return of the bond vigilantes

8/14/2019 Return of the Bond Vigilantes

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THEBOECKHINVESTMENTLETTER WWW.BOECKHINVESTMENTLETTER.COM 1

Return

of

the

Bond

Vigilantes:

TheGreatDilemma

Thebondvigilantesarebackintownasindicatedbytheblowoutearlierinthemonthin

sovereigncreditspreadsofthePIGS(Portugal,Ireland,GreeceandSpain),andwideningof

corporatespreads

over

Treasuries

(Chart

1).

It

was

precipitated

by

Greeces

catastrophically

highfiscaldeficit(13%ofGDP),debt(120%ofGDP)andcurrentaccountdeficit(10%ofGDP),

numbersthatimplydefaultislikely. Bondinvestorshavereassessedriskinanumberof

countrieswhosefiscalpositionistrackingGreeces.

Saddledwithrisingcostsfromthefinancialbailoutandtheprospectofbelowtrend

growth,

many

developed

nations

will

need

to

take

drastic

action

to

reign

in

their

ballooning

deficitsinthenextcoupleofyears.Japanisintheworstshape,withgovernmentdebttoGDP

at200%,fiscaldeficitsof13%ofGDP,interestpaymentsof1.9%ofGDP,andlittlehopeof

growingitswayoutoftheproblem.Suspicionofsovereigndebthasspreadtothesecountries,

asindicatedbyrisingcreditdefaultswaps(thecostofinsuringbonds).InthecaseofJapan,CDS

insuranceabsorbsalmosttheentireyield.CDSspreadsintheU.Saresuchthatsomehighgrade

corporatebondsareratedaboveTreasuries.

Therewassomeeasingincreditmarkettensionslateinthemonth,althoughcivilunrestin

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FEBRUARY25,2010


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Greece,PortugalandSpaincallintoseriousquestionwhetherdeficitscanbereducedinsome

countries. TreasuryyieldshaveeasedabitasdidU.S.corporatespreadsagainstTreasuries

(Chart1).However,itisclearthatcreditriskfearsforbothsovereignandsubinvestmentgrade

corporatedebtarenotgoingawayanytimesoonasmoreandmorepeoplearefocusingonthe

limitstogovernmentborrowingandwhathappenstotheeconomyandprivatedebtonce

governmentstimulusisunwound.

Chart1

Pressurefromthebondvigilantesisalreadyforcingtheauthoritiestotalktough,andinthe

caseoftheU.S.,theFedraisedtheceremonialDiscountRateby%.TheFedhasalsobeen

talkingaboutbackingawayfromdebtmonetizationatsomepointandreducingitsswollen

balancesheettoprecrisislevels(Chart2).Othercountriesarealsoshowingconcern.Germany,

forexample,seemsunwillingtoparticipateinaGreekbailout.CNNandothermajormedia

voices1 havesharplyraisedthevolumeontheglobaldebtsaga.

1See,forexample,MartinWolf,TheworldEconomyHasNoEasyWayoutOftheMire;FinancialTimesFebruary

23,2010.

Chart2


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TheauthoritiesareperfectlyawareofprecedentsintheU.S.(1937)andinJapan(post

1989onthreeoccasions)whentighteningofeconomicpolicytoimprovepublicfinanceswas

prematureandcausedfragilerecoveriestoabort. Inallcases,unemploymentrosesharplyand

intheend,thegovernmentsfiscalpositiondeterioratedevenmoresothanhadtheystayed

thecourse.However,thebondvigilantes,eachintryingtoprotecttheirownassets,may

collectivelyhavetheoppositeeffectofunderminingthevalueofthoseassets.Thisisaclassic

exampleoffallacyofcompositionandputstheauthoritiesinadifficultsituation.

Thedilemmaforthebondmarketisalsoclear. Outofcontroldeficitsanddebt:GDPratios

tendtopushyieldsup.Theprescriptiontoreversethesetrendsisfirsttogenerateasustainable

growthrateinnominaltermsfortheeconomythatismorethantheaveragerateofinterest

thegovernmentpaysonitsdebt.Thesecondisforthegovernmenttoreduceitsdeficitbelow

theinterestpaymentsonitsdebt.Forcountrieswithsomeflexibility,theformerisbyfarthe

moreimportant.However,whenthecreditgeneratingmechanismisbroken,asisstillthecase

inthe

U.S.,

the

economy

cant

sustain

growth

without

government

intervention.

Deflation

will

resumeoncethegovernmentpullsbackonstimulus.Thistendstopushinterestratesdownin

theshortrun,butbyreducinggrowth,governmentdeficitsanddebtwillremainontheirlong

termrisingtrend.Thisinturnfeedsthefearsofthebondvigilantes.ForcountrieslikeGreece

whichhavehitthewallandgrowthprospectsarenonexistent,thereisnochoicebuttoslash

the

deficit

if

they

do

not

have

their

own

central

bank

to

print

money.

OntheU.S.creditscene,U.S.banklendingisstillcontractingatarapidrate.U.S.money

supplyontheM2definitionisfallingatan8%rate(charts3&4).Themonetarybasehas


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continuedtogrowbutthatsimplyreflectsfinancialconstipationbanksareholdingincreased

reservesbutnotlending.Hence,themoneymultiplier,theratioofmoneysupplytobank

reserves,hascontinuedtoshrink.Thewellwornanalogyisthatyoucantakeahorsetowater,

butyoucantmakeitdrink.

Chart3

Bondinvestorsfacethedifficultdecisionofwhethertofocusontheshortrunwhichwould

suggestthatanysignificantriseinU.S.Treasuryyieldsoughttoreverse,ortofocusonthe

longerrunwhenpressuretopushyieldsupwillbecomestronger.Theissueisfurther

complicatedbythefactthatU.S.Treasuryyieldsareprobablyaboutahundredbasispoints

(1%)toolowcomparedtowhatwouldbefairvaluebasedongovernmentdebt,deficitsand

longruninflationexpectations.Therefore,fromarisk/rewardpointofview,owninglongterm

governmentbondswillprobablybeapoorinvestmentandinvestorswillbeluckytobreakeven

onatotal

return

basis,

barring

another

debt

deflation

scare

like

the

one

in

2008

2009.

Inourlastissue,wefocusedonpotentialproblemsinfinancingthehugeU.S.government

borrowingrequirementshouldbondpricesfallandtraditionaldemandfalter,asseemsalmost

Chart4


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economicrecovery(Chart9).Firmshavedelayedhiring,astheyalwaysdoatthebeginningof

aneconomicrecoveryandthishasheldtheunemploymentrateatveryhighlevels.Chart8

showsanothermeasureofcorporatesectorliquidity:theratioofcorporatedebttoequity. The

ratiodoubledin2009.However,adjustingforstockmarketvolatility,theratioisat0.4,not

muchchangedfrom10yearsearlier.

Chart9

ItisimportanttonotethatakeydifferencebetweentheJapaneseexperiencepost1989

Chart 1 Chart 8


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marketisintact,butitdoesdependoncontinuinggovernmentinterventiontocompensatefor

weakconsumptionanddeleveraging.However,gainsin2010willbemuchhardertocomeby

thanlastyear.

Governmentbondyieldshavenowheretogobutup,andasharpriselaterin2010is

possibleiftheFedisdeterminedtoshrinkitsbalancesheet.Atpresentthatisnotinthecards

butconditionscouldchangeinthe2ndhalfoftheyear.Thecompressionofcorporateyield

spreadshasbeenplayedout(Chart1). Thejuicyreturnsseeninthissectorin2009wontbe

repeateduntilthenextcycle.

Goldhaslostmomentum.Theone&threemonthmovingaverageshaveturnednegative

(Chart10). Fromatechnicalperspective,goldiscurrentlytradinginadownwardsloping

channelandweexpectthistrendtocontinue. Webelievethatgoldhasreacheditspeakinthis

cycle,evenconsideringthesovereigndebtdramanowplayingout. Inflationremainstameand

U.S.monetaryauthoritiesstillseemtohaveenoughroomtomaneuverintheshorttermto

avoidthe

type

of

dollar

collapse

gold

bugs

have

been

fantasizing

about.

The

risks

in

the

longer

term,however,arestillpresent.

Chart10


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Industrialcommoditieshavebeenextremelyvolatileoverthelasttwomonths.Coppersold

offby15%inamatterofweeksandhassincebouncedback. Aluminumandzinchaveshowna

similarpatternalthoughthereboundhasbeenweak(seecommoditychartsp.13).Weexpect

oilandnaturalgastoremaininanarrowtradingrangeoverthenextfewquartersandthis

shouldbeapositivebackdropforprofitsofenergycompanies.

Insummary,ourbasicviewremainsunchanged;welookforstockpricestomovehigher

butonamuchflattertrajectorythanlastyearandTreasurybondyieldstoremainrangebound

atbestwiththeriskclearlytotheupside(downinprice).TheU.S.dollarhasbeenfirmoverthe

lasttwomonths,ingoodpartreflectingtheunfoldingsovereigncreditproblembroughttothe

forebyGreeceandtheotherPIGS.OurviewhaslongbeenthattheU.S.dollarwillnotcollapse

butrathererodeslowlyovertimewithcountertrendrallies.Aslongasthisremainsthecase,

inflationisnonexistent,andunemploymentisat10%orso,theFedcankeepmonetarypolicy

veryloose,providingasolidliquiditybaseforstockprices.Nearzeroshortterminterestrates

willkeep

pushing

investors

into

riskier

assets

to

increase

expected

returns.

However,

we

must

continuetourgeinvestorstofocusonwealthpreservation.Thereareplentyofthingsthat

couldgowrongonaveryshortnotice.

Tony&RobBoeckh

February

25,

2010

www.BoeckhInvestmentLetter.com

[email protected]

*AllchartdatafromIHS/GlobalInsights,andmaynotbereproducedwithoutwrittenconsent.


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Charts

Stock Market Indices


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Commodities


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Exchange Rates


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Interest Rates

return of the bond vigilantes

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