its non-neutrality, transforming long term economic reality.

Once bubble burst, deleveraging process took place and destroyed the chain, leaving the legacy—excess supply capacity. All of a sudden, we are left with the world of abundance. A sudden shift from management of scarcity to abundance, together with the shift from leveraging to deleveraging, transformed price environment from inflationary to deflationary. Along this line, corporate management enhanced the reduction of fixed cost—cutting labour input—by mobilising new innovation. As a natural consequence, labour psychology turns dire. As they adjusted their consumption behaviours, demand stagnates. In this picture, employment is a critical component in restoring demand, the core driver of the money multiplier.

Simply put, in the post-bubble era, the private sector is compelled to mobilise new innovation to cut down fixed (especially labour) cost. Without addressing unemployment, any government intervention cannot restore aggregate demand. In this picture, monetary policy, although in a unprecedented scale, does not seem promising.

As the historical episode of a drastic change in price behaviour relative to the bond wave—from the Gibson's Paradox to Schiller's Paradox around the 1970s to 1980s—witnessed, the price behaviour may again exert an unexpected drastic change in its relationship with the bond wave.

As a reminder, the bond wave must not be applied deterministically when we observe the present or anticipate the future: instead, it should be applied probabilistically. In a way, this requires a Bayesian approach: i.e., we need to incorporate new developments into our probabilistic application of the bond wave.

Overall, with bond wave mapping so far, we have observed that there is a remarkable synchronization in the transformations—both evolution and recurrence—among price behaviour, the international monetary arrangement, and the bond wave.

Notes

1. The term relates to the direct involvement of military conflicts in the homelands of top sovereign member states in the world hierarchy.

2. The United Kingdom managed to mitigate the impact of the Great Depression by its currency devaluation rather than fiscal expansion. The statement is about the US New Deal Policy.

Reference

Goldstein, J. S. (1988). Long cycles: prosperity and war in the modern age. New Haven: Yale University Press.
Jarvis, J. (2009, June 12). When Innovation Yields Efficiency. Retrieved from: http://buzzmachine.com/2009/06/12/when-innovation-yields-efficiency/
Keynes, J. M. (1965). A treatise on money: Vol. II, The applied theory of money. London: Macmillan & Co Ltd.
Shiller, R. J. (2015). Irrational Exuberance (3rd Edition ed.). Princeton, New Jersey: Princeton University Press.