The Kondratieff Cycle: The Kondratieff Cycle

Mike Shedlock explains what The Kondratieff Cycle is — and exactly where the US economy is on it.

The Kondratieff Cycle

Let’s take a step back. Inquiring Mish readers just might be wondering who was Nikolai Dmyitriyevich Kondratieff (1892-1938)?

“Kondratieff’s major premise was that capitalist economies displayed long wave cycles of boom and bust ranging between 50-60 years in duration. Kondratieff’s study covered the period 1789-1926 and was centered on prices and interest rates. Kondratieff’s theories documented in the 1920s were validated with the Depression less than 10 years later…
“The Kondratieff wave cycle goes through four distinct phases of beneficial inflation (spring), stagflation (summer), beneficial deflation (autumn), and deflation (winter). Since the last Kontratyev cycle ended, around 1949, we have seen beneficial inflation 1949-1966; stagflation 1966-1982; beneficial deflation 1982-2000; and according to Kondratieff, we are now in the (winter) deflation cycle, which should lead to depression.”

K-Cycle theory should more than explain Greeenspan’s conundrum. Indeed, one should expect Treasuries to perform well in both autumn (disinflation) and winter (deflation) as interest rates fall. Junk bonds should perform extremely well in autumn, but debt will destroy them in winter.

Right now, I look for corporate spreads to start and keep widening. As the risk of default widens in K-winter, we should soon see some of the effects. Indeed, we have already seen this to a limited extent with the downgrade of GM’s debt to junk status and the resultant widening of GM yields versus Treasuries. In general, the widening of corporate spreads versus Treasuries in conjunction with the flattening action in Treasuries as the curve nears inversion is not a good sign for stocks or the economy.

The Kondratieff Cycle: Resolving the Conundrum
In theory, we are in the worst possible environment for stocks: tightening of the yield curve (which will mean falling profits for financials, the biggest sector of the S&P 500) and declining or stagnant earnings as evidenced by a slowing worldwide economy. So far, stocks have shrugged off the bad news and have stayed relatively flat as the VIX has dropped like a rock.

That conundrum (they seem to be everywhere you look these days) will probably be resolved as stocks start plunging when the Fed pauses or cuts rates. Indeed, stock market bulls cannot have it both ways, with rising interest rates seen as a sign of a good economy and falling rates seen as being good for stocks simply because they are falling.

Some think we are in a prolonged period of inflation, or even hyperinflation. I disagree. I do not believe the K-Cycle can be defeated. Postponed, yes; defeated, no. Greenspan managed to postpone the inevitable by slashing interest rates to 1%, which fueled the biggest housing bubble the world has ever seen, not only in the United States, but in Britain, Australia, and other places. All he has accomplished is to create bigger and bigger bubbles that will ultimately be deflated away.

Hyperinflationists will have you thinking the K-Cycle can be defeated or that seasonal stages can be skipped. I do not wish to repeat myself. If you missed my previous two articles challenging hyperinflationist Jim Puplava (challenges that still have not been adequately replied to…)

Where we are in the cycle is extremely important to stock, bond, and commodity traders. Treasuries and bonds in general will get hurt in spring and devastated in summer. Stocks typically get hammered in summer and winter. Commodities tend to do well in spring and summer.

Given that K-Cycle seasons are fairly long events, and given the stock market run-ups in the United States for 20 or so years up to 2000 and falling stock and land prices in Japan for the past 20 or so years, it seems to me to be totally preposterous that America has undergone deflation in one quick drop from 2000-2002.

A closer look at debt levels should be convincing enough. In K-winter, debt levels and excesses should be purged. Instead, we are seeing bigger and bigger bubbles and higher and higher debt levels as people plow more and more into housing.

That is why I am confident that Greenspan delayed the K-Cycle, instead of defeating it. In effect, we have just experienced what I think of as a false spring. We have only just begun winter, but some would have you believe that spring has arrived. Do not fall for it.

The biggest clue as to where we are in the cycle should be readily apparent from all of the protectionist talk spewing forth from Washington, D.C.  Indeed, it was the current protectionist talk in Washington threatening 27.5% tariffs against China, as well as threats to label China a “currency manipulator,” that was the biggest factor in deciding exactly where to place that arrow on the opening chart.

The Kondratieff Cycle: Additional Clues

Enquiring Mish readers just might be wondering if there are any additional clues. Indeed, there are.

Falling long-term Treasury rates are an enormous clue. Long-term Treasury yields have refused to rise, in spite of repeated jawboning by Greenspan attempting to talk them up. In spite of nine consecutive rate hikes by the Fed, the 10-year Treasury yield is still below where it was when Greenspan first started hiking the federal funds rate. Those understanding the K-Cycle know exactly what is happening and why. Greenspan, on the other hand, remains in a clueless conundrum.
The downgrade of GM and Ford to junk status is another big clue. Ultimately, I believe the debts of both GM and Ford will be worthless.

In addition, I believe steel prices are a clue. Steel prices have collapsed this year. I do not think we would see that in K-spring.

Finally, the Baltic Dry shipping index has been plunging like a rock. That index reflects shipping costs for various commodities. It would not be behaving like a yo-yo if this were really spring. The FinData Web site lets you pick a time frame in which to analyze shipping rates. I suggest looking at a duration of about five years or so. It shows what I believe to be false spring.

In theory, oil prices should be declining in K-winter. So what’s up with that? That conundrum is resolved by the knowledge that oil is subject to geopolitical issues, as well as peak oil concerns. K-winter cannot stop prices from rising in situations in which the commodity is simply running out and/or situations in which world tensions and terrorism prevent supplies from reaching the market. Oil is affected by both. Indeed, Iraq is pumping less oil now than before Bush invaded.

Also note that commodities might be tricky in general, because Japan should just about be coming out of K-winter and China (being a command, as opposed to a market, economy) does not follow the K-Cycle exactly.

Taking all of the above into consideration, the great preponderance of evidence is that this is indeed a false spring, and sometime soon, Mr. Groundhog (aka the typical consumer and house flipper) will indeed be frightened by his own shadow and go scurrying back into very prolonged winter hiding. The economic consequences of this are not likely to be pretty.

The Kondratieff Cycle: Six Points from Bill Gross

Bond guru Bill Gross provides a list of his main points in a well-written article entitled “Fire!”:

“1. The current, rather mild U.S. recovery has been driven by asset appreciation/consumption, and not employment or capex growth.

“2. Future growth is dependent on additional asset appreciation in real estate and stocks if Asia continues to absorb much of our investment and many of our jobs.

“3. Recent asset appreciation has been set ablaze by several fiscal/monetary pumps… with five-year real rates being the central driver/gasoline can.

“4. Tax cuts are a thing of the past and five-year TIPS yields can theoretically decline only 60 basis points or so more.

“5. The reason why intermediate/long TIPS have an interest rate floor is that if we approach potential deflation, investors risk losing money on a government-guaranteed investment. The same concept applies to homes, stocks, and other inflation-adjusting assets without government guarantees.

“6. The Fed may soon be out of fuel, despite hints of Bernanke-style helicopter money. Stocks and houses are already at low yields and high prices reflective of European economies nearing Japan-style liquidity traps.”

He continues:

“If the asset pumps run dry and the kerosene cans empty, the inevitable path of the U.S. economy will reflect slow growth at best, and recession as a realistic alternative. Inflation then would return to low 1% levels in the ensuing years and be pressing the deflationary crossover line. Nominal Treasury paper would enter the 3-4% zone for 10-year maturities, and lower still for shorter intermediates. Such an analysis argues for capturing yield via duration extension now, in the face of admittedly artificially low current yields. If Rome burns, long maturity bonds will rule the day, and that day may come sooner than many imagine possible.”

I do believe that long-term investors can follow Bill Gross and comfortably hold Treasuries. Short-term players may note that the capitulation of Bill Gross, as well as Stephen Roach, could mark a temporary bottom in Treasury yields.

Finally, I repeat my thoughts that there may be one last set of spikes in yields when the Fed does pause, and perhaps again when the Fed first cuts rates. It might even be fitting justice to the Fed, who at that time will probably not want to see that spike.
Mike Shedlock / Mish
July 13, 2005