Wednesday January 19, 2005 - 11:28:57 GMT
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Black Swan Capital - www.blackswantrading.com
A bullish bond (and dollar?) forecast
A friend sent to me the Hoisington Investment Management 4th Quarter Review and Outlook. Hoisington is fixed income manager serving primarily institutions. And they are very good at what they do because their economic analysis is excellent.
Early in ’04 they were bullish on long bonds, when the consensus was not. And we know the rest of the story. Again this year the consensus (I plead guilty) expects long bonds to get clobbered as the Fed hikes interest rates. But Hoisington says “the potential will again lie in the long end of the market.” Slower economic growth and lower than expected inflation are why.
I believe much of Hoisington’s forecast has implications for the dollar, for example:
1) On the falling dollar’s inability to stimulate export growth: “Most forecasters expect U.S. exports to improve this year because of the two year decline in the dollar, but this view may be too optimistic…We believe that global excess capacity and a fear of losing U.S. market share caused these importers to hold the line on prices despite the falling dollar.” [In addition, the impact of tighter monetary policy and higher energy prices means the major economies will be stagnant in ’05.]
2) Why we should see increased savings and less spending this year:
a. “Household debt levels imply that the financial condition of the typical American household is stretched. Household debt was a record 115.3% of disposable personal income in the third quarter, an all time high for the series… Repairing the consumer's extended balance sheets will serve to stunt spending.
b. Oil shock: "Each of the preceding oil shocks were associated with recessions [the current shock is the third largest of five since 1970]…Historically, the first response of consumers is to reduce saving to pay for higher interest expenses and energy bills, and only later do they decrease their purchases for discretionary spending."
3) Why inflation will surprise on the low end: “When the Fed says that it wants low inflation, and that it is willing to further tighten monetary conditions, the record suggests that it should be taken at its word…Thus, the macro economy will be characterized by too many goods chasing too little money, the condition that produces disinflation.”
“In the past twelve months the CPI increased 3.5%. This advance reflected a 56% surge in oil prices from the end of 2003 to the close of last year, as well as large increases in some key commodity price indexes to all time highs. In the present situation, such events are contractionary, not inflationary, even if they temporarily lift the core inflation rate. They are only permanent if the Fed monetizes them by accelerating monetary growth. The rate of increase in M3 like that of M2 dropped to a nine year low in 2004, effectively isolating the higher oil and other commodity prices. The CPI should reverse sharply to the downside this year, and the multi-year low in the core inflation rate lies ahead.”
Though Hoisington believes the Fed will continue to hike short-term rates, the sharp reduction in inflation due to slower growth, more consumer savings, falling commodities prices, and a stagnant global economy will push inflation rates sharply lower in 2005. The Fed achieves what it wants: higher real interest rates and slower monetary growth. And according to Hoisington, long bond investors get what they want: “…a safe and very rewarding investment.”
This economic scenario supports the view that a weak dollar does little to help reduce the US current account deficit. Yet it provides the backdrop for increased US savings (reducing the need for foreign funding of US deficits at the margin) and rising real interest rates. Both would be good news for the buck.
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