Below are extracts from commentaries posted at www.speculative-investor.com on16th September and 19th September 2004.
This is not your father's bond market
Gone are the days when the performance of T-Bond futures told us something about the market's expectations regarding inflation. If anything, inflation (money supply growth) now BOOSTS bond prices because more than 50% of the dollars leaving the US on the current account (the huge US current account deficit is simply an effect of the rampant inflation of the past several years) are soaked up by foreign central banks and then used to purchase US Treasury and Agency debt.
But buying by foreign central banks isn't the only explanation for the elevated price of US T-Bonds. It is also the case that with much of the world oblivious to the US inflation problem and with the Fed capping short-term rates at an artificially low level there remains a strong incentive for private banks and hedge funds to borrow short-term in order to purchase long-term debt. This, in turn, has created 100s of billions of dollars of additional demand for long-term debt instruments such as T-Bonds, putting further upward pressure on bond prices and downward pressure on yields. And if all this wasn't enough, the US Government continues to report 'inflation' statistics that are so far removed from reality they should be ridiculed by the financial press but instead they are rarely even questioned; while Ben Bernanke keeps the potential for direct Fed support of the bond market fresh in the minds of market participants.
On this last point, in a paper presented to the Brookings Panel on Economic Activity, September 9, 2004, Fed Governor Ben Bernanke et al state: "There is some evidence that central bank communications can help to shape public expectations of future policy actions and that asset purchases in large volume by a central bank would be able to affect the price or yield of the targeted asset." And: "If the Federal Reserve were willing to purchase an unlimited amount of a particular asset, say a Treasury security, at a fixed price, there is little doubt that it could establish that asset's price. Presumably, this would be true even if the Federal Reserve's commitment to purchase the long-lived asset was promised for a future date. Conceptually, it is useful to think of the Federal Reserve as providing investors in that security with a put option allowing them to sell back their holdings to the central bank at an established price."
So although the Fed has, up until now, primarily relied on foreign central banks to support the targeted asset (US Treasury debt), it is clear that it would resort to aggressive buying of its own if 'push came to shove'.
Of course, when Ben Bernanke and other Federal Reserve representatives speak of buying bonds in order to suppress long-term interest rates they are supposedly addressing the problem of how to create more monetary stimulus in an economic environment in which there is a threat of deflation, but does anyone think to ask them why it would be necessary to support bond prices in such a bond-friendly environment? After all, if deflation were really a genuine threat then long-term interest rates would be falling of their own accord, that is, there would be no need for any artificial assistance. By the same token, the only time that central bankers and politicians ever feel the need to target any price is when the price they want is different from the price justified by economic reality.
Further to the above, over the past few years the US bond market has probably received more artificial support than any other market in history and in all likelihood it will continue to receive substantial support of this nature. However, this doesn't mean that a sharp fall in the bond market can be postponed indefinitely because at some point inflation expectations WILL start to rise in an uncontrolled manner. And once this happens private-sector buyers will retreat en masse and any official attempts to support the market will become counter-productive (official attempts to suppress interest rates would ADD to the inflation fears in such an environment).
Bond Market Outlook
Our interpretation is that a secular bear market in bonds commenced in June of 2003 and that last year's initial sharp decline has been followed by a very lengthy consolidation. This consolidation will eventually end in a downside breakout, but it's quite possible that the August-2003 and May-2004 lows will hold for many more months. Due to the length of the consolidation, once a downside breakout does occur the ensuing decline will probably be explosive.
When it comes to deflation...
When it comes to deflation we think we have, over the past 6 months, heard/seen it all. At various times and in various publications it has been explained to us that falling interest rates are a sign of deflation and that rising interest rates are deflationary; that a rising oil price is deflationary and that a falling oil price is a sign of deflation; that despite the obvious evidence of inflation in the performances of the US$ and the prices of most commodities over the past few years, this year's counter-trend moves in the currency and commodity markets are signs of deflation (as if any market ever moves higher or lower in a straight line); that a falling gold price reflects deflationary pressures while a rising gold price is a sign of deflation because gold is money and during deflation the demand for money increases; that even though a rising oil price is deflationary due to the additional burden higher energy prices place on consumers, when Walmart reduces the same burden by importing a lot of cheap stuff from China the effect is also deflationary.
So, Mr Greenspan, you can proceed full-steam ahead with your inflation agenda because no matter how much INflation you promote there will be plenty of analysts/commentators who will continue to refer to DEflation as a clear and present danger and who will, therefore, unwittingly assist you in the critical task of managing inflation expectations. After all, figuring out how to inflate has never been a challenge for the Fed and nor will it ever be as long as there are no objective limits on money creation. Instead, the real challenge for the Fed has, on occasion, been to figure out how to inflate whilst keeping inflation expectations in check.
