Earnings season continues...heavyweights including NAB, Coca-Cola Amatil and QBE all reported first half results today. But we'll leave all that for tomorrow once the dust has settled. There's something more important going on in a different market.

Before we jump into today's reckoning, a follow on from yesterday. We explained that complexity creates fragility by hiding how things are interrelated and affecting each other. Over in America, an over-complex financial system unexpectedly blew up in 2008 because people didn't realise how the assumption of rising house prices underpinned the entire economy.

Here in Australia, the question is whether we also suffer from complexity. Do we rely on industries that feature a lot of 'unknown unknowns' and could suddenly collapse?

The first place to look is of course our dominant resource boom. As difficult as it may be to find an ounce of gold or a pound of copper deep underground, mining, in theory, is a straightforward business. You find a resource and you find a way to extract it at a profit. Admittedly, it's a lot easier said than done. But that's not what we're getting at here.

There are plenty of known unknowns, like commodity prices and production costs in mining. But miners don't face a sudden collapse like a financial system can. The miners face a cyclical risk, not a systemic risk. It's a real risk, but recurring and thus manageable.

Even surprising events like the floods which laid low much of the Queensland gas drilling industry for a few months last year were conceivable. In contrast, back in 2006 falling house prices were inconceivable to American bankers. Federal Reserve Chairman Ben Bernanke famously refused to answer a question about what would happen if house prices fell because it was such an outlandish idea.

But what about the industries and economies that miners sell their commodities to? Do they suffer from complexity and fragility? You bet. There are few systems more prone to collapse than a centrally planned economy like China. Just look at what happened to the Soviet Union and its satellite states. They were eventually forced to free up their economies, but that came at an enormous cost. They effectively collapsed before they could be reformed and grow again.

China watchers like to point out that the country has adopted a slow and steady approach to embracing capitalism. Unfortunately, they've embraced all the bad parts. China's growth is politically motivated and capitalistically funded. In other words, politicians borrowed money to finance projects. That's the worst possible combination because it creates just the kind of complexity and fragility that's dangerous. You can't pay off debts with politics, you need profits. And politically motivated projects, such as empty cities, lack profits.

So Australia's complexity may not be home grown, but it's definitely there. The very factor which kept us out of the 2008 economic crisis will be the one which drags us into the next one - China, but this time crashing instead of bubbling. It's just the kind of possibility that's inconceivable but possible.

That crisis could be a long way off though. Right now, stock markets are just sputtering, not crashing. The S&P500 closed down for the fourth time in a row for the first time this calendar year. Europe had a bad week too. But the real action is in bond markets.

Unfortunately, bonds are one of those painful financial topics that take a whole load of explaining before you get to the interesting parts. But they're also the most influential part of our financial system - more important than stock markets and foreign exchange.

That's because they are the focal point of the financial system. They set the so called 'risk free rate' which you'll find in just about every equation in finance. When you decide how you should invest, bonds and the return you can get on them are your starting point, because they theoretically carry no risk. Governments don't default.

Of course, all this is theoretical. Governments default surprisingly often. But the importance of bonds remain, because they are the benchmark other investments are measured against.

When deciding whether to invest in something, you should ask yourself two questions: How much risk does the investment have, and how much additional return can you expect above and beyond a bond's return? If the investment offers a decent return above a bond with little additional risk, you invest.

So if bond markets are shifting, that effects the viability of all other investments because it raises or lowers the bar for taking on risk. That means, if you want to understand what's going on in all other investment markets, you've got to keep an eye on the bond market. Which is what we'll do in a moment.

First of all, you need to understand the difference between price, interest rate and yield. When a bond is issued, its price is $100. Investors demand a return in the form of an interest rate paid in dollar coupons. From here on in, it's a simple supply and demand story. A $5 coupon, or interest payment, gives you 5% yield if the bond is priced at $100. But if buyers bid up the price to $105, the yield becomes 4.76%. If the price falls, the yield rises, because you pay less for the same $5 income stream.

Just as bonds are the focal point of a country's financial system, so the American bond market is the focal point of the world bond market. American bonds are considered the closest thing to 'risk free', making them the global benchmark.

But enough of the theory...

So what's going on in the US bond market? This chart shows how US government bonds have tumbled in price, or surged in yield (whichever you prefer). Yields are now at a two year high.

Over in Europe, the local 'risk free' bonds are the German government's Bunds. They also tumbled to a recent price low. There's no point referencing other European yields, because they're not considered risk free ever since Greece defaulted on its bonds.

Australian government bond prices have also dropped, with the government now paying more than 4% to borrow money for 10 years. That's odd because the RBA has been cutting interest rates, which usually supports bond prices.

The problem is, this picture of rising bond yields paints a heck of a lot of words. There are a thousand explanations for what's going on. So many things are factored into bond yields, it's often impossible to interpret them. And how will the moves in the bond market affect the stock market and economy?

Right now bonds are selling off fast, increasing yields, which is the point the chart is making. That means a higher risk free return is available to investors, which should in time goad more of them out of risky investments like shares and back into bonds.

The influence of bond yields can also be more direct. Most US mortgages are tied to the 10 year bond yield, so the sudden jump has had an effect on borrowers too. And that's had an effect on the US housing market, with refinancing drying up suddenly. As you can see, the refinance index has plunged as the mortgage rate jumped.

Source: Mortgage News Daily

Last night bond yields jumped and US housing stocks took a beating.

The effect of a higher bond yield also reaches the economy. Less mortgage refinancing means less spending, which means less economic growth.

One thing to keep in mind here is that bond yields are still at incredible lows. That exacerbates any given move in percentage terms. Case in point is the US 7 year yield. It rose more than 100% since April, but only because it started out around 1%.

So what's causing the bond market tantrum?

It's all about the taper...at least that's the market's interpretation. It's worried about whether the Federal Reserve will reduce its quantitative easing. Put differently, it's betting the Federal Reserve will reduce its monthly purchases of US$85 billion in mortgage and treasury assets. But how will the economy and financial markets look without the Fed's monthly largesse?

It's difficult to know, but each time that outcome looks more likely, we get a taste. Investors panic and sell stocks. Falling stock markets don't taste good.

Making everyone's life difficult is the fact that there is nowhere to hide from the Fed's tapering. The bond market will struggle if the Fed exits. The economy could worsen, making stocks a losing bet too. And there will be less inflation pushing up commodities, including gold.

It's a conundrum worth pondering. Where do you invest in a world where central banks begin rolling back their stimulus?

Going back a step, what has us baffled is the 'why'. Why would the Fed taper now, or anytime soon?

Inflation is low. Unemployment is high. The economy is doing poorly. In fact, it may be sliding back into recession. Historically, whenever economic growth reaches such a low rate in the US, a recession always follows. In fact, a few analysts have had the guts to say a recession already started in the US. GDP revisions will supposedly confirm it eventually.

So what's Fed Chairman Bernanke thinking, mentioning tapering now?

We haven't got a clue what he's thinking. But we do know what he might be thinking about.

First of all, the Fed has been financing the American government. It's steadily increased its holdings of American government debt while others have stopped accumulating them.

Source: Bank of America, Merrill Lynch

Central banks don't like to be seen as financing the government because that's dangerously close to what unleashes inflation.

Next up is the fear of a quality collateral shortage. It's not as complex as it sounds. When the financial system goes into lockdown during a crisis, financial institutions need to secure bailouts from central banks. That's why central banks were created.

But one of the rules of bailing out financial institutions is that they should have to pledge quality collateral - usually government bonds. It's kind of like mortgaging your house to get a loan. Do you think the bank would lend you a million dollars if you didn't mortgage your house as part of the deal? Well the same applies to those who lend to banks. They want something safe pledged as security too, and nothing is safer than government bonds.

Right now, Bernanke might be worried about a shortage of acceptable collateral because he's been buying up so much of the quality collateral out there as part of his QE program. Most of it consists of buying government bonds.

But in the end Bernanke's job is to maintain price stability and employment. Financing the government and soaking up collateral come second. So as soon as a tapering in QE begins to have a negative impact, the Fed will be ready to unleash a whole new torrent of money.

This leaves the bond market balancing two forms of chaos. On the one hand, it's clearly in a bubble. Yields are still incredibly low and only vast amounts of central bank bond purchases are able to sustain such high prices. Adjusted for inflation, some bonds are a losing proposition altogether. Who would agree to invest money at an interest rate which loses purchasing power? Only if the alternative was even more dangerous.

Which brings us to the other hand. If the Fed is unable to reduce its QE without the economy collapsing around it, the bond market could blow up anyway because of inflation. In fact, it will blow up eventually because of inflation under such a scenario. That's how all experiments like the Fed's have ended historically.

If you take a step back from all this, there's something beautifully ironic. The western governments of the world decided long ago they didn't really believe in a free market. The economy had to be controlled, probably to improve the chances of politicians trying to be re-elected.

The tools they chose to keep control over the economy were the interest rate and the money supply. By setting the price of debt, controlling the money supply, and doing both by buying government bonds, politicians could prime the economy. To keep an air of respectability, they founded central banks and appointed academics to do the job for them.

Now ask yourself, where have all the crises been these last few years? Precisely in the area the government controls - debt. The part of the economy the government has the most control over is precisely the part that's causing all the problems.

Hopefully the next crisis will force the government to relinquish control over this last bastion of central planning. That seems unlikely though.

Thanks for all the emails in reply to yesterday's DR. Voting doesn't seem to be a popular activity with Daily Reckoning readers. There were a lot of toilet references when it came to the ballot paper. But just so you're all informed, here are the relevant sections of the Commonwealth Electoral Act 1918:

  • Section 245(1): 'It shall be the duty of every elector to vote at each election.'
  • Section 245(15): 'An elector is guilty of an offence if the elector fails to vote at an election.'
  • Section 233 explains voting as 'mark his or her vote on the ballot paper'.

Don't get caught!

Regards,

Nick Hubble+
for The Daily Reckoning Australia