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Friday August 26, 2005 - 11:35:27 GMT
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Thinking about interest rates...

Key News

• The U.K. economy grew 0.5 % in the second quarter, faster than previously estimated. (Bloomberg)
• Japanese postal reform asset reallocation estimate: Citigroup estimates a change in ownership would drain $1.375 trillion out of Japanese bonds, including JGBs and municipal and corporate debt, as either new management searches for more lucrative investments or customers shift their business elsewhere. The analysts estimate that $127 billion would go into U.S. bonds, $64 billion into European fixed income, and a whopping $521 billion into Japanese equities. (WSJ)
• Key reports due today (WSJ):
9:50a.m. End of Aug Univ. of Michigan Consumer Sentiment Index. Consensus: 92.8. Previous: 96.5.


“There is nothing like desire for preventing the things one says from bearing any resemblance to what one has in one’s mind.”

Marcel Proust

FX Trading

Thinking about the money that could flow into US Treasuries from Japanese postal reform made us think about this comment from Lacy Hunt recently, during his appearance on Bloomberg Television recently:

“If we look at the last 135 years the long Treasury, not the 10-year, has averaged 4.2 percent. So, we're still above the 135 year average. If we look back at that earlier global period, which
was brought on by the Transcontinental Railroad and the Suez Canal and the Panama Canal, tremendous innovations, very similar to what we have today, the long Treasury average is 2.9 percent, with a .7 percent inflation rate.” [our emphasis]

Shocked you say! Well yes, a 2.9% long bond rate sounds shocking. But, and this I know is a narrowly focused examination, let’s just consider how darn deflationary the global environment has become, and should continue to become.

The first piece of evidence before the court:


We have seen an explosion in raw materials prices from early 2001 onward. But we haven’t seen these costs flow back into final goods prices. Granted, part of this may have something to do with the falling dollar from 2000 to late 2004 i.e. with global commodities priced in dollars a falling buck effectively reduces the cost of imported goods. But there is big problem here: China’s currency was tied to the dollar, so they got no benefit on the cost side of the equation as the dollar was tanking. And yet we still haven’t seen much of any inflation in China.

Let’s consider crude as our moniker of rising resource costs. We are still waiting for the oil price shock forecasts to kick into gear. In the process of waiting, we noticed this very interesting article appearing on the Ludwig von Mises Institute website, The Oil Price Mirage, by Pierre Lemieux:

“[H]istory of the oil industry is replete with exaggerated demand forecasts, pessimistic supply limitations and sky-high prices. The median forecast of experts polled by the International Energy Workshop in January 1986 was for crude oil prices of $240 by 2005 (in today’s dollars). Four years earlier, the median forecast for 2000 was $400.

“In his challenging 1981 book The Ultimate Resource, Julian Simon showed that resource prices had generally decreased over time. The relative price of oil (in terms of other goods) has fallen by perhaps as much as two-thirds between the 1860s and today. During the same period, the price of oil in terms of salaries has decreased by more than 90%.”

Waiting for Godot? When is a shock a shock when the real cost is falling and innovation and production efficiencies keep on increasing?

“As for the growth of demand, which normally follows population and revenue growth, Simon argued that it would be dampened by new technologies that reduce the use of oil (like lighter cars), and eventually by new materials. The value of petroleum as a proportion of finished products will continue to decrease. And contrary to Malthusian fears, population growth will spur the potential for inventions.”

Now we go to the chart:


Real crude prices* January 1970 to July 2005

* West Texas Intermediate in constant (July, 2005) U.S. dollars. SOURCES: Federal Reserve Bank of St. Louis, and Bureau of Labor Statistics.

(Warning: A very long sentence to follow)

Back to thinking about long-term bond prices as it relates to future deflationary expectations, cued off the fact that the boom in resource costs has not flowed back into the real economy with the inflationary impact many were expecting, makes Mr. Hunt’s seemingly silly comment about a 2.9% long bond yield starts to make a bit of sense:

• Efficiency and innovation are deflationary.

• This goes to the point of Schumpeter’s “creative destruction” playing a structural deflationary role.

• For it was the bipolar world two competing super powers—Russia and the US—that effectively walled-off huge segments of the world from the opportunity of economic innovation.

• A unipolar world with the US at the helm, there are plenty of warts here we admit, has effectively unleashed billions of new workers into the global mainstream of final goods production—this is deflationary.

If we believe in the deflationary argument, then maybe we shouldn’t be too concerned about the “housing bubble.” If long bond rates continue to fall, one has to believe the cost of funding housing will continue to decline along with it over time. Maybe Goldilocks’ lives!

Is there a point to this ramble? If so, it is this: There are structural forces at work behind our daily view of the world that play havoc with price forecasts—whether it be crude oil, or wages or houses or the dollar. It’s just something to think about on a Friday.

Jack Crooks
Black Swan Capital


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