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

To: John Vosilla who wrote (49423)	1/11/2006 9:39:22 AM
From: Crimson Ghost	Read Replies (1) \| Respond to of 110194

US Bonds: A Gift That Should Keep on Giving, or a Pig in a Poke? January 9, 2006 Rob Lee is an economist residing in the U.K. who has been involved in investment markets for 30 years, the last few in nominal retirement. In his January Investment Outlook (“ A Gift That Should Keep on Giving”) PIMCO MD Bill Gross puts forward a bullish case for US Treasury bonds in 2006. Mr Gross is an outstandingly eloquent writer and thinker on investment issues, as well as a very powerful participant in the bond market itself. It is a brave or foolish man who tackles him on his own turf. However, one of the virtues of retirement is that one ceases to fear appearing foolish. I therefore suggest that there is a major flaw in his case, and that buying US Bonds now could be a serious mistake. Let me start by stating where I agree with his argument. I agree that the recent inversion or near inversion of the US yield curve heralds at least a significant slowing of the US economy (Indeed I think a recession likely - see below). His concept of the spread between the Fed Funds rate and the average cost of intermediate Treasury financing of the last five years is a powerful one. It strongly supports his contention that “yields everywhere on the curve are much more restrictive than they appear”. This is really a sophisticated way of observing that massive accumulation of debt has made US economic growth more vulnerable to higher interest rates. So, policy is more restrictive than it appears? Yes. [Incidentally, it is also more restrictive than intended.] Growth is going to slow more than expected? Yes. Therefore US Bonds are a buy? Well, no. This is where I part company with Mr Gross. The missing element in his argument is the position of foreign investors. They already own a huge amount of that accumulated US debt and must be persuaded to not only retain that debt but continue to buy it in unprecedented amounts. The consensus view appears to be that foreigners will indeed continue to buy US assets in vast amounts apparently in perpetuity. It is argued that they have to do this otherwise their currencies would appreciate (in the case of central banks) and also that the value of existing dollar investments would take a knock. I find these arguments naïve in the extreme. Basic economics tells you that when the supply of an item is continuously increased without reference to potential demand the price will eventually fall precipitously. One of my first bosses in the investment world once told me “ if there is going to be a panic, panic first!” There are early signs - notably the rise in the gold price - that some dollar holders may be on the verge of panic. Once begun, the dynamics of currency weakness and extreme dependence on foreign capital are devastating . I lived and worked in a country where this happened - South Africa - and can testify that the results are very painful. Growth slows dramatically but inflation and interest rates rise not fall. To take a very extreme case, if a weak economy always led to lower inflation and interest rates why does Zimbabwe have hyperinflation? Why did Argentina have massive inflation when its economy collapsed after the Dollar peg broke? Of course I am not suggesting that the US faces a future anywhere near as extreme as these examples. What I am saying is that the consensus view is far too complacent. Mr Gross is right to be worried about the US growth outlook, but underestimates the dangers of currency weakness and dependence on foreign capital. You can have recession and rising inflation at the same time and I believe this is what faces America in 2006/2007. Into this volatile mix is added a new Fed Chairman. Mr Bernanke’s unorthodox views may be academically stimulating but they are not reassuring to conservative foreign investors. Buy US bonds? Not me. P.S. On a personal note, I recently had an unnerving experience as a foreign investor in the US. Several years ago I bought US Silver Eagles from a well known and reputable precious metals dealer. They were stored with a depository service. In December I decided to sell them (this was only part of my silver holding - I am still very bullish) The broker I bought them from refused to buy them back! The provisions of the Patriot Act apparently made them liable if I turned out to be a terrorist. He eventually found me an outfit who agreed to take the “risk” of buying them back (reducing the price to me accordingly). Will I be cautious about investing in the US again? You bet.