Expert Commentary

The Crocodile of Debt Deflation

The laws of nature cannot be dodged forever.

It really is amazing to think that dinosaurs still live on our wee blue planet. Go to the Northern Territory in Australia and see them in the wild. Saltwater crocodiles are simply awesome creatures and have survived 80 million years. Even we humans, who have seemingly tried to eradicate everything else in nature, cannot harm them much. When you see a crocodile in the wild, run! (Which reminds me of a joke, but I’ll leave that to the end).

If you used your imagination and squinted your eyes a little, the chart below could resemble a crocodile with its mouth wide open (ok, ok, maybe after a dram or two). The chart shows the level of Non-Financial Corporate Debt as a proportion of Gross Domestic product in the U.S.A as well as the Moody’s Seasoned Baa Corporate Bond Yield. That bond yield series represents the middle-to-lower quality of corporate debt.


Debt Deflation Ahead- USA Corporate Debt Proportion of GDP and Baa Bond Yield


Up until around 2012, there existed a loose relationship between the two. As the level of debt rose, so did the bond yield and vice versa. Since 2012, though, corporate debt has advanced relentlessly, zooming higher over the past year. On the other hand, corporate bond yields have continued to decline. This would appear to be a highly unusual situation which is probably unsustainable.

Even if we take the point of view that corporate bond yields have structurally declined on the back of declining U.S. Treasury yields (and interest rates going to effectively zero), the obvious case of Japan springs to mind. Rates and bond yields structurally collapsed there in the 1990s, but that was also accompanied by the beginning of private sector debt deflation, a trend that existed for a couple of decades thereafter.

A similar situation could be developing now in the U.S. Debt has inflated over the past few decades. With social mood turning negative, it is now time for it to deflate.

(Bonus joke. Two wildlife photographers are filming a pack of lions eating a zebra. The lions are getting increasingly excited. One of the photographers takes off his jungle boots and puts on a pair of Nike running shoes. “You’ll never outrun a lion in those,” says his mate. “Forget the lion,” he says, “as long as I outrun YOU I’m happy.”)