With US Treasury
yields ending 2008 at 50-55 year lows, 1-month t-bills yielding 0.00%, the Fed
embarking on quantitative easing (printing money) and the incoming
administration planning a massive debt-financed fiscal stimulus, the â€śBonds for
Dummiesâ€ť manual adherents are warning that 2009 may bring the near demise of
the bond market (the new asset bubble).
humbug. No question supply of Treasuries will explode in 2009 to pay for
everything. But the idea that economic forces are ready to bounce back to
like at the drop of a quantitative easing hat is utter drivel. Japan
wrestled, albeit very ineffectively and inefficiently, with quantitative easing
and large fiscal stimulus packages for years before having any impact on
inflation and inflation expectations which must happen to restore risk taking,
business investment (a form or risk taking) and consumption (a form of risk
taking). And through Japanâ€™s experience of quantitative easing JGB yields
remained depressed, even after the policy yielded some successes by
mid-2000s. Many JGB shorts had lots of L and no P on betting QE in Japan
would drive yields up.
But the US is
not Japan. True. Japan has a high savings rate and US a low savings
rate. Japanâ€™s private domestic savings could absorb much of the debt
issuance without seeing yields on government debt rise much. Moreover,
the BOJ was an active buyer of JGBs as part of its quantitative easing program
(keeping longer-term rates from rising).
So why am I
bullish on Treasuries in 2009? To be clear I am not arguing for much more
upside, just against the notion of lots of downside â€“ 2008 was the year of
crashing Treasury yields and 2009 will be the year of low yields.
On the question
of low US savings, this is yesterdayâ€™s behavior. The threat of losses in
income from unemployment and losses in wealth from falling home and stock
prices will make for a Japanization of the American consumer relatively quickly
â€“ ask a retailer, ask a restaurateur, ask a hotelier, ask a bond traderâ€¦
And if these anecdotes are not convincing look at the data from chain stores,
Commerce and sentiment index publisher. And look at GDP.
investors may flee Treasuries as the Fed prints money and the government
borrows its way to prosperity. Foreign official holders of US Treasuries
are not likely to fleeâ€¦like China despite its verbal posturing today over a
subtle warning that US officials should not take for granted ever rising
Chinese demand for US government debt, particularly if the policy mix becomes
unacceptably risky. China canâ€™t sell â€“ mutually assured financial
self-destruction principle holds. China has to buy â€“ Chinaâ€™s economy is
not going to switch from export driven to domestic demand driven overnight and
maintaining a competitive yuan necessitates amassing foreign currencies and hence
debt denominated in foreign currency.
selling of US debt by foreign private and public holders is inevitable (GSE
debt has seen foreign official accounts dump it for US Treasuries in the last
I see two
sources of demand for Treasuries that should offset anything short of a
wholesale exit of US debt by foreign holders (again a world where there would
be nearly no winners). Like in Japan, US banks can borrow Fed funds at
zero and buy 30-year debt and pick up 262bps which will do some of the heavy
lifting in restoring bank capital. And like in Japan, the US central bank
will be a buyer of Treasuries (amounts to be determined). I think the
lesson of the last 16 months is buy what central banks like the Fed are going
And I have
problems with the bond bear timelines for recovery and inflation.
First of all
every prior recovery, outside of Japanâ€™s lost decade, any of us have seen in
the last 55 years has come with a banking system fully intact and operating as
a credit creation machine (taking in deposits and making loans). That
machine, outside of healthy (smallish) regional banks, is now broken.
Japanâ€™s banking system was broken too and was a key reason why the policy mix
was so hopelessly ineffective in bringing deflation to an end.
Without a banking system acting as a transmission mechanism for credit to
reach households and firms, central banks and governments are at a distinct
disadvantage in using monetary and fiscal policy to spark consumption and investment
(something that should only be done in periods of extreme downside
risks). Hence the zero rate bound and quantitative easing alternative is
in response to a broken banking system (caused by it â€“ liquidity trap).
In Japan the BOJ wrongly stuck with the banks as the primary transmission
mechanism to create credit when there was no chance the banks would invest in
anything other than risk free government bonds. The Fed, aware of this
shortcoming, is doing an end run around the banks as it embarks on quantitative
easing, buying securities (of all sorts) from the market directly (biggest
problem for the Fed is that the non-bank credit creation machine is too small
for the job which argues in time for the Fed directly providing (or
guaranteeing) credit to the private sector.
My point is that
the Fed has no fairy dust to sprinkle on the economy and bring it rushing back
to life and back closing the output gap. Even with the knowledge of how
not to repeat Japanâ€™s errors, the Fed (and US government) will need lots of
time before policies have the desired effect. Selling bonds today for an
outcome that might take five years to unfold is not the best timing. Bond
bears want to go short just as the recession has gone from bad to very worse â€“
no trough in sight and no recovery imaginable for a few years at the
soonest. And a similar story plays out for price level developments â€“
selling bonds before deflation risks have been thwarted (drop in energy prices
assures that headline inflation will run negative in Q1) mush less before
disinflation has peaked.
is a necessary but not sufficient condition to higher Treasury yields much less
inflation and inflation expectations. Again see Japanâ€™s experience.
Bond bears are guilty of skipping stages.
Jim Grant would
have everyone believe that the US government debt is not worth the paper it is
printed on â€“ a conclusion he reached years ahead of the current recession and
financial crisis. As much as I like and respect Grant, the chance of a
credit rating agency downgrading US government debt in the next few months (try
my lifetime) is zeroâ€¦okay maybe credit ratings are not what they are cracked up
I would also
note that in the dollarâ€™s plunge last week which many pinned on the Fedâ€™s ZIRP
and QE (monetization or running printing press ahead), Treasury yields went to
50-plus-year lowsâ€¦in Zimbabwe where printing presses run night and day, I
suspect government debt is as worthless as the ZWDâ€¦they go hand in hand.
I will worry (much later in the crisis) when bond yields and the dollar are
moving in lockstep (bond prices and dollar down). Until then I think the
Treasury sky is not falling. Will it never fall? I tend to think it
wonâ€™t. But I am also not suggesting that in the coming months and quarters
that bond prices and the dollar wonâ€™t sell-off some. But I doubt it will
happen because of a wholesale rejection of US liabilities (bonds and the
And as far as
the business cycle is concerned, the data suggest the risk of disinflation becoming
entrenched deflation is growing. Housing data for November, out earlier
today, were dreadfulâ€¦no bottom in sight. Retail sales areâ€¦not even worth
the effort. Household wealth is depressed (stocks down 40% from November
2007 highs and home prices still falling). Corporate profits are
collapsing. Global trade is slowing rapidly. Firms and households
with high levels of leverage (debt) are at serious risk of default,
bankruptcy. Again the banking system is broken. Oil is under $40 a
barrel and falling and there is no talk of speculators shorting the
market. This is not the time to put on trades based on a crisis in
confidence in US government debt and the dollar.
So I am not
calling for major new upside in Treasuries (prices) in 2009, just not a lot of
Where I see
upside is in instruments the Fed and Treasury will be buying â€“ GSE debt and GSE
MBS, munis and higher quality ABS more generally.
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