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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: mishedlo who wrote (21952)	11/18/2004 1:49:26 PM
From: ild	Read Replies (1) \| Respond to of 110194

Thursday, November 18, 2004 conversations with Mishedlo, part 2 here a recent exchange with Mishedlo, which was prompted by an idea i expressed on another occasion , namely that the decline of the dollar could eventually lead to a panic, since officialdom seems at a loss as to how to deal with the US current account debacle. everybody knows the current account deficit must be brought to heel, but they want the process to be 'painless' - which is plainly impossible. since this represents a quandary to which no obvious solution presents itself, it seems likely that the market will take over at some point and FORCE a readjustment. Mish writes: "What would a panic look like? Sudden collapse in the US$ for sure but would that force interest rates up? What about interest rates overseas (Europe and the UK) what would they do. How likely is a panic?" my reply: first of all, i do think a dollar panic is likely at SOME POINT - but it's impossible to say when. right now, everybody and his auntie are short the dollar - so a bounce seems more likely near term. would it force interest rates up? it should, normally. but then, a weakening currency is normally always bad for interest rates, but in the dollar's case this is at least at the moment not true. the reason is that the market expects a weak dollar to prompt foreign CB intervention, via the buying of US debt instruments. this expectation is entirely reasonable. also, it is imo wrong to assume that a weaker dollar automatically precludes deflation. the Japanese yen fell a lot between '95 to '98 , and that couldn't stop deflation in Japan. i admit i'm at a loss as to how rates might behave in a dollar crisis. they'd probably rise initially, but i don't think the long term downtrend in rates is endangered even then. i can't see a rise in rates even near term. sentiment, as you correctly remarked, is remarkably bearish on bonds. in fact i've never seen a market so close to multi decade highs so infested with bears. i'm uncertain about the dollar, but i feel extremely confident that new lows in yields will be seen in the not too distant future. overseas rates (esp. European) will imo continue to correlate with US rates. Mish: "Should the US$ rally would that necessarily be because treasuries are sold and interest rates go up." my reply: currently it is more likely that the cause-effect relationship will be the exact reverse of this - i.e., a dollar rally could prompt a correction in bonds. Mish: "Is monetization of US treasuries increasing at an alarming rate?" my reply: not at all. in fact, the 13 week ma of broad money supply growth recently even dipped into negative territory, a very rare event (it has recovered a bit since). the debate about debt monetization related to the idea that foreign CB buying of US bonds might stop at some point, which then could force the Fed to step in (in view of the contiunuing Keynesian deficit spending agenda of the Bush administration). this has neither happened thus far, nor is it likely to happen in the near future. once it DOES happen, i expect US domestic demand to pick up the slack - the coming retirement of the baby boomer generation means that safe income will be increasingly chased. i also expect the stock market to be discredited as a vehicle for 'savings' in coming years , and money should increasingly flee into safe haven alternatives - i.e. bonds and gold. it is also very important to keep in mind that there has historically only ever been ONE way to actually reduce a US current account deficit: via a recession, specifically, a consumer led recession. thus the adjustment of the deficit (which is unavoidable, like death and taxes) can be expected to be accompanied by the things that usually accompany a recession: a falling dollar, and sharply falling interest rates. it is possible that a currency crisis will only happen at the tail end of this process - in the form of a final wash-out. like i said previously, i'm far less certain about how the secular dollar decline will play out (after all, the confetti issued by other CBs isn't materially different...it's all fiat money, and the printing presses are manned everywhere. the 'competitive devaluations' game is played by all sides), but i remain confident that the current account deficit will be corrected, and there are in fact no 'painless' ways to achieve that. most likely a coming US consumer recession will lead to another synchronized global recession (the overheating boom in China will probably suffer a grave setback on that occasion as well), and interest rates will consequently lurch lower once again all over the globe. the 'reflation' of 2003/2004 has sown the seeds of its own demise, by helping to squeeze corporate margins and consumer wallets alike - while the debt mountain has kept on growing at an astonishing pace. eventually a lot of housing bubble related and unproductive consumer debt will probably end up in default (after all, it seems obvious that the quality of credit has declined more and more the bigger the credit bubble has grown), which in turn should give government debt paper an additional shot in the arm. the only circumstance that could endanger the down trend in industialized nation government debt interest rates imo would be a confidence crisis regarding the solvency of the issuers - an extremely unlikely event. the US and the Euro-zone are not Argentina. while the US dependence on foreign inflows to finance its twin deficits is obviously worrisome, it still seems unlikely that the government's solvency will come to be doubted. in Argentina's crisis, interest rates rose sharply because it became apparent that the government was in fact about to go bankrupt and that it would be impossible to keep the dollar/peso peg supposedly guaranteed by the currency board alive (this was btw. a failure of the fractional reserve banking system - while in theory, every peso was supposed to be backed by a dollar in currency board reserves, Argentina's banks continued to create pesos willy-nilly in the domestic market - so the backing did not exist in practice). posted by pater tenebrarum at 1:39 PM worldmarket.blogspot.com