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Tuesday November 1, 2005 - 12:52:20 GMT
Black Swan Capital -

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Buy bonds, but...

Key News
•European manufacturing expanded at the fastest pace in 13 months in October (Bloomberg)
•Key reports due today (WSJ):
7:45a.m. ICSC-UBS Store Sales Index For Oct. 29 Wk. Previous: -0.2%.
8:55a.m. Redbook Retail Sales Index For Oct. 29 Wk. Previous: +1.0%.
10a.m. Oct. ISM Manufacturing Business Index. Consensus: 57.0. Previous: 59.4.
10a.m. Sept. Construction Spending. Consensus: +0.6%. Previous: +0.4%.
2:15p.m. FOMC Announcement
5:00p.m. ABC/Money Consumer Confidence For Oct. 30 Wk. Previous: -19.

“AG: Ben, Ben, you have so much to learn. That transparency stuff is fine for academic research. In the real world, never giving the market too much information means never having to say you're sorry. Or that you were wrong.”

Caroline Baum, Bloomberg

FX Trading
Are we buying or selling the long bond today? If we’re buying bonds, it probably means we are adding stocks to the shopping list. If selling bonds, we dump SPU for good measure.

Chart: S&P 500 Weekly vs. 30-yr bond futures

Hoisington Investment, an institutional bond manager, and a firm that has been “right as rain” on bonds for a long time, believes it’s time to buy bonds. We added a couple of “buts” that explain why we are straddling differing camps. Below is from Hoisington’s Third Quarter Review and Outlook [our emphasis]:

“History is interesting in this regard. During the Vietnam War and the Nixon and Carter presidencies, the deficits were large in nominal dollars by the standards of that time, but small relative to GDP. What made them inflationary was Fed policies which allowed them to be underwritten by a sharp lift in the money supply. From 1964 through 1968, M2 jumped by 7.5% per annum, or above the 105 year average of 6.7%. From 1971 through 1973, M2 swelled an even faster 11.4% per annum. In the five year span ending in 1980, M2 grew at a near 10% per annum pace, and the only faster time spans were during the Spanish American War and World Wars I and II.

“If Fed policy dictates that the 2006 deficit be financed from existing money balances (i.e. without a boost in the money supply), short-term rates will climb further since the bulk of the Treasury financing will fall on that portion of the curve. Yield spreads between short- and long-term bonds would continue to level out, and in all likelihood invert. Raised short term borrowing costs, combined with such yield curve changes, would serve to transfer spending from the private to the public sector. As such, the enlarged budget deficit would do little to invigorate activity, and the inflation rate would not escalate.

But we were told that yesterday’s reported consumer spending and income numbers, on a nominal basis, were juiced by federal spending—the budget deficit. “Consumers have been spending their hurricane windfalls on big-ticket durable goods, such as cars, which have also been discounted and promoted to attract buyers,” reported the BBC.

Housington’s point is that M2 growth is declining, therefore the Fed rate increases are starting to bite on the economy…

Chart: M2 Money Stock

But consider the rate of growth in MZM is also slowing, (high powered money that can be used as a measure for consumer demand for money). Its growth rate is well below that of M2 (comparing growth rates on the right margin in graph above to graph below), indicating there is still plenty of juice in the system to keep the inflation train moving…

Chart: MZM Money Stock

And finally, Hoisington points to the yield curve to solidify its case long bonds are still a good bet.

“Flatter yield curves are signs that investors expect: (1) a less exuberant economic situation, or (2) reduced inflation or (3) a combination of both. Moreover, by reducing the profit making opportunities at the financial intermediaries and thereby reducing lending, a more horizontal yield curve works to help ensure that these expectations will materialize,” writes Hoisington.

Chart: Treasury Yield Curve (Source: WSJ)

But we haven’t seen a drop off in lending from banks just yet…

Chart: Commercial and Industrial Loans at All Commercial Banks

Even if Hoisington is right, which would be no surprise, the rising inflationary expectations might require Mr. Greenspan to get a bit tougher with his language. If so, Hoisington could be right in the end, but wrong just after today’s announcement. Economics! Pick your poison.

Jack Crooks
Black Swan Capital


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