Bonds Rally, But for How Long?

Includes: BLV, ITE, SPTL
by: Sean Maher

There has been a decent rally in US Treasuries in recent weeks, driven initially by the commodity sell off/Eurozone growth shock soothing inflation fears, and latterly by a renewed burst of risk aversion as rumours of bank and hedge fund failures circulate.

Many strategists at the bearish end of the economic spectrum are making bullish calls on 10 year yields to possibly hit sub 2% in the face of protracted US recession from the current 3.8% (already implying just over 2% CPI through 2018 based on the TIPS these guys think inflation is going to zero? For a decade?). I posted back in May that government bonds would be the riskiest medium term asset play at the tail end of a 25 year secular bull market in Government Bonds: That fat Lady is Singing, and retain that view.

After some truly awful PPI figures from Germany and the US this week, it seems obvious that the 20% fall we have seen in key industrial commodities like oil and copper in the last month won't remotely mitigate the inflationary momentum now apparent in markets from industrial chemicals and fertilizers to textiles and transport. These kinds of price rises tend to be infrequent but sticky, as suppliers have had to absorb a margin hit until they could finally push through higher selling prices and now it's payback time.They're not going to reverse course until convinced the commodity markets and other input price pressures have turned definitively, which will only happen in a major global slowdown to sub 2% growth. The disinflationary windfall we all enjoyed from cheap Asian outsourcing over the past decade is over, and bond markets seem slow to accept that reality.

An even more bearish issue for the bond market is simple supply and demand; the US deficit will soar in 2009/10 and may hit $1trillion soon after as the corporate tax take crumbles, while the costs of bailing out the financial sector/fiscal reflation plus ongoing war costs soar.

This will occur just as demand for Treasuries and GSE bonds from the default buyers, the current account surplus Asian goods exporters and OPEC/Russia dries up as their excess liquidity shrinks rapidly in line with the fast disappearing US trade deficit. Indeed I wouldn't be surprised to see Asian surpluses tumble 30-50% from their 2007 peak by next year, implying a huge contraction in global liquidity (and oil prices back in a $60-80 range as demand destruction mounts).

Demand for both imported consumer goods and energy is now falling at record pace in the US, and Europe and Japan will soon follow suit. The change in the US isn't just cyclical, but structural, and I'd expect consumption to fall from 71% to maybe 66% of GDP within 2-3 years (which was its pre credit bubble level) to make room for saving and overdue infrastructure investment (which could rise from a derisory 0.6% of GDP to 3% plus). The demographic crunch implied by the baby boomer retirement surge will accelerate these enormous structural trend changes.

A tumbling US current account deficit, in conjunction with a soaring fiscal one, is not technically a bond friendly environment (although net positive for the dollar). Many totems of received wisdom in the investment world have tumbled in recent months, and the notion that bonds are a safe haven may be the next.

Disclosure: No current position