What Don is thinking...
Don Coxe
January 23, 2003
Conference call from Chicago
jonesheward.com
Chart: Yield on 10 Year Treasury
Question: How much risk is there in bonds?
I think that this is potentially one of the biggest stories of the year. And I realize that these calls tend to be very much equity oriented. When you have a runaway stock market it’s much easier to talk about things that are giving people such quick returns.
But I realize that I’ve skimped on bonds in my commentary and the irony is that Basic Points was originally designed, the reason the title was that, it was designed as a fixed income research product which would then comment on equities partly but just in the background, as it were. And of course it’s morphed gradually in response to the audience that we have and also that my job changed so that I was responsible for managing equity portfolios directly.
To rectify that oversight, I want to talk about what I see as a very, very high level of endogenous risk in US dollar denominated bonds and particularly US government. Now endogenous risk, as you know, is internal risk in the asset class itself. But in the past, they’ve talked about Treasury Bonds there wasn’t endogenous risk, it was exogenous risk. In other words, the inflation rate would go up or the deficit would go up. Or at least people thought that if the deficit would go up that bonds would be in trouble. Or some event external to the quality of the asset itself.
What we’re dealing with now is a situation where quite frankly, what you have to say is this may be one of the most overpriced financial assets of our time. Now you say, “Come on, there’s all those NASDAQ stocks”, yeah but at least with those what you know is the kind of people that are playing them know that they’re inherently risky and the hedge funds who are big players in them now will be moving to the exit as soon as - and this is one of the points I’m going to address later - as soon as it’s a sign that the Fed is tightening and that the easy money is no longer coming to the table.
So what I want to talk about here is that the reason why these bonds are so risky is what we do not have, in my view, is a reason for standard investors to buy them. By standard investors I mean those who are not borrowing short in order to go long, like banks or like hedge funds, and just that it’s like bond mutual funds or pension funds or individuals.
In this country, you can go to any one of the Federal Reserve banks – there’s one two doors from my office here in Chicago – you can open your own account with the Federal Reserve bank, because they are a bank, and then you can bid in a Treasury bond auction. And the order will go through a broker.
So, why can I say that there’s very little participation from those kinds of investors?
Well let’s look at who’s actually buying them. China, Japan and South Korea, in particular, have been buying Treasury bonds at a level that’s somewhere around 400 billion dollars over the last 18 months and the pace seems to have picked up. I say somewhere, because the statistics that one gets, there’s a mixture of statistics, the way you look at it, the published exchange reserves of the countries and then there’s a statistic that the Federal Reserve publishes, which is holdings of Treasuries for foreign accounts. And that tends to be where most of the bonds that have been acquired by foreigners end up, is in that category.
But anyway it doesn’t have to be. They can acquire treasuries elsewhere, and there’s been evidence in the past that some foreign central banks liked to have some acquisitions where they were holding these securities in their own pockets. This has certainly been true in the past of some Arab governments. Because they are familiar with the fact that from time to time the US may decide to sequester assets.
For example, that’s what they did to the Pakistanis who bought and paid for a whole batch of US fighter plans about 12 years ago. And then Congress passed a law when Pakistan exploded a bomb, saying that no military exports could go to Pakistan. So what happened was they sat on the planes and never refunded the money.
So, for that reason, what you look at is not only what the governments are doing, but in the case of Japan, the Bank of Japan had recently obtained authorization , if you can believe this, to invest up to 560 billion dollars in holding down the value of the Yen. So something like half to 60% of the fiscal deficit is being funded by these buyers.
Now they aren’t buying any of the 10-year notes or 30-year bond, only a steep yield curve, that’s taken care of by the carry trade as it’s called in the bond business - those that borrow at the Fed funds rate or the Eurodollar rate and then buy up the curve. And this is a risk-free way to make money, as long as you exit before all of a sudden the bond market sells off on evidence that the Fed is about to tighten.
So that’s why if you look at that chart, you see the sudden drop in Treasury yields and of course that occurred after the unemployment number. And for the Canadians on the call that was the week where Canada reported 51 times as many new jobs as the entire US of A did for the month. An embarrassing statistic - just imagine a hockey game in which Canada shut out the US 51 to 1, or virtually shut ‘em out 51 to 1, that’s an amazing statistic.
Against that though, we got the fact that GDP growth is robust and at some point the Fed is going to have to raise rates. Because in addition we’ve got the specter of what’s happened to the American dollar. Surely it is an amazing irony that Treasury bonds are trading at such low yields denominated in a currency that is the worst and most dangerous of the tradable currencies in the world of liquid currencies.
In the past, if you’d known that the US dollar was going to be in a major bear market and if you had known that the current account deficit was going to go to more than 5% of GDP and if you’d known that the US fiscal deficit was going above 5% of GDP and if you’d known that the US would be almost single-handedly trying to straighten out two areas of the world, Afghanistan and Iraq, with token help from others at enormous cost to the taxpayers, what you’d say is that “Hmmm, okay, with the dollar going down and all these things happening, Treasury bond yields are going to reflect this perception of risk.”.
Instead, they’ve done splendidly. Absolutely amazing! So, the only reason for that is, of course, this phenomenon, you’ve got these strategic buyers who are buying Treasuries to hold down their own currencies.
Now what I want to suggest to you is that a strategy which is based on the assumption that you know 12 months ahead what the governments of China, Japan and South Korea are going to do, is one that ordinarily you would factor in some investment premium for that risk. But instead, what it is, is Treasuries are still being treated as the least risky bonds in the world, because they’re the most liquid.
Now that may have been true once, but it isn’t true anymore. And so, I believe that what we have in the US bond market is a situation where the bedrock bonds are actually much riskier than investors perceive and that they’re apparent strength is an illusion. And the source of that strength could be withdrawn at any given time.
Given that I remain as bearish as I ever was on the outlook for the US dollar, what we’ve got is a real incentive to true investors abroad, those who actually you know, pay up in full the cost of holding an investment to keep selling Treasury bonds, which they’ve been doing.
So what we’ve got then is a situation where real investors are gradually moving to the sidelines or out and the investors that are in there, are central banks suppressing their currencies and hedge funds borrowing short and lending long.
Now, that is a recipe for disaster.
As if that weren’t enough, within the Lehman Aggregate Index, which is our basic index here in this country - we now have a bigger asset class than Treasuries, which is US mortgage backeds – and they are an even more vulnerable asset class because as you know the peculiarities of these, these are bonds that extend duration dramatically when they fall in price. You don’t just lose on principle you’re losing on duration and - here’s the point, the holders of these, they protect their position by hedging with the 10-year Treasury note.
That’s one of the reasons I included the 10-year Treasury note in this is because we have - I specifically didn’t mention this earlier - we have huge holders of the 10-year Treasury note who I don’t call real investors because they’re using them in hedging purposes. And when mortgages are getting hit, they have to sell the 10-year Treasury note, to protect their position.
So what we actually have out there is the biggest US investment holders are actually once again not holding them as true investors, they’re hedging their exposure to their own basic asset class.
Seems to me what you’ve got then is a situation where all these players have managed to move themselves close to the exit and meanwhile what we’ve got is a gigantic new supply that’s coming out every month.
Now, I don’t know when we’re going to have serious trouble in this but I find it hard to believe that we’re going to get through this year without something dramatic happening.
And what I find is a remarkable insouciance among the strategists. “Yes, interest rates are going to go up”, but they talk in terms of things like ¾ of a point. Oh no, no, no. If these kinds of things start to unravel, we’re looking at much, much bigger jumps than that. Because what we don’t have is anybody to jump in and support them.
Yeah, the Fed theoretically could buy up the curve and they’ve done that occasionally in the past but that would be only in a true crisis environment and you wouldn’t want to have exposure to US dollar denominated bonds in a crisis environment.
So, what I want to tell you is that first of all, Canadians out there who have bond funds which invest heavily in US dollar denominated bonds, that’s not an asset class you want to promote with your clients. Secondly, for those of you who, for one reason or another, do hold US bonds in portfolios, you’ve got to hedge your position, at least the currency part of it.
But I believe those bonds have, and I’ll come back to it, serious endogenous risk of their own and so if I were a global rating service I would want to reduce these down to single A level, now that’s ridiculous in one sense. You start with these and you talk about who’s Triple A, but it’s not difficult to see the following scenario. Let’s talk about what could do it.
First of all, we’ve got the first signs that China is going to diversify it’s basket of foreign currencies while still holding down the Renminbi. Secondly, we know that Russia has already started to diversify its currencies for selling oil. Third, we know that China is going to at some point do something about the value of the Renminbi, and in a way, what will drive this is if we continue to have a commodity boom lead by oil and metals. Think about it.
What China is doing with its Renminbi policy right now is protecting its export prices because the US dollar is falling and by tying it to the Renminbi it means that China’s export prices are falling along with it. But, what it’s not doing is doing anything about its cost structure as opposed to other nations in the world whose currencies are going up which means their cost of energy and of metals is going down or at least not going up along with the prices of the metals.
So, if we should have a situation where the price of commodities starts rising faster than Chinese estimates, geniuses, those in control had estimated, then they may decide that one way to reduce their cost structure is to let their currency rise and of course one way to do that is basically by stopping buying dollars.
I don’t anticipate that they’re going to try to dump them, the Treasuries, that would really be an extreme situation, besides they’re sitting on more than 400 billion of them so who do you sell to? But, I just think that if we found out this week that India had 8% growth last year, now that’s more amazing in its own way than China did 9% despite SARS.
So this new middle class theory that you’ve been hearing from me for some time is really unfolding. Which means that we could very easily see a situation where copper goes from its current level of 1.11 ¾ up to 1.40 and other metal prices move similarly. And that oil prices move up through forty bucks a barrel, even with Iraq moving its production up to 3 million barrels a day and that’s what the Iraqi oil minister is saying they will do by year end. Not too many people are taking that seriously but, that’s out there.
What you’ve got to realize is that although the shills and mountebanks don’t talk about this, there’s a pretty good correlation between oil prices and GDP growth and what we’ve found out about China is that they’re now the number two users of oil in the world, behind the US, moving ahead of Japan. And the percentage increase in their consumption is dramatic.
So if China puts in another year of 7% or more growth, and India keeps at its current rate, what we’re going to have is such demand for basic materials there might be therefore big incentive to try to control your costs by letting your currency float.
Now this is all somewhat supposititious but what you’ve got to realize is that there’s just too much complacency out there about Treasuries, that they will always be regarded as the base bond market of the world. Frankly, there’s no more reason to believe that than the United States is entitled to believe that if it goes off and launches a preemptive war that everybody is going to swing on side in the West on the basis that the US has been the leader in the West really since they came into World War II.
So, if there’s more risk in the bond market, frankly what I’m saying is if you were taking a levered position, I’d rather own futures on the TSX than futures on the 30 year Treasury bond, in terms of endogenous risk. It seems to me that things are really getting better for Canada and yeah, the Canadian dollar’s pulled back modestly to the 76 ¾ level, but it’s in a major bull market and Canada’s finances are still strong. And the orientation of the Canadian economy is still something that you can feel confident about.
Meanwhile, you have to worry, about this country in a way, because George Bush has been effective about getting tax cuts through. Hopelessly ineffective at restraining Congressional urge to spend, this omnibus spending bill that passed this week is an embarrassment. I mean this has more decorations on it than the most tacky Christmas tree you’ve ever seen.
And it’s part of a bigger problem that Bush has never vetoed anything. It’s fascinating to me the dynamics that are now unfolding here – the Democrats are starting to gain in the polls nationally on the basis that they are going to try to do something to get the budget under control.
This is an election year. And this is something that is selling for them. This is an Alice in Wonderland world, where you’ve got a Republican President and a Republican Congress and the Democrats are impressing people as being the party of prudence and people are getting scared about the sheer scale of the deficit. And of course the average American has no idea about the current account deficit which is on the same order of magnitude as the fiscal deficit. That’s something they don’t understand. But that’s building up external liabilities at the same rate.
Put it all together, I think that if you’re trying to reduce risk in your accounts you should not use the standard old thing, which is just automatically increasing bond exposure. I certainly do think that this is an occasion for shortening duration. And oddly enough, now you may say if obviously the bond market crashes, Treasury bond market, that’s going to kill the stock market.
Well, it will some kinds of stocks but if one of the things that’s driving is because commodity prices have got to a level where its forced countries to move off of the dollar standard, then owning shares of commodity-producing companies should be a great place to be and that includes, obviously, gold, in such a situation.
So, before we go to the question period, let me just sum up that my view of what could be the big surprise this year is that we would find out that the US bond market could go in to the kind of troubles it had in 1994 only this time it might be worse because the dollar problems are dramatically worse than they were back then. Back then the dollar was in okay condition, not great, but okay. Now the dollar is only staying where it is as a result of massive support.
Just think what would happen to the value of the Canadian dollar and the Euro if China and Japan and South Korea stopped buying Treasuries. You’d have the Canadian dollar just going up through 85 cents in no time at all. The Euro would go to a buck and a half and those two countries would be helpless to prevent their currencies from levitating. And that would certainly mean all sorts of consternation in bond markets.
So, as optimistic as I am, it seems to me that what we’ve got is a situation where the Fed is going to have to raise the funds rate. They can’t carry this through having the funds rate at 1/5 or 1/8 of the US growth rate. This is surreal.
So we’re going to have a raise in the funds rate this year. We’d better have it in time before a dollar crisis starts to build, because this is chutzpah on a grand scale. To be the central banker of the world’s supposed reserve currency, which is getting supported only by economies that didn’t matter anything 20 years ago and at a time that you’re having to fight significant military operations and clean-up operations abroad which is draining the current account even worse…this is a recipe for something unpleasant.
So therefore I think when you’re looking at an overall portfolio structure, do not assume that you are automatically safe because you’ve got exposure to US bonds.
That’s it, any questions?
Excerpt from Q&A period:
Question: Why did the Bundesbank announce proposed gold sales?
What we’ve got here is the demographics of central bankers. Those gold hordes were put together by the generation of central bankers who came out of World War II and the Bretton Woods agreement and that inflation was the inevitable fate for democratic countries because they always promise more than they can deliver. And the Germans in particular of course had a deeply-rooted, visceral fear of inflation because of the Weimar Republic. In France it was Jacques Rueff(?) who convinced deGaulle about making sure their foreign exchange reserves were in gold. And the Germans just accumulated reserves on the basis to make the signal to their own people that the Deutschemark could be counted on.
And this was part of making the German miracle occur, was convincing people that the Germans could actually produce the strongest currency in the world. As a matter of fact, by the late 70’s, it was about the only institution in Germany that Germans believed in was the Deutschmark. They were very skeptical about their government, very skeptical about their companies, skeptical about their unions. The military had been virtually neutered. And so the big institution there was the DM. When they agreed to put that into the Euro, that was no longer something that had to be kept sacrosanct, backed by gold.
But now we move on to the demographic change. The people who are running central banks these days, with the exception of Alan Greenspan, are of a new generation. They’ve grown up having learned modern economics, which is dating from Keynes, that gold is the barbarous relic and gold is a terrible investment, they were stuck with it as they watched it go down through the triple waterfall crash era. And these central bankers are eager to be able to improve returns for the foreign exchange fund.
As I’ve put it before, today’s breed of central bankers looks on gold the way a manufacturer of artificial Christmas trees looks on the real thing. He looks on the fact that the pine needles shed, that you’ve got to cut down the forest for it, it’s a nuisance to move in and out in the halls of buildings and so his attitude is I can do better than God.
That is something that is part of what makes central bankers able to get together for brandy in Basel. Is that they really feel that they’ve liberated themselves from gold. That they know how to manage each others pieces of paper.
So, in order to prevent the central bankers of Europe from selling too much gold, the gold industry was able on behalf of countries in Africa who are getting hurt by gold sales to get them to cut down their sales under an agreement to 400 tons a year. That agreement is going to be extended but what it shows you is there’s been a gigantic change. So what you can say is they’ve been wrong about gold for most of the time. And they’re wrong about gold again. They were enthusiastic about it, they’d built up their reserves in the 70’s because of the idea that inflation would never calm down they lost money on those acquisitions and now they’re saying we’ve repealed gold we finally made it obsolete because of their ability to fight inflation. We shall see. |
