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Of Bombs and the Bond Market

A version of this essay was first published in The Daily Reckoning.

So spoke Larry Kudlow, of CNBC fame, in a recent "Cramer and Kudlow" show. However, what Kudlow failed to specify is precisely on which number or color we should place our chips.

I have recently taken a negative view about bonds... despite the almost universal consensus that bond markets around the world had reached a bubble peak and would from now on decline. The so-called reflation trade', which most strategists are advocating, implies that the selling of bonds and the purchase of equities is the way to play of the day.

Recently, however, I received a study by Ray Dalio and Jason Rotenberg of Bridgewater Associates, an institutional economic service I highly recommend, which pointed out that whereas the twin deficits - the budget deficit and the current account deficit - exploded in the period from 1983 to 1987, and in the process weakened the U.S. dollar, bonds continued to rally from their secondary lows in 1984 (the major low was reached in September 1981) until 1987.

Bridgewater doesn't buy the argument that the present bulging twin deficits, each of which will soon reach around 5% of GDP (a record, I might add), is necessarily be bearish for bonds. The Fed has the means to create sufficient liquidity to support bond prices and simply let the dollar slide in order to make the necessary adjustments.

Since I religiously read the research papers published by Bridgewater Associates, I did some thinking about whether bonds could resume their 22-year bull market and confound the consensus, while the dollar weakened much further. In the process, I discovered some important fundamental differences between the present situation and the economic conditions that prevailed in the 1984-1987 period, which permitted the bond market to rally while the dollar was tumbling.

First, when bonds began to rally in the fall of 1981, they had completed an almost 40-year bear market. In addition, the 1983-1984 renewed weakness in bond prices saw the yield on government bonds spike up once again to over 14%, whereas inflation had by then already declined to less than 4%. Thus, in 1984, bonds had an unusually high real yield, as the investment community still believed that inflation would reaccelerate at any time.

In other words, in those days, inflationary expectations were extremely high, because investors were conditioned by the highly inflationary 1970s during which it appeared that there was no end in sight to rising commodity prices and inflation rates.

However, when commodity prices continued to decline between 1984 and the summer of 1986 and the CPI declined to around 2.5%, while at the same time the Producer Price Index was briefly deflating, bonds staged a huge rally, bringing yields down from above 14% to less than 7.5%. Now, however, it seems to me that the very high inflationary expectations of the early 1980s, which led to record-high real interest rates on long-term bonds, have been replaced by widespread complacency about future inflation rates and, in fact, fear about outright deflation.

Another point that should be mentioned is that, whereas until 1987 the U.S. had a positive net investment balance (it owned more assets abroad than foreigners owned assets in the U.S.), this has today been replaced by a negative investment balance, which amounts now to around 25% of GDP and is currently growing by around 5% of GDP.

Thus, today, the ownership by foreigners of U.S. Treasuries, corporate bonds, and equities is more than twice as large as a percentage of GDP as it was in 1984 - not an insignificant point when appraising the future of bond prices amidst a U.S. dollar bear market, as Bridgewater seems to forecast. It is, to my mind, doubtful that foreigners will continue to increase their already very significant exposure to U.S. bonds, which are now offering very low yields, if the dollar is going to weaken much further.

Another point I believe to be relevant when comparing the 1984-1987 bond bull market and the present situation is that, at the time, Paul Volcker was Fed chairman. By contrast, we now have monetary policy makers such as Alan Greenspan and Mr. Bernanke at the helm, who are much more likely to tolerate higher inflation rates than Paul Volcker would ever have done.

Lastly, it should not be forgotten that crude oil prices tumbled between 1985 and 1986 from more than US$30 to less than US$12.

Now, I am not suggesting that oil prices couldn't decline once again, but a decline of this magnitude seems highly unlikely given both the rising oil demand we have in Asia and how badly the occupation by the coalition forces is going in Iraq, which will be unlikely to lead to significant oil exports from Iraq. At the same time, the cost of the occupation is almost certain to increase the U.S. fiscal deficits for some time to come.

I have been highly skeptical about the invasion of Iraq. I have subsequently received several hate emails for having the audacity to question the war, so I have decided to refrain from making any additional comments. I am, however, indebted to my friend Professor Marvin Zonis, a brilliant international political analyst, for allowing me to reprint some of the views he expressed in a recent report entitled "Terrorism Alert: 'Waste Deep in the Big Muddy' of Iraq". Under the subtitle, "A Guerilla War in Iraq", he writes:

" Before the U.S. war against Saddam Hussein, I predicted that the outcome would, eventually, resemble the fate that befell the Israelis after their invasion of Lebanon in June 1982. The Israelis had liberated Lebanon from its near-total control by the PLO, which had fled to Lebanon after losing its war against King Hussein in Jordan in 1970. After a rapid and total Israeli military victory in the summer of 1982, Yasser Arafat and his PLO fighters were put on freighters in Beirut and exiled to Tunisia. But in 1983, hundreds of U.S. and French Marines were killed in separate terrorist bombings in Beirut and the U.S. pulled out.

" By 1986, the Israelis had fled from Lebanon, unwilling to sustain the low level of casualties that were constantly inflicted on their armed forces. Before the U.S. war against Saddam Hussein, I suggested that the Iraqis would turn against the U.S., as the Lebanese had turned against the Israelis, seeing them as occupiers rather than liberators and that a turn against the U.S. would come to be one way the Iraqis could generate a national identity and create a unified Iraq. The turn against the U.S. has already occurred. (Like all other processes in our age, the transformation of the U.S. from liberators to occupiers occurred more quickly than was conceivable two decades ago for the Israelis in Lebanon.)

" The most dangerous part of this story, however, is not in Baghdad, but in Washington. The Bush administration appears to be in a state of denial about the seriousness of the U.S. position in Iraq. What has become increasingly obvious is that the deaths of American soldiers and the looting in Baghdad and Basra are the product of organized opposition to the U.S. occupation. The U.S. is now in a guerilla war - a low-intensity conflict - in Iraq. The killings of Americans are not the product of disgruntled, lone, Saddam loyalists. They are the product of determined opposition to the U.S.."

According to Zonis, the violent opposition appears to be largely the work of Sunnis, but the Shiite areas of Iraq are apparently also increasingly restive, complaining that U.S. officials promised that Iraq would be turned over to the Iraqis as soon as Saddam was overthrown. And commenting on President Bush's response to the rising casualties, Marvin (not me, although I agree with his views) writes: "President Bush displayed his usual macho style [recently], when he told reporters, 'There are some who feel like conditions are such that they can attack us there. My answer is: Bring them on. We have the force necessary to deal with the situation'. But by all accounts, however, the U.S. does not have the force necessary to deal with the new terrorism."

Zonis then explains that before the start of the war, "Army Chief of Staff, General Eric Shinseki, argued that hundreds of thousands of troops would be necessary to stabilize a post-Saddam Iraq. Secretary Rumsfeld and Deputy Wolfowitz slammed the General (who has now been retired from the armed forces) on the grounds that his estimates had nothing to do with Iraqi realities. The word from Baghdad is that U.S. administrator Paul Bremer has asked for a substantial boost in U.S. troop strength. The request has been denied by the Pentagon."

According to Zonis, "armed resistance to the U.S. occupation of Iraq is likely to grow and not diminish as the U.S. fails to restore vital services - electricity is still being delivered to Baghdad for fewer hours per day than Saddam supplied - and as Sunnis are energized by a new crop of young hot-headed clerics. That the U.S. is involved in a classic guerrilla-type war is, incidentally, also the opinion of the U.S. military's new commander in Iraq, General John P. Abizaid, whose views seem to be in sharp contrast to earlier statements by Defense Secretary Donald Rumsfeld."

Now, if the U.S. is indeed engaged in a guerrilla war in Iraq (and by all accounts, it certainly looks that way), victory won't be easy. I remember well my meeting with a French member of the Foreign Legion on the Island of Corsica in the 1960s. He had fought in 1954 at Dien Bien Phu in Vietnam, and served during the Algerian uprising prior to Algeria gaining independence in 1962. According to him, his regiment was relieved when they left Vietnam. Every legionnaire was looking forward to being stationed in Algeria, which they thought would be like a paradise when compared to the tough campaign and eventual hellish defeat they had experienced in Vietnam.

However, this proved to be an illusion. According to him, the Algerian war turned out to be far worse than Vietnam, because the French troops in Algeria never knew who was friend or enemy and, therefore, incurred tremendous casualties in continuously recurring ambushes, acts of sabotage, and raids on their camps.

The problem with guerrilla wars is that the enemy isn't visible, and so, unless the local population almost unconditionally supports the occupying forces, guerrillas can easily hide among and seek support from the local population. Claus von Clausewitz describes in his classic work "On War" (first published in 1832) that any "attack which does not lead to peace must necessarily end up as a defense. It is thus the defense itself that weakens the attack. Far from this being idle sophistry, we consider it to be the greatest disadvantage of the attack that one is eventually left in a most awkward defensive position."

This is exactly where the coalition forces find themselves now - in a very awkward position. Not only do the minority Sunnis oppose the occupation, since in a reconstituted Iraqi government they would be outnumbered by the Shiites, but it is likely that some more radical elements of the Shiites with the support of Iran will fight the occupation, which, according to some well-placed sources, will lead to an American attack on Iran sometime early next year. In any event, it is doubtful that the occupation will be over soon.

While it is unlikely that the tactics employed by the Iraqis will lead to a "Teutoburger defeat", which, when in AD 9 the German leader Arminius lured the Roman legions into the Teutoburger forest, resulted in the liquidation of three Roman legions under the command of Publius Quintilius Varus (the emperor Augustus is quoted as having exclaimed, "Varus, Varus, give me back my legions!"), a costly, drawn-out war with heavy casualties, along the same lines as the Algerian war, should not be ruled out. I might add that Arminius is widely regarded in Germany as a hero who, according to the Roman historian Tacitus, was "unquestionably the liberator of Germany", since the Romans were subsequently forced to retreat south of the Rhine and behind the Limes and Danube rivers. This is the reason why Germany, unlike Gallia (France), was never Romanized.

It also goes to show that the so-called Pax Romana, which reached its zenith under Augustus, is more a myth than reality, since Roman legions were continuously engaged in costly wars in the Empire's provinces.

The situation into which the coalition forces have boxed themselves in Iraq is potentially far more serious than the financial markets are giving it credit for. It could, if it deteriorates, not only have implications for the budget deficit and President Bush's chances of being re-elected, but also for geopolitics, since one can safely assume that both the Russians and the Chinese (who are becoming increasingly dependent on Middle Eastern oil) have little interest in seeing the Americans succeed in their endeavor.

As a result, I believe that the risks in U.S. financial assets remain high and that the U.S. dollar, U.S. bonds, and U.S. equities are vulnerable to a large number of potential negative factors, which could disappoint investors, if not in the second half of this year, then in 2004.

So, as Larry Kudlow suggested, where should investors get their chips into play?

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