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March 18, 2005
The bond market traded poorly all week long. Rates aren't any worse -- 4.50% for 10-year T-notes, just under 6.00% for mortgages -- but every attempt at even a technical rally in this oversold market was quickly sawed off at the knees.
Two news items should have helped, but did not: oil broke to $57/bbl, and General Motors self-announced its descent to junk status. The high-oil equation used to produce inflation; now it presumes suppressed consumers and a slower economy. Each energy spike in the last two years was a help to bonds, but not this one. GM's semi-permanent trouble pushed money from overbought corporate bonds to safe Treasurys and mortgages, but not enough.
Oil has a demand problem, not a supply one like the OPEC embargoes 1973-1980. Global consumption at 84 million barrels per day is still rising, thus far impervious to a doubling in price. How can that be? One way: if oil consumption in India and China increased by one tea cup per person per day, at 16 cups/gallon, 55 gallons/bbl, times roughly two billion citizens... that's another 2.27 million barrels.
One cup per capita per day.
At some point and some time, high prices will encourage both more supply and less consumption, but neither point nor time is in sight. If prices rise much more, even temporarily, we are at risk for both suppressed consumers and inflation.
GM's situation is perilous in the eyes of the bond market. Its senior (most secure) bonds now trade at fifty-two cents on the dollar, yielding 9.33%; that price-yield relationship says an investor should expect interest until default or bankruptcy, and little or no return of principal. GM's trouble doesn't have much to do with cars: it is today a giant HMO trying to cover the health care premiums of its retirees by hawking cars. The plan doesn't work very well because foreign competitors enjoying state-funded health care don't have a comparable retiree burden. Trivia: per car, which costs GM more, the metal in the car, or the per-car health-care expense?
Soon to be an economy-wide problem in a nation near you....
Weakness in the bond market has for weeks been attributed to the weak dollar, foreign central banks diversifying to other currencies, incipient inflation, and hedge funds bailing from borrow-short-buy-long positions.
Keep it simple: the Fed is coming. The Fed has raised the overnight cost of money enough that further hikes will push up long-term rates. Mr. Greenspan's "conundrum" -- short rates rising while long ones steadied -- turns out to be no riddle at all, just an illusion. Short rates were extremely low -- at 1.00% so low that the Fed's nine-month-long, 1.50% hike had no impact on long rates. Hikes to come will have impact.
For a while this winter, the closing gap between short and long rates looked like a classic warning of economic slowdown: all recessions are preceded by such a narrowing gap. Most are preceded (some say all) by an "inversion", in which the Fed tightens late in a tightening cycle, and longer rates fall below the Fed's rate. If the Fed tightens another percent or two, and long rates stick or decline, then we will have a slowdown indicator. This past episode was more mirage than conundrum.
Some fear that the Fed will remove the "measured" language in its post-meeting statement next week. Worry about something else. In the screwball world of Fedology, a merciless Fed helps to allay bond-market fears of inflation. Besides, the modern Fed is always measured, .50% and .75% hikes the rarity they should be.
Something else to worry about? When the Democrats become the party of fiscal discipline, then worry. The Senate voted 51-49 yesterday, the 51 all Republicans, to un-do Mr. Bush's miniscule effort to cut the deficit. Amazing.
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