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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 (54623)	2/24/2006 8:53:32 AM
From: Ramsey Su	Respond to of 110194

PIMCO article presented a good scenario. pimco.com Q: We’ve talked about a lot of variables, but what is the bottom line in terms of the outlook for bonds and the shape of the yield curve? Dialynas: The outlook is very path-dependent. There is this notion that the U.S. in particular, but other industrialized countries as well, has received a subsidy from the global savers in the form of lower rates. The estimates are that rates are 50-100 basis points lower than they would otherwise be as a result of this symbiotic trading and financing relationship between surplus countries and deficit countries and that if something should disrupt this process, then rates would go up substantially. On the surface, this seems pretty logical, and certainly if things unwound slowly, that would probably be the path. As the subsidy dissipated, assuming the capital needs were consistent, you would need higher interest rates or a lower currency to continue to attract capital, particularly because, as we’ve discussed, the successful transformation of China would result in massive outflows of U.S. capital to China. But if things were disrupted by some sudden surprise event, then it seems to me rates would probably decline across the curve, and probably more so for short rates than long rates. Economic growth would most likely slow substantially and you’d probably go into recessionary conditions. It could go either way and that’s why trying to forecast the investment behavior of those who hold the dollar reserves and those who continue to have huge trade surpluses is really a very, very important call for us to make. If you look at the volatility of the market and the price of options on currencies, interest rates and stocks, volatility premiums are quite low. And a flat yield curve would be indicative of, at least for a while, lower volatility premiums. In terms of the yield curve, part of what we are seeing with the flatter yield curve is lower term premiums but it is very hard to assign cause and effect because we have a re-regulation of the pension system that is resulting in better asset liability management on the part of defined benefit pension plans. So we have all of these factors with respect to trade flows. But then we have also got this huge stock of assets in the pension industry that are horribly mismanaged with respect to asset/liability management. Pensions are very short duration and regulations are being tightened to make it much more costly to be mismatched, and so one of the responses is to better match and that means buying more long bonds, resulting in lower rates and a flatter yield curve. So it is hard to dissect the inferences that one might normally make about the yield curve shape with respect to the economic cycle, with respect to trade flow influences and with respect to asset liability management. And finally, in terms of risk premiums, I think it’s interesting to note that from an economic point of view, other than the growth in debt, it seems to me we have been completely insulated from the economic hardship we might expect to be normally associated with fighting a war and financing a war. So there is a question as to whether some of the complacency in the financial markets is not only a function of capital flows but also a function of the fact that most Americans seem completely unaffected by the fact that we are engaged in a serious war. And it’s interesting to wonder whether it makes a difference in risk premiums and the financial markets in one regime versus the other, as to whether part of what we see with low risk premiums is the situation where we are engaged in a war but with good growth, low inflation, and low risk premiums even as we finance the war through the debt accumulation and the trade flows.