subtitle: have i f'd up?
or, alternatively: my convictions wavering?
Back in December, when the US 10 yr flirted with 2%, I figured that I'd been right to predict/worry that the housing depression, the blowing up of the debt bubble, the stock market collapse, the dismal economy, and the consequent imminent risk of deflation implied a period of structural lower government bond yields, a la Japan.
How fleeting that feeling was!
With the exception of a brief rally in late March after Ben announced implementation of Q.E., rates have been steadily trending higher almost all YTD, with the 10-yr now back to 3.45.
What's changed? Not the economic reality. The economy has contracted at a fast rate over the last two quarters (having fallen faster to a lower level now than anyone in mid-December must have been thinking likely), and though its contracting at a slower rate now (+ve 2nd derivative), the contraction is not yet over (still -ve 1st derivative).
The housing market has shown blips, but its done that off-and-on for two years. So the housing recession is also not yet over, for reasons I've cited before: home prices still too high relative to incomes or rents; still too much excess supply and shadow inventory; credit is constrained, particularly at lower end, which prevents the whole process of sellers at the lower end moving up to be buyers at the higher end. The debt bubble has burst, and a new credit cycle has not been restarted; it will take a long time yet to digest the excessive (private) debt already in the system, an unhealthy portion of which is bad. Particularly given that unemployment keeps rising and incomes are stagnating (at best). Similarly, the consumer retrenchment, as hard as it is psychologically for Americans to give up their spendthrift ways, also won't be over with just a few months of paring back. In a deleveraging world, and one in which repaying debt is prevalent because asset prices are no longer rising, then spending will be constrained to something less than incomes, which themselves are contracting. Corporate profits have tanked, margins are constricted, cost cutting is the order of the day, capacity utilization is awfully low, etc. There don't seem to be many areas in which there is pricing power.
So, for all those reasons, the deflationary forces are as pertinent today as they were in December, if not more so.
But what HAS changed is the market's perception of government's approach to dealing with all this. As Karl Denninger says in U.S. credit rating under fire:
Inflation fears in this regard are somewhat misplaced, because there is a black hole of defaulting credit into which one is attempting to issue, but it is perceptions that counts in a fiat currency world, and the perception in the market is that the US Government has lost control of its deficit and budget process, and The Fed has lost control of the money supply.
Perhaps the bond vigilantes really ARE back!
Denninger believes foreign central banks are selling into Ben's bid, and, if that's so, the game is up --- there will be a bond market implosion and an economic collapse. (Denninger's been warning of this for over a year, of course, which means he was warning of it with yields north of 4%, well over where they are now. I don't believe he foresaw them dropping as low as they did at the end of last year, so the sell-off we've experienced recently still doesn't get us back to levels at which he was saying bonds were doomed. That said, maybe his concerns back then took some time to become widely perceived, but, now that they are, this sell-off, which is already nearing 150bps, could go a long ways yet if Denninger is right. And, needless to say, its views of his type that test my convictions.)
My impression has always been that Denninger's concerns are totally valid, but the question is one of timing. I saw David Walker's Fiscal Wake-Up Tour material while he was still Comptroller General at the GAO (before leaving to work on the same crusade at the Peterson Institute), so I know Denninger is right: the U.S. simply cannot afford to pay off its debts, not while also maintaing the commitments it has made through all its non-funded liabilities, particularly healthcare. At least, it can't do so with dollars that are worth something! The burden is just too big: as Walker's GAO material pointed out, it added up to $170,000 PER PERSON, or $440,000 per household --- and that was as of the end of 2006!! As per the Peterson Foundation, the burden is now $184,000 per person and growing.
But, in the meantime, deleveraging and debt contraction and deflation and the historically very low proportion that bond holdings represent of the U.S. household sector's balance sheets and the relative near-term safety of government debt relative to riskier assets which have taken a drubbing, all meant that there was plenty of room for incremental new internal domestic bond demand to take up the incremental new supply (as Rosenberg argued repeatedly). And even low nominal yields look okay in a disinflationary or deflationary period --- this is one of those rare times that real yields are actually higher than nominal yields.
Meanwhile, though foreign central banks certainly realize the risk to their appreciable U.S. holdings, they're stuck between a rock and a hard place. They may not want to throw good money after bad, but if they stop buying U.S. debt now, not only do they guarantee a loss on their existing positions, but their currencies, which they've been holding down relative to the US$ with those past purchases, would go the other way, killing their own export-dependent economies. And, to the extent that they have trade surpluses with the U.S., they need to do something with the dollars they receive. Would they rather exchange those greenbacks for Euros? Pounds? Yen? Swiss Francs? Lats? Lira? Roubles?
Besides, I'm really not sure Denninger is correct that foreign C.B.s are indeed cutting back on their purchases. Brad Setser is the expert in this field, and he says that central banks still (heart) dollar reserves. Now, it is true that the U.S. trade deficit has declined, in part because oil prices have fallen, and in part because personal consumption has fallen, so imports have fallen faster than exports. And to the extent that the trade deficit is smaller, that implies a smaller net outflow from the U.S. of dollars to the world (to pay for imports relative to received for exports). So less currency recycling is necessary just as the government is ramping up issuance.
But, according to Setser, central banks have actually increased their Treasury holdings at the Fed by almost twice as much as required to finance the trade deficit. However, they are indeed shortening the maturities of the U.S. debt they purchase. So maybe they don't (heart) long bonds. But Setser believes that as the yield curve has steepened significantly, we'll soon get to a point where those foreign buyers will once again look at the paltry yields they're getting on their bills and notes and opt again for the higher yields on bonds.
All told, my convictions have been sorely tested, but, perhaps naively, I don't think I've f'd up too badly. Just like last year when the markets were all gung-ho about commodity-driven inflation, the markets this year are now gung-ho about money-printing-driven inflation. And, just like last year when government bonds rallied in the second half, I remain convinced, like the Van Hoisingtons and Gary Shillings of the world, that we'll have another significant rally coming.
Where my conviction has been most sorely tested, and maybe even lost, (which isn't much help for tactical trading), is how high yields might get in the meantime. But, as I suggested in my May 4 notes about 1998 Japan (In Japan in 1998, long-bond yields declined fairly steadily from 2.70 in January to 1.16 in October, then spiked back to 2.97 by year-end and 3.53 in February. They then fell back below 2 by May.) I think these so-called "green-shoots" type periods will hurt bonds, but, ultimatley, all the bond-friendly factors will prevail, albeit with remarkable volatility in the interim.
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