The Long-Term Bond Bear
Below is an extract from a commentary originally posted at www.speculative-investor.com on 25th July 2007.
Our short- and intermediate-term bond market views have recently become more optimistic because a number of factors should lend support to bond prices over the remainder of this year. In particular, the mortgage-related debt crisis in the US will probably get worse before it gets better, leading to additional demand for zero-risk Treasury debt at the expense of lower-quality/higher-risk debt. Also, significant stock- and commodity-market corrections are likely to occur over the next few months, thus putting additional upward pressure on Treasury bond prices (downward pressure on yields) due to a flight to safety. However, we remain as confident as ever that bonds are in the early stages of a secular bear market.
Bond bulls routinely cite weakening US economic growth to support their case, but such arguments are only valid on a short-term basis and only then to the extent that weakening growth gives bond-related sentiment a boost. As discussed in last week's Interim Update and in other TSI commentaries over the years, the idea that weaker economic growth will lead to less inflationary pressure (less upward pressure on prices) within the economy is illogical because less output, or slower output growth, will result in more money chasing fewer 'things' than would be the case if real growth were stronger. Putting it another way, the fatal flaw in the "slower growth leads to reduced inflationary pressure" argument is that inflationary pressure and real growth are INVERSELY correlated.
But what if weaker economic growth caused the supply of money to fall relative to the demand for money due to an economy-wide scramble to de-leverage? Couldn't this more than offset the increased inflationary pressure resulting from a fall in real output?
That's a possibility, but it's very unlikely. It's unlikely because counter-cyclical monetary and fiscal policies would by implemented to combat the tighter monetary backdrop. Private entities can only handle so much debt before the repayment burden becomes too great, but there is no limit to how much of its own currency a government can borrow into existence because the central bank stands ready and able to monetise every dollar of new government debt (to quote Alan Greenspan: "...a government cannot become insolvent with respect to obligations in its own currency"). Furthermore, if it chose to do so the central bank could monetise private debt and assets in addition to government debt.
Due to the way governments and their central banks invariably react to economic downturns, combined with the virtually unlimited powers they have to create new money under the current monetary system, the weaker the economy becomes in the short-term the more inflation there will be in the long-term. For example, if the US economy were to slide into an OFFICIAL recession during the second half of this year then our long-term bearish outlook on bonds would be bolstered because the weaker the US economy becomes this year the more inflation there will be during 2008-2009. Note that we've capitalised "official" in the preceding sentence because the US economy is probably already in recession; it's just that the bogus numbers used to calculate real GDP enable the reporting of a small amount of real growth each quarter.
Although there are no rigid limits on the amount of new money that could be created by the government in concert with the central bank, it could be argued that the bond market effectively imposes limits on the amount of inflation; that is, it could be argued that when bond yields begin to rocket upward in response to the effects of inflation the abilities of the government and its agencies to inflate further will be curtailed. We agree, but the point is that this will only become a factor AFTER the bond market has plunged to much lower levels; it will not be a factor while long-term interest rates remain in single digits.
Now, it should be noted that inflation (money supply growth) is not always a problem for the bond market. For example, there was inflation during the 80s and 90s -- albeit nowhere near as much as there has been during the current decade -- but this did not prevent bonds from experiencing a long-term bull market.
There are, however, important differences between the current decade and the preceding two decades, including the fact that bonds began the 1980s and the 1990s at under-valued levels (bond yields were discounting a lot of currency depreciation at those times), whereas there is very little future currency depreciation factored into current bond yields. In other words, bonds were cheap then and are expensive now. We've covered the reasons for today's over-valuation many times in the past, but the main ones are the fast rate of productivity growth in the developing world, the large demand for bonds stemming from price-insensitive buyers (central banks), Japan (discussed later in today's report), and the preparedness of many investors to ignore the evidence of their own eyes and believe the absurd government price indices. These are all, we think, transitory factors that will only postpone the inevitable.
Another important difference between the current cycle and the bull-market bond cycle of the 80s and 90s is that the commodity sector has been, and should continue to be, one of the greatest beneficiaries of this cycle's inflation. This relates to valuation and scarcity in that real commodity prices began the current cycle near Great Depression lows and two decades of dismal real returns (1980-2000) led to the situation where there was a general inability to increase supply to cater for even a modest increase in demand.
In a nutshell, we are long-term bearish on bonds at this time because current bond yields do not come close to reflecting the amount of currency depreciation that's likely to occur over the next several years and because the sectors of the economy that usually trend inversely to bond prices should continue to be the main beneficiaries of this cycle's currency depreciation. At some future time, however, the opposite may well be the case due to bond prices having already tanked.