Obama Honeymoon Likely To Be Cut Short By Bond Market

As President-elect Obama's soaring rhetoric meets soaring deficits, I know which will win out. After the stunning incompetence of the Bush era, we can hope that the incoming administration will be as disciplined and skillful in governing as it has been in campaigning. However, the current euphoria reminds me of that surrounding the equally clever and fresh faced Clinton in 1993, who quickly discovered that while a President may propose, the bond market disposes. The Treasury has over $500 billion of bonds to place before December to meet the funding needs of the various bail-out packages, and over $1 trillion more in 2009 and probably for several years thereafter. The question is: who are the buyers, particularly with yields at a 30 year low?

Foreign central banks have been key purchasers of Treasuries in recent years, as they recycled their trade surpluses driven by record merchandise exports and commodity prices; that global liquidity engine is now sputtering. I expect Chinese GDP growth in 2009 to be sub 5%, and the collapse in key indicators of forward activity from shipping (Baltic Freight Index down 90% from high) to petrochemical feed stocks (ethylene, benzene, naphtha etc all at 5 year lows on slumping plastics demand in Asia) and slumping demand for copper and iron ore, all indicate that industrial activity in the country is simply in free fall.

That $2 trillion in Chinese foreign exchange reserves should give limited cause for comfort, given the stretched and opaque balance sheets of the private sector; as we discovered in Russia (with almost $600bn in August, now down to $400bn), impressive sovereign reserves get used up fast in a deleveraging panic that demands huge state bailouts. Those reserves will be needed at home in coming months to offset what will feel like an economic slump by recent Chinese standards. I have been warning of an imminent implosion in the Chinese export and investment led growth model since March; (see China 'miracle' faces meltdown for example) the stock market is down over 70% in a year, and residential real estate is down 30% in major metropolitan areas like Shanghai. All this while consumer demand in the US is now in rapid and structural decline, as the illusory above trend growth of recent years was funded by equity withdrawal from the housing boom and reckless credit expansion.

A decline of 5-6% in consumption share of GDP in the US back to the mid 60s level that prevailed a decade ago seems inevitable. The Chinese (and indeed the Russia and the Gulf States, who face fiscal deficits of their own at sub $70 oil) simply won't have surplus liquidity to invest into the soaring supply of US Treasuries (or UK Gilts). The flip side of this reversal is that it's likely the US trade deficit will simply disappear in 2009. Money is being repatriated globally to its rightful owners, and those countries running a large structural funding gap that cannot be met by domestic savings will have to offer higher yields to attract the shrinking pool of available capital.

We are moving from a period of excess global savings to a period of shortage (not just the economic cycle, the demographic surge in retirees in Japan and Europe, and soon in the US, means investments are being drawn down rather than accumulated), and this will demand a huge re-balancing of the now dysfunctional post Bretton Woods economic system, notably greater savings and investment in the US and greater domestic consumption in China. Apart from TIPS, now yielding well over 3% and pegged to CPI-U (with negative inflation breakevens out to the 2016 issue, do you expect deflation for the next 8 years?), and Munis, which are trading at historical premiums to Treasuries, US Government yields look unsustainably low given the increasingly poor demand fundamentals, and recent yield curve steepening may be a sign of things to come. Winning elections is the easy part.

Comments

[whidbey:]

"We are moving from a period of excess global savings to a period of shortage (not just the economic cycle, the demographic surge in retirees in Japan and Europe, and soon in the US, means investments are being drawn down rather than accumulated)"

Will ,maybe if interest rates rise sufficiently new behaviors can be learned. With sufficiently high interest rates even the young can learn to save money, of course, they will not want to be taxed on their interest or they will just consume the surplus, or hide it, or maybe not work (back bending demand curve?). It is a serious issue for the new President to ponder as he plans higher taxes, more domestic spending and international sharing of the wealth.

2008 Nov 05 05:51 PM

[prudentinve...:]

Time to encourage work through lower taxes, to encourage savings through high interest rates, and to let "high life and high living" fail!

2008 Nov 05 06:12 PM

[Distressed ...:]

I agree with you, great article. Definitely unsustainable, higher yields are coming. Might take some time to digest though due to this deflation matter. Yield curve is interesting too, it looks like rate cuts caught up to the curve (making it normal).. I just hope the big dump doesn't happen all at once, just imagine what those hedge fund redemptions will cause....

2008 Nov 05 08:24 PM

[moonbat1775:]

High rates, low rates, smo rates. Let's have natural interest rates set by the market and not central bankers. Everyone wants to be a dictator it seems (except LewRockwell readers).

2008 Nov 05 09:00 PM

[flow5:]

The prudential reserves of the E-D banks consist of various U.S. dollar-denominated liquid assets (U.S. Treasury bills, U.S. commercial bank CDs, Repurchase Agreements, etc.) and interbank demand deposits held in U.S. banks. These are liquid balances in the U.S., or any other major currency country. If a bank’s balance is inadequate to meet a specific payment in the E-D system, it borrows in the London money market at or near the LIBOR rate (the London Interbank Offering Rate), a rate substantially below the prime rates of most banks. By both promulgating excessive money and credit creation, and avoiding statutory reserve requirements, E-D banks are able to preserve their competitive advantages with lower interest rate loans.

The volume of prudential reserves held by each E-D bank presumably is dictated by “prudence” – not by any legal requirement administered by a monetary authority. All prudential reserve banking systems have heretofore “COME A CROPPER”. Money creation by private profit institutions is not self-regulatory- the “unseen hand” simply does not function in this area.

Invariably the systems created too much money, speculation became rampant, inflation distorted and destroyed economic relationships, confidence that the banks could meet their convertibility obligations eroded, “runs” on the banks caused mass banking failures, and entire economies were left in ruin. Déjà vu

2008 Nov 06 10:34 AM

[thannagan:]

Yes, the accelorated demand for (government) financing will tend to create/require higher prices (rates), except for that portion of funding that is offset by a (significantly) greater supply of "money" looking to go to work. The future financing requirements will happen in the currency of the day, not just with today's money supply. And we know who prints the stuff.

2008 Nov 06 10:48 AM

[Mowog:]

Great read! I suspect the printing presses will be put to the "public good." My bond fund pays me $100+ monthly thanks to those Carter/early Reagan T-bonds. On November 4th, we got President-Elect Carter II. He's an earnest fellow, but the poor guy's going to get clobbered, hard and fast; it will roll downhill, gaining momentum as it goes.

2008 Nov 07 08:37 AM

[zanardm:]

As mentioned, is the ultimate bubble, the treasury bubble coming? Was foreigners' markedly decreased purchase of Fannie Mae and Freddie Mac securities, a harbinger of the future for treasuries? Would the resultant lack of government ability to borrow be what is required to deleverage politicians? Possible dual currencies here, like for Europe, since there is greater faith in ECB than our Fed? Possible U.S. borrowing in eurodollar and yen denomination securities overseas? Is this the worse case scenario? Would a U.S. budget deficit less than $1 trillion, and other fiscal conservative measures, sent the right message to creditors, both domestic and foreign? Or is it the same old spend and spend (code word for debt); what did the vote on bail out indicate? The private sector is deleveraging; but not the public sector. A another generation (25 yrs) for the excesses of the last 25 yrs, to be deleveraged? Good luck to all of us.

2008 Nov 08 11:46 PM

[Teutonic Kn...:]

As I recalled, last time when Regan was being sworn in during the deep recession of 1982, the market was sinking fast a stone; continuing so and persisting into February and March if I remember correctly. (Please correct me if I am wrong). This time around I would agree with Sean that Obama's honey moon would be awefully short. The deep sinking will come early, like in this November, December and January...Stay tuned...

2008 Nov 12 02:08 PM