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February 25, 2005
Thirty-year Mortgage rates are just holding on to 5.75% as shorter-term rates continue to rise.
New economic data brought few surprises: CPI is still behaving well, its core rate rising at a steady .2%-per-month pace; and unemployment claims are reinforcing a four-year low, suggesting better payroll numbers ahead (or demoralized ex-benefit recipients falling off the radar). Oil blew past $50/bbl, and gold shot back to $435, but both engraved old levels, not setting new ones.
Tension in long-term rate markets borders on the unbearable as Mr. Greenspan's "conundrum" deepens. Why would ten-year Treasury yields fall from 4.89% last year to 4.27% today while the Fed has tightened 1.50%, and will soon add another half or full percent?
Why would investors steadily place bids for ten-year T-notes yielding 4.27% the week after an implicit warning by the Chairman, and when five-year T-notes pay 3.91% for half the duration risk? The classic answer is "reinvestment risk": better to lock in ten years at the higher yield because in five years, when the five-year note matures, new five-year notes will trade way lower than 3.91%. Yeah, but why would the five-year then be lower than 3.91% -- a very low yield from the perspective of the last forty years?
The answers are all deployed: Asian central banks have lost their minds, become maniacal buyers of Treasuries, trying to keep their currencies low and their export engines going. Hedge funds... must be those nasty hedge funds; if no single one, several dozen highly leveraged ones distorting long-term rates and constituting new systemic risk like LTCM in '98. Or... it must be pension and life and health funds, desperate buyers of scarce long-term assets, trying to offset long-term liabilities.
We not only have the answers, we have the solution to the conundrum and the conclusive convulsion in sight. So says the best bond trader alive (he says that, too), Bill Gross, Chief Resident Deity at PIMCO, the largest bond-market mutual fund this side of Pluto: "Market yields currently qualify as a 'mispricing',... most vulnerable to foreign central bank diversification or a 'buyers' strike.'"
There is no conundrum; the markets are wrong (Gross says by at least a half-percent in yield). The conclusion: ahead soon is an epic, unprecedented run on the dollar in the form of panicked selling of Treasuries.
I hate to write about apocalyptic scenarios. They wear out me and readers, and have always been wrong. (I offer evidence: we have not had an apocalypse lately; corrections, but no catastrophe.) However, any investor or borrower is going to have an impossible time avoiding the drumbeat of versions of Gross' Day Of Reckoning.
Here is the sleep-well counter-argument. Hyperbolic growth in our trade deficit will soon stop because all economic hyperbolae stop (a corollary to Herb Stein's Law: "Unsustainable trends are not sustained."). As it slows there will be more volatility in financial markets, but I do not believe in huge "mispricing" in markets that are twenty- or thirty-trillion dollars deep (as opposed to shallow sillies like the NASDAQ), nor do I believe in suicide among trading partners. Any "buyers' strike" among exporters to us, suddenly dumping dollar assets, would instantly result in our inability to buy their junk. Economic suicide.
Could it get ugly for a while? Sure, ugly enough to work out a new global currency and trade regime -- very healthy. The ultimate conclusion to the conundrum and to the trade deficit hyperbola, one way or another seems to me to be an inevitable decline (gentle, with any luck) in America's ability to absorb the world's exports, which will exert gradual slowing and deflationary pressure on the global economy, and make a 4.27% ten-year Treasury not such a silly buy.
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