September 09, 2003

Defitics Turning U.S. Into Russia, Bond Market Calls

The world has fallen into fiscal and monetary madness. Normally, increasing the supply of something causes its price to fall. Not so with U.S. bonds lately. President Bush is asking for $87 billion to nation build in Iraq and Afghanistan. The Federal deficit could top half a trillion dollars this year. Yet T-Bond futures are rising. How to explain this? Ten Year Note Futures on the Rise Only two ways, really, and the first is so unlikely as to barely deserve mentioning. But it could explain things. It COULD be that the bond market sees inflation ahead later this year. In this scenario, we find the bond market and the Fed in a heated disagreement. The Fed plans to keep in short-term rates low for as long as it takes to “get America moving.” The bond market, judging by the action in the futures market, thinks the Fed is wrong and that the economy is already moving. I find this explanation…way too simple and completely at odds with the economic evidence. There’s no telling what the bond market is “thinking.” You can only see what it’s doing. And the latest commitment of traders report shows that for the reporting period ending September 2, Commercial traders are net long 53,097 contracts in T-bond futures. That’s a 15% increase from the previous week, says John Kosar at Bianco Research. The “smart money” is still betting on a bond market rally. But a bet on a bond market rally is not the same thing as a bet on inflation. In fact, it could be the opposite…a bet on Deflation. This is the second explanation for rising bond prices and one that makes more sense to me. It means the current global financial regime of U.S.-led consumption and Asian over-production may have a yet another round in it. No regime change yet. Ultimately, this is only compounding the disaster for the world’s financial system. It encourages more U.S. debt, more global over production, and the bastard offspring of the both phenomena, debt deflation. And it’s putting the U.S. in a foreign policy in the hands of foreign bond holders. More on that in a moment. For now, it looks like the Japanese and Chinese are content to keep their currencies low (and their exports competitive) by buying bonds with all those U.S. dollars they get from free-spending American debtors. The Bush people must be of two minds about this. One, they know that cheap imports from Japan and China keep American consumers borrowing and spending. Good for GDP. Good for CNBC. Two, they know that cheap imports from China and Japan are profit killers for American manufacturers--and THAT is a political issue the Democrats are already running with. What to do? Bush and Snow will make noise about Chinese revaluation. But it’s really up to the Chinese, not George Bush. Asia accounts for 39% of all U.S. bond purchases. Japan and China alone own a combined $565 billion in U.S. bonds. This is the deflationary dynamic that’s bond supportive. Asia overproduces and takes global profit margins down to razor thin margins, driving out all the competition and dumping the dollar proceeds into bonds yielding 4%…or 3%….or 2%…or less. A geopolitical eco/conspiracy question for you: Could it be a calculated Chinese strategy to wreck the world’s economic and military hegemon (the U.S.) by deliberately producing below the cost of production…making more goods in China than can possibly be sold in the world in order to pummel American industry into oblivion? It COULD be. But even if it’s not deliberate, it partly explains the persistent foreign buying of bonds despite the growing U.S. supply. Time to own bond calls again. TEN YEAR NOTES LOOKING BULLISH Meet the New Russia: America 2004 You may be one of those investors who find it inconceivable that the United States is a bad credit risk. And when bond prices rise even as the U.S. twin deficits (federal and current account) get larger, it’s hard to argue that foreign buyers are getting nervous about the size of the debt. And the conventional thinking is that foreign bondholders are in some way beholden to the dollar the more they buy U.S. bonds. After all, unless they support the dollar by buying U.S. assets, the dollar falls, and the value of their dollar-denominated assets falls with it. But it IS possible that in the near future, U.S. debt levels will be so high that it forces a huge revaluation of the dollar, whether anyone likes it or not. Who knows exactly what precipitates the reaction an investor has that a given piece of paper is not worth nearly what was paid for it? A housing recession. A unemployment rate of 10%? Regardless of what will cause the dollar crash, foreign bondholders will suddenly find they have a tremendous amount of geo political leverage. U.S. debt will have to be paid, either in an inflated currency, or another, less conventional way, with a different kind of currency that you might call….policy complicity. We may soon see the day when foreign bondholders call the shots on U.S foreign policy. In exchange for U.S. flexibility on say, the Palestinian question…or North Korea…or India…foreign bond holders either forgive a portion of the U.S. debt or renegotiate it on favorable terms. Sounds crazy? Maybe. Think of how the Russians have turned their outstanding debts (and nuclear arsenal) into political leverage. No one can afford to let Russia fall apart. Russia, under Putin, has been able to use its delicate debtor status to renegotiate favorable terms on debt (rather than defaulting again), attract capital (to prevent catastrophe, of course), and exert a disproportionate influence on regional and global events. It’s not exactly a position of strength. Yet it turns a primary weakness to its best use. It’s something U.S. politicians may need to learn quickly. Or course, they’ll probably keep right on spending until they’re forced to quit. And it’s clear that as long as U.S. politicians decide to pursue the War on Terror, the government is going to run larger and larger deficits. There will be no spending cuts in an election year. And it’s hard to imagine either Bush or a Democratic candidate taking office on a program of sweeping defense and domestic cuts. There may be a Democrat who will campaign to eliminate the Bush tax cuts. But not a one of them will touch spending. And so higher the twin deficits go…at what price, we don’t yet know…


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