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Friday February 11, 2005 - 16:13:53 GMT
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Bond Market Tremors

Bond Market Tremors

Thursday's sell-off in the 10-year note and resultant steepening of the yield curve has shaken Treasury market assumptions about the most crowded trade in the financial markets...short the short end and long the long end. Keep in mind anyone trading bonds who believed the invisible hand of the market sets yields/price was a repeated seller of the 10-year in the last nine months only to have the much anticipated rise in yields/decline in price never materialize. Instead the bond market was humbled by a relentless bid in Treasury notes by the visible hand of monetary authorities. What else can possibly explain why the curve ignored the Fed tightening cycle from a 45-year low in Fed funds rate, signs of inflation picking up (especially last spring), record budget deficit and debt supply, and the US economy humming along at a 4% clip should have brought the yield curve to attention. Instead the yield curve never got out of the bunk for revelry, and was downright catatonic.

You did not need to be one of Pavlov's dogs to figure out that shorting the long-end of the curve has been a painful exercise since the Fed began tightening. And it has become unlearned...until Thursday. Pavlov's treats have gone nearly exclusively to those putting on flatteners...the learned behavior.

Why? Hearing some of the explanations for why the flattening trade has paid out during a Fed tightening cycle and growth spurt is reminiscent of the efforts to justify equity valuations in the spring of 2000.

But the truth has more to do with structural distortions than market forces. It is scary when one realizes that the US yield curve is not really representative of inflation expectations in full, but reflects the visible hand of governments, the orgy of currency intervention in Asia, the recycling of $50 a barrel oil by OPEC and more recently a determined effort by US firms to reduced under funded pension liabilities. I find it incredulous that Greenspan or any Fed official can talk seriously about inflation expectations when market forces are taking a back seat to the designs of governments for currency manipulation. What market really? What signals from the bond market really? Don't get me wrong, I for one am not quivering under my desk fearful of some imminent inflation problem. All I am saying is what would the yield curve look like ex-oil shock, ex-currency intervention and ex-pension repair? US market rates are probably more distorted today than at anytime in history...the accumulation of dollar reserves by foreign governments/central banks is unprecedented.

Greenspan has adroitly noted that this intervention cannot continue indefinitely without bloating the money supply of countries buying dollars and leading to a monetary (no not all inflation problems are monetary in nature) inflation problem. Look at South Korea where the issuance of FX operation bonds by the central bank has been crowding out government debt issuance, and most certainly corporate debt issuance. So much so that a few week back the yield curve steepened significantly despite the economy
stalling. Currency policy here is having a contractionary effect by driving yields up, though longer-term it will be inflationary. Can China be far behind?

I just don't believe that the yield curve has been telling us that the economy is ready to roll over into a period of sub-par growth and stagnation where inflation is a problem officials want to have. The Fed's forecasting model is as good as any out there and it is predicting above-tend growth this year. I am sorry but the bond market tends toward Pavlovian when it comes to following Fed thinking on key economic issues. Again this is less about the bond market's independent thinking and more about distortion. The bond market tried what was natural in repeatedly sold the long-end only to get crushed by the central banks who bought everything in sight. Ask any bond trader on the sell side what customer desk prints the most tickets (ask FX traders too)...the central bank desk.

My argument is the yield curve is not very meaningful right now in telling us much about inflation expectations. And it won't until the distortions end...currency management in Asia ends.

In the meantime, the scale of foreign central banks' US Treasury positions is so colossal that any modest adjustment in position by say the PBOC can rattle the bond market as happened Thursday (talk Asian central banks sold the show at the 10-year auction too). Even modest attempts to diversify into other sovereign debt markets will create tremors in the Treasury market ahead. I am not making a case for steepeners. Timing when foreign central banks will hoist the white flag of surrender on currency manipulation is all dart throwing. China appears in no hurry to end this practice. And hence the region will hold on as long as China does.

But as the scale of foreign official ownership of US Treasuries grows increasingly unwieldy and for the sake of the financial markets and the US economy (housing), let's pray that the investment strategy of the visible hand of foreign governments and central banks is buy and hold. I am a seller of US budget deficit containment ahead.

David Gilmore


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