Forecast: Volatility

Originally Posted by Jeff Bernstein on Urban Digs June 12, 2009

After the stunning swoon in Treasuries - the 30 year has plunged over 20% year-to-date - it's only natural to ask, where the heck are bond yields going from here? Even more fundamental, what about the availability of credit? Just for a little historical perspective, let's take a look at where we have been.

Here is a long-term chart of the 3-month Treasury yield. Now I know it's no intellectual leap to say we have touched absolute bottom driven by a near death experience and there ain't nowhere to go but up. But let me layer a bit more of the completely intuitive on top of the transparently obvious.

1) Government issuance of new debt is expanding to historically high levels to cover the bank bailouts, stimulus plan(s) and continued pork barrel spending. You can find a great visual for the relative size of the bank bailout program, versus past major U.S. spending initiatives in the chart below.

According to a recent Forbes article, the U.S. government has said it will need to borrow $2 trillion, or 14 percent of the country's total economic output, in 2009 alone. Some have been reminding those of us who care that we should not forget that additional borrowing from mortgage giants Fannie Mae and Freddie Mac will contribute to overall U.S. government borrowing being much higher.

2) Bond market "vigilantes" now more likely foreigners than U.S. investors (when Ed Yardeni coined the term back in the early 90s) are worried not just about return on their money (vs. domestic and other alternatives), they also worry about return of their money. Their cooperation in funding our debt will only be bought with higher rates of return. Let me quote one of the larger buyers of our main export (Chinese Premier Wen Jiabao):

Whether to buy more US Treasury bonds, and if so by how much, that should be based on China's need, and based on our requirement to keep the safety of our foreign reserves and their value.

Of course, others are more sanguine about the chance of a buyers' strike in bond land.

"The reserves are so large that they have little alternative but to hold a substantial fraction in U.S. Treasuries and guaranteed paper," said Harvard economist Richard Cooper, referring to the People's Bank of China.

My guess is that, at the margin, the Chinese do anything they can to soak up their FX reserves with something else rather than U.S. bonds. Of course, Urban Digs readers know it's a second derivative world, where change at the margin drives everything (because markets drive economies today and they respond largely to incremental data).

3) With the massive stimulation of the U.S. economy, and little opportunity to deploy that capital into value added investments (those which offer a fundamental competitive advantage in efficiency/productivity or provide for a true unmet need), money will quickly seep into financial and or raw material asset speculation and producer price inflation.

But wait. Why are some very smart investors like Mohamed El-Erian suggesting that inflation will come, but it will come later in the cycle rather than immediately.

As you can see from the chart above, Pimco has some fancy ways of saying that U.S. and global growth will be slower going forward due to damage from the recent downturn, but also from exposure by the downturn of unsustainable trends in industries and economies, which will begin to normalize, in some cases rapidly (restructuring of the U.S. auto industry) and in other cases slowly (deleveraging of the U.S. consumer balance sheet).

I agree with El-Erian that these factors suggest slower growth and less inflation pressure, suggesting that the bond market behaves in a manner befitting a non-inflationary environment. However, this doesn't take into account the risk premium being built into U.S. bonds for credit quality deterioration as impacted by both increased default fear/desire to diversify and massive issuance.

In his most recent commentary El-Erian points out that the bond market implosion that has taken place since his piece on lower inflation pressure is reinforcing deflationary trends:

The Treasury bond sell-off is now putting pressures on other markets in the economy. We should worry most about housing where borrowing rates are rising notwithstanding the Federal Reserve purchase program. Indeed, according to data released on Thursday, already 12% of U.S. households are facing difficulties meeting their mortgage payments.

My forecast? Volatility. I think that whenever the economy gets weak, China will rush in and buy commodities - which props up emerging markets where they would like to sell more of their widgets - and gets them a supply of cheap materials for making infrastructure they need as well as exports. It also allows them to recycle FX reserves into a productive and in their mind relatively safer use. This will keep commodity prices volatile, but trending higher.

To the U.S. consumer this will be felt as pain in food and energy prices.....not measured in the headline inflation numbers. When energy prices get too high....as they are now.....you will see the U.S. economy downshift, pushing the commodity complex back down.

As the U.S. economy slows we will see a flight to the dollar and U.S. bonds, which will tend to feather back the inevitable trend towards higher rates. This may give temporary help to the mortgage market, but at this point the housing recovery may become stymied by generally higher mortgage rates.

Without a housing recovery I can't see how general credit availability can improve. Banks will be stuck in the recovery room and the recent round of capital raising will be their easiest. My guess is they horde that capital. Not a prescription for a booming economy and CPI inflation.

In my mind, the misery of inflation is going to be felt in higher food and energy costs to the consumer and investments in commodities will be relatively safe, as should many emerging markets (suppliers of commodities) largely due to the closed loop of China investment demand.

Hold on to your hat!

Comments

[Donald Ingram:]

Disagree; "flight to the dollar and U.S. bonds".
This trend is now reversing as wealth preservation now see the dollar as a higher risk.
Agree; "the misery of inflation".
Inflation has been happening for some time now as food and energy costs have soared.

The dollar is very vulnerable to any further shocks in the global financial world. Such as any country found to be dumping their dollar holdings. A case in point is the $150 billion in U.S. bonds found by Italian authorities, trying to be smuggled into Switzerland this past week. Its surmised that these bonds originated in Japan, and that they where sereptitiously trying to get them to Switzerland to dump them without alarming the global markets.
Price (asset) deflation will continue as evidenced by the U.S. housing market, while price inflation strikes the consumer led by higher food and energy costs.
The dollar will continue to lose ground.

Jun 14 12:23 PM

[Peter Cooper:]

Short term there is a bond trade as the stock market rally ends, but the longer term outlook is terrible with inflation and devaluation set to wipe out bond holders, see:
arabianmoney.net/2009/.../

Jun 15 12:21 AM

[aardvark:]

Let's say there are a minimum of 5,000,000 jobs lost over the past year,not counting reductions in pay/hours of remaining jobs. If each job is valued at $30,000 per year this means $1.5 trillion has been taken out of the economy,the tax base, and has required unemployment support. Add to this the ramifications of the impact of existing indebtedness, foreclosures,etc and the green shoots don't look so green. Reality isn't nearly as much fun as Disneyland.

Jun 15 01:40 PM