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Kondratieff wave

Kondratieff (Kondratiev) was a great Russian scientist who discovered the 50-70 year cycles in market economies in his 1920s works. For his failure to proclaim the death of capitalism he was arrested and eventually executed by the communist regime.

What you can read below is an old version (early 2007) of the article about Kondratieff Wave. Please visit this link to read the more up-to-date (2008) version about Kodratieff Wave. As the whole market economy is essentially the monetary phenomena, the Kondratieff Wave can be reduced to basic monetary principles: 1. The wave consists of the two legs of inflationary cycle first part is 30 years of inflationary trend, which ends with absurdly high inflation, then there is another 30 years of disinflation, which ends with absurd deflation 2. The whole wave is one big credit cycle it starts with very low outstanding credit levels, when the authorities are forced to increase the monetary base not by credit increase but by printing money. Then the credit grows and the 60-70 year cycle ends with absurd credit levels and then everything collapses with massive defaults

The charts
The first principle can be illustrated with the following chart (click to enlarge):

As you can see, the current K-wave, which started in 1949 with 2.5% yield on 10-year Treasury note, finished the leg up with absurd 15%+ yield. Currently we are in the down leg with 10Y/30Y bouncing around 4.7%-5%. This leg will be completed when the yield goes down to 2.5%. The second principle can be illustrated with the following chart:

Here the consumer mortgage debt is used as a proxy for the 60-year trend of rising debt levels, which finally reached the absurd levels, as it should. The current Kondratieff wave will be completed when the mortgage debt will collapse back to historic levels of the start of new wave, i.e. 10%-15% of GDP. Obviously, it means that $4-$6 trillion of outstanding mortgage debt will end up in default, which means many millions of homes will foreclose and losses will devastate the banking sector. The same could be illustrated with the growth of financial debt (assumed by banks, insurance companies, GSEs and all the likes):

Unwinding of that debt back to 10% of GDP will complete the cycle.

Above is another illustration of the same trend: debt piles up and then defaults in 50-70 years cycles. I think the length of the Kondratieff wave (50-80 years) is fundamentally related to the length of the human life, as every cycle is repeating the human mistakes made in the previous cycle. As the pop of the housing bubble and accumulation of the credit bubble in 1920s is not witnessed by any of the currently living people, the pumping up the bubbles was cheered and celebrated as it was back in roaring twenties.

The Kondratieff wave consists of the four seasons, with the season definition not necessary very strict. I will try to describe them in details

Spring
The Spring starts after the devastation of the Winter of the previous cycle. At this moment the balance sheets of corporations and individuals are quite healthy, the debt level is low, consumption is low and well below incomes. The newspapers will call that the nation of savers. For example, one can hear a lot about Japan being the nation of savers in 1990s and 2000s. In fact there is nothing special about Japan, they entered their Spring season of the K-wave in 2006 and they are saving a lot because thats what Winter and Spring seasons are all about. In Spring the economic expansion is moderate, the necessary increase of monetary base to cover the bigger economy needs is covered by modest debt growth and modest monetary inflation. Based on the charts above the Spring can be defined as the 1949-1966 period. The 30-Y Treasury yield stayed in the sub-4.5% range all that time, i.e. inflation was growing, but growing very slowly. The debt was expanding moderately and was easy to service in the period of low inflation

Summer
The Summer period is 1966-1981. The growth is pretty good, but the inflation finally gets out of hands. The growing inflation makes debt servicing problematic, which prevents individuals and corporations to take too much more debt. But the economy needs money, so the Feds are forced to turn on the printing press as they just cant force more debt into the system. Obviously, the rampant inflation makes the debt servicing even more problematic, which creates a vicious cycle of Feds printing more and more money. At the end the inflation becomes so bad that it becomes a political problem. Feds finally dont have any choice but to kill the inflation by raising the interest rates above 10%. The treasury yield jumps to 14%, the economy is knocked down into recession and everybody start moving money from active sectors into attractive treasury bonds. The 32-year bear market in T-bonds is over and the bull market starts

Autumn
This period is the best. US economy is enjoying it from 1981 t0 2007, 26 years of fun. Autumn is a debt bonanza. Falling inflation and interest rates allow consumers and corporations load up debt without increasing debt servicing obligations. Feds are happy because they can slow down the money printing machine as now banks and broker-dealers can create money all by themselves, without the Fed help. Feds are also happy because its very easy to control inflation. The debt load is so big that slight changes in interest rates can accelerate or slowdown the economy as desired. It is important to differentiate that while in Summer stage money supply is growing in an inflationary way in Autumn its all just leverage (or debt). Money is a claim for goods, leverage is a claim for money. The banks are creative in the ways they create leverage, as they cant physically print the currency with the president faces. Instead, they create all kind of derivatives, collaterized debt obligations, mortgage-backed securities and stuff like that. Its a big fun to print those papers and collect fees! It is very important to mention that during the Autumn the increasing number of borrowers (individuals or corporations) are becoming the Ponzi units. Ponzi borrower is the one who needs a constant increase of its debt burden in order for new debt to be used to service the old debt obligations. Usually it works fine as the assets used as debt collaterals are exploding in price. Until they dont. Autumn is typical for all kind of bubbles. For example, the 1920s in US were famous for real estate bubble, credit bubble and stock market bubble. It was very bubbly time. The efficiency of debt is declining sharply during the Autumn:

As you can see it takes more and more of debt to get the same GDP growth

Winter (or Depression)


All the fun must end. The last Autumn bubble will eventually pop. The reason that bubble pops is not the increase of interest rates or any other Fed mistake. Feds do it all right. The bubble usually pops on its own weight, because the increasing number of Ponzi units need a constant increase of debt to stay solvent. Eventually creditors go to strike and deny the new credit. At this time the collateral used for the debt is falling in price, because the music stops and there is no enough chairs. This is called the Minski moment, when most Ponzi units are denied new credit all at once. The collapsing credit is essentially equivalent to the collapse of monetary base, because the debt obligations are essentially money, or at least very similar to money. The collapse of money supply is called deflation. It leads to the decrease of all kind of prices goods, real estate, labor, stock market. There is no enough money and too much goods competing for money. Its a time of oversupply. Too many factories, too many factory workers. Too many farmers, too many oranges. Too many banks and too many bankers. Too many homes and too many defaulted homeowners. The solution to the problem is massive elimination of all

excesses. There are massive defaults, bankruptcies and foreclosures. There are ghost towns with empty homes. People are laid-off because they are not needed. How to fix that? Very smart Ben Bernanke suggested that he can drop money from helicopters. He is very smart and he had sent a very clear message to those who listen. The only solution to the problem he knows is to use helicopters. The only solution. So, if indeed he does not plan to drop money from the sky then there is no other way to fix the problem. I dont know the way either, and nobody knows, because there is no way. The Winter of K-wave has to happen the same way as the winter happens in the nature, every single year. The main idea of Kondratieff was that the market economy self-heals itself each time it goes into trouble. USA was the strongest country in the world in 1929, and it still was the strongest country in 1940s, after the Great Depression. So the Great Depression does not break the economy, it heals it. The idea is that all the bad debt must be eliminated, which probably means that pretty much all debt must be eliminated. The nation of spenders is converted into the nation of savers, which can export more than it imports, which produces more than it consumes, which saves more than it spends. When the Spring comes, all the leafs are green and flowers are ready to flourish

Relationship between stocks and bonds in Kondratieff context


Let see the relationship between stocks and bonds in different phases of Kondratieff wave. First of all let separate corporate bonds and government bonds. The yield of corporate bonds is composed from inflationary issues and credit risk issues. The yield of Treasury bonds are composed from inflationary expectations and some geopolitical issues, but mostly its just about inflationary expectations. The relationship between corporate bonds and stock market is easy. When yield spreads are widening, the stock market will drop immediately or with some delay. When yield spreads are tightening back the stock market is bullish or is about to become bullish. Thats pretty much it. The relationship of Treasury bonds and stock market is much more interesting.

In the first three periods of Kondratieff wave stocks and bonds are moving in the same direction. In Winter stocks and bonds are moving in opposite directions Why is that? In inflationary context the main problem is, you guess it, the inflation. So when the economic expansion is maturing the inflation heats up and bonds are turning bearish. The peak of inflation requires a violent credit tightening from the Feds, which is producing the economic contraction and bear market in stocks. When bonds are finally turning bullish it usually means that the Feds can finally relax the credit and money supply and the stock market will signal that the next economic expansion is underway. In deflationary context its all different. Then the main problem is deflation, not inflation. The inflationary phase of the economic cycle is pretty relaxing and does not threaten the economic growth that much. People dont even understand why the Feds are fighting that inflation when the things are so good. So the booming commodities and stagnating Treasury bonds are not bearish at all. New unprecedented heights of the oil prices are coincident with new heights of the stock market. That was not the case back in 1970s. But things become quite different when treasury bonds are becoming bullish. In deflationary context it is signaling that the happy inflationary period is over and the ugly deflationary period is about to start. The stock market will not drop right away as all the classic books written during the inflationary context tell that rising Treasuries are bullish. But thats wrong, which comes as a surprise. The bear stock market in the deflationary context is very ugly, much more ugly then in the inflationary context. The reasons for that are: 1. In the inflationary context the inflation itself is adding to the stock prices, as money get cheaper. The stock market falls 15%-30% and its pretty much it 2. In the deflationary context the bull market of ultra-safe Treasuries is soaking up money from everything, from the stock market, commodities market and real estate market. When the safest possible instrument is so bullish why would you risk your money in the stock market? So I dont expect the 2007 bear market to be gentle, bad things are coming soon (Im writing this September 11 2007, let never forget WTC)

The start of new Winter

Based on above, we can determine the approximate dates of entering the new Kodratieff Winter in the first decade of new century. The detailed charting and analysis is presented in this post.

You can see that in 1980s and 1990s stocks and bonds are usually moving in the same direction, with bonds slightly leading.

But we can observe that this relationship was broken with the first deflationary scare in 1998, but the normal order was restored in 1999-2000:

It seems to me that 1998 was a dress rehearsal of Kondratieff Winter. The chart shows that economy entered the Winter period in 2000 but the normal order was restored again in 2003:

Please click on the following chart:

The stocks and bonds diverged in December 2006 until August 2007, then briefly synchronized for 3 months and finally broke apart in October 2007. The above charts show that Winter has hard time to start due to high awareness of Federal Reserve about a possible deflationary tailspin. Both Greenspan and Bernanke did everything to postpone the day of reckoning as far into future as they can, most likely making the matters worse when the gravity finally wins. The tentative starts of Kodratieff Winter in 1998 and 2000 were averted. It seems that early 2007 can be marked as the third and powerful start *** Copyright Theroxylandr, reference is necessary when the content is used Call for charts: if you can give me the charts covering the previous cycles I will appreciate, thanks