September 15, 2003

Bearish on Bonds

I was in London last week meeting with investors. One of them was Jim Bianco of Bianco Research. I've heard Jim speak several times now, and he's one of the most effective and blunt critics of Fed policy you'll ever meet. He didn't disappoint. His main theme on Thursday was this: The Fed and the bond market have completely divergent expectations for the economy. The net result will be more bond selling. Jim points out that the Fed has signaled its intention to keep the Funds rate low for a "considerable" period of time. The Fed fears deflation and would rather risk inflation. Ironically, I think the Fed is right to fear deflation, but wrong to keep interest rates low. The bond market partly agrees with me, and wholly disagrees with the Fed. The bond market fears inflation. That's why it drove up longer-term rates in July and August. The bond market understood the Fed's message. But it told the Fed, "We think you're wrong." Who's right? I think the Fed is right, for now. The greatest risk the world faces right now is that instead of addressing the global imbalance in production/consumption, the rest of the world will try to keep its currency low relative to the dollar and export goods to the American market for profit. In this scenario, the dollar remains strong because everyone else chooses to stay comparatively weak. Does the rest of the world overestimate the strength economyU.S. ecomomy? Or does it underestimate its need to move toward an economic model that's based on a healthier balance between consumption and production? Who knows? The world likes what it gets out of the dollar-centric system for now. The dollar-centric world economy is simple to understand: U.S. consumers leverage their houses to consume above their means on goods produced overseas by cheaper labor. The dollars spent by U.S. consumers go to foreign savers or central banks, who return them to the U.S. market through foreign purchases of Treasuries. As long as the dollars coming in match the dollars going out, the currency itself retains its purchasing power and the whole system remains stable. Despite mammoth twin federal and current account deficits, foreigners continue to plow their export-acquired dollars right back into the bond market. The latest Fed flow of funds report shows that private foreign citizens bought an unprecedented $129 billion in United States government and agency securities. "Official accounts, mostly central banks, added $43 billion more," according to Floyd Norris in the New York Times. Norris ads that "foreigners bought almost 80 percent of the net increase in Treasury and agency debt during the quarter. They now own 38 percent of outstanding Treasuries, more than double the figure of a decade ago." What's shocking in Norris' numbers is the level of private Treasury buying. Either the U.S. bond market is still seen as the world's safest asset haven in dangerous times, or an awful lot of folks were late to the bond bubble before the big sell off. The latter explanation makes more sense to me. The rest of the world crowded into bonds rather than confronting the abyss of a world without a strong where U.S. consumption was not the engine of global growth...a world in which Asia and Europe could not rely on exports to the U.S. to cloak the structural problems that they face. The Fed is destroying this world by accelerating the supply of dollars. Its policy is designed to be inflationary. But it's only inflating U.S. asset prices, not prices for goods and services produced overseas. My belief is that ultimately, creating all those new dollars and issuing billions more in debt will make the U.S. government a credit risk (particularly since the Feds implicitly guarantee the bonds issued by mortgage lenders Fannie Mae and Freddie Mac--a market that's even larger than the government bond market.) Either way, whether it's the perception that the government is a credit risk and is creating too many dollars and issuing too many bonds, or that the bond market is right and inflation is a big threat, bond yields may rise even more. Jim Bianco thinks that they could rise to at least 6% before it's all over. And of course, as yields rise, the prices will fall apart.


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