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Tuesday April 20, 2010 - 14:19:10 GMT
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Long rates go lower!

Key News
  • European Central Bank Governing Council member Axel Weber has told German politicians that Greece may require assistance of up to 80 billion euros ($111.8 billion) in the coming years. (Reuters)
  • The [German] Mannheim-based ZEW Center for European Economic Research said its index of investor and analyst expectations rose to 53 from 44.5 in March.
  • Bank of Japan Governor Masaaki Shirakawa said on Tuesday the quantitative easing policy the central bank used from 2001 helped financial stability but had little impact on the economy. (Reuters)
“Predicting the future is always a crap shoot, no matter how hard economic modelers try to convince you otherwise. Getting a grasp on the here and now is generally easier.

“Not this time. Rarely have so many observers looked at the U.S. economy and come to such diametrically opposed conclusions. We’re either entering the Promised Land or staring into an abyss.

“Even the business cycle gurus at the National Bureau of Economic Research came up short when they convened on April 8. Members of the Business Cycle Dating Committee met, talked and decided any determination of a cyclical trough to the recession that started in December 2007 would be ‘premature.’” —Caroline Baum

FX Trading – Long rates go lower!

Is bond worry all wet?  I got caught up in the expectation of a surge in long bond yields, which hasn’t materialized.  Being in the deflationary camp, it was a dumb assessment on my part.  I think the perennial bond worry-warts have it very wrong again.   For sustenance on our deflation view we turn to Van Hoisington and Lacy Hunt.

Hoisington and Hunt are the best there has been for many years on bonds.  They toil away quietly at Hoisington Investment Management Company, based in Austin, Texas.  No fanfare from this crew, just excellent analysis on the long-term trend of the economy.  Despite the various calls of inflation and credit risk now implicit in government credits, Mr. Hunt and Hoisington just carry on their merry way making money staying long long-bonds for their investors.  Some excerpts from their latest economic analysis prove interesting as always [our emphasis]:

The federal government cannot create prosperity by spending funds that it does not have. It can, however, spend us into poverty by taking dollar balances from highly productive individuals and their business entities, through borrowing or taxing. This process of transferring these assets from income and wealth generators to other government applications has profound economic consequences.

…Viscerally, the normal reaction to a massive increase in government spending is to assume it is an inflationary event, particularly in the U.S. where amounts have been so large over the past ten years (Chart 1). [Chart not available in text format.]

Has this huge spending shift from 18.4% of GDP in 2000 to 24.7% today made the U.S. more prosperous? The results are unequivocal. Inflation today is 1.3% versus 1.7% ten years ago (core PCE deflator.) The percent of the population working today is 58.6% while prior to the large budget deficit spending of the last ten years it was 64.6%. Our GDP was growing at 4.8% ten years ago, and today we are staggering out of recession.

History displays the same pattern in other countries where excessive government deficits have been implemented. The modern example is Japan.  Its government debt soared from 52% of GDP in 1989 to 184% today (Chart 2). The economic results: GDP in that country is no higher than it was 18 years ago; its employment is no higher than it was 19 years ago, and there is no inflation since consumer prices are at 1993 levels.

… Milton Friedman gave us a modern theory of interest rate determination that has stood the test of time.

Using this theory, what is happening in the U.S., and what does it mean for long-term interest rates?

Money growth is decelerating sharply. Thus, the line sequence runs in the opposite direction, or in Friedman’s own words: “Paradoxically, the monetary authority could assure low nominal rates of interest. However, to do so it would have to start out in what seems the opposite direction by engaging in a deflationary monetary policy.” Friedman states that a deflationary monetary policy is one where the rate of growth in the quantity of money is decreasing, which is the situation at hand (Chart 3). The current 1.4% annual growth rate in M2 is miniscule compared with the 6.6% annual average growth rate since 1900. 

Similar slowdowns have occurred in MZM and the Austrian money supply. [Chart not available in text format.]

So, worry warts will keep on worrying…but Hoisington says despite volatility, “with excessive levels of debt and contradictory monetary and fiscal policies in place, inflation will continue to moderate, thereby driving long term interest rates lower.”

One key point from a currency perspective I’d like to add: Often you see the US dollar doom and gloom crowd first point to the rising level of US debt as a reason to sell the US dollar.  Well, take a look at the two charts below of Japanese government debt as a % of GDP compared to the movement in the USD-Japanese yen pair and tell me if you see any correlation there:

[Charts not available in text format.]

So, let’s do our best to but the US government debt dollar path canard where it belongs—in the trash heap.  

Jack Crooks
Black Swan Capital


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