Where Are the Bond Market Vigilantes!?

            As we all know with the benefit of hindsight—but as many predicted a year or more ago—the great short sale of 2003 was the U.S. dollar.   The greenback surrendered roughly 15% of its value as measured by the U.S. Dollar Index—and more against some currencies, including the euro.

            Virtually everything that should have accompanied the decline in the dollar did so.  Gold, oil and other commodities denominated in the world’s shrinking reserve currency rose.  Easy, and fairly safe, double-digit returns were reaped in virtually all manner of overseas bonds, with the biggest returns being turned in by emerging market debt.  Stock markets rose at a healthy clip, both due to needing to bounce (if only temporarily) from a three-year bearish grip and due to their choosing to focus on the beneficial effects of monetary easing.  Corporate bonds—the junkier the better—turned in great years as well.

            The one key market, though, that did not play out in 2003 as would have been expected given all of the preceding was the market for U.S. Treasury securities.   In fact, with the first full week of 2004 now behind us, and helped out last Friday by a disappointing report on new jobs (actually, on the lack thereof), the yield on Uncle Spendthrift’s bellwether 10-year note was down to around 4.1%, almost identical to its level of a year ago.

            Bond market bears—of which I am unabashedly one longer-term—have again watched this all in amazement, and wondered aloud, where are the “bond market vigilantes?”  Over the last year, we’ve seen a torrent of news and developments that should have resulted in soaring yields for Treasuries, as investors tripped over one another to get out, just like rats jumping off a sinking ship.  The dollar is being trashed.  An allegedly conservative Bush Administration is borrowing and spending money at a clip to make Franklin Roosevelt and Lyndon Johnson blush.  Commodity prices are soaring, guaranteeing a future surge in consumer price inflation, a plunge in corporate profits or both.  Last but not least, the fact that the U.S. is in an uncertain and likely open-ended conflict against the more radical elements of the world’s billion and a half Muslims also casts aspersions against the stability of the dollar.

            Certainly last week should have seen the current owners of Treasuries get the willies.  Federal Reserve Governor Ben Bernanke told us that the futures markets—which had priced in a 50 basis point increase in the federal funds rate (currently one percent) by the middle of 2004—were dead wrong.  Seeming to take back the baby step the Fed made last month toward acknowledging the inflationary implications of its policies, Bernanke intimated anew that the Fed would not raise short-term rates again until The Second Coming.  The dollar promptly—and predictably—sold off more, and gold’s price reached new bull market heights above $430 per ounce.  That level had not been seen since 1988.   Yet, in spite of all this and more, those who continue to want to BUY the Bush/Snow/Greenspan/Bernanke IOU’s have overwhelmed the sellers.  Looking at how Treasuries have remained fairly strong—and now have rallied further--you’d think that the dollar was the most fiscally sound currency in all of recorded history.  The once-reliable bond market vigilantes have again been silenced.

            What is going on, anyway!?

            The answer is this:  The Fed’s latest “Damned if we do, damned if we don’t” bargain with itself has perversely resulted in this contradiction of the bond market rallying even as the dollar sinks.  At the same time, however, it also means that when this particular stop-gap measure runs its course—and it surely will—there will REALLY be hell to pay.

            Twice in the last six months, the Fed has had to make an important decision.  The first time was in mid-2003.  Stocks and bonds had been going up in tandem for a few months, with bonds extraordinarily so.  The yield on the 10-year note plunged to within a whisker of three percent, helped along by a few “winks” from Fed officials that the Fed might at some point consider being the “buyer of last resort” for the hapless Treasury Secretary John Snow’s IOU’s.  Greenspan and Company knew they could not make both stock and bond investors happy any longer—and had to make a choice.

            As we found out, they chose to support the stock market by suddenly becoming bullish on the prospects for the economy, and backtracking from their previous hints that they would monetize Treasuries.  For a while, bonds tanked; but then they stabilized.  Stocks took off and accelerated their liquidity and momentum-driven cyclical bull move. On the surface the Fed seems vindicated, having reinflated the stock market bubble together with goosing the economy.  But detractors insist that by further postponing a needed cleansing, the Fed has only guaranteed us a worse fate later on.

            Similarly, the Fed has recently had to decide again which of two major constituencies it will assist, and which it will…well…screw.  They are, first, the foreigners who for several years have poured money into U.S. assets—including Treasuries—and in a couple notable cases continue to do so.  The other group on the Fed’s mind are those domestic (primarily) financial institutions who have indirectly been doing the Fed’s bidding—and feathering their own nests—by engaging in the “carry trade.”

            Foreign investors in Treasuries, of course, have been taking it on the chin.  In recent months, the level of new buying from private investors has plunged, as Europeans in particular have tired of losing their money.  Even in some “official” European corners, the appetite for U.S. debt has waned. 

            However, there are two notable exceptions:  Japan and China.  Both are buying more Treasury debt than ever before, as they “recycle” their trade surpluses.  China doesn’t lose—yet—since its currency, the yuan, is tied to the dollar.  Japan is losing in one respect, as the yen strengthens modestly against the greenback in spite of continual Bank of Japan interventions; however, keep in mind that Japanese financial institutions worked out a deal with Greenspan back in 1995 giving them the same access to the Fed’s discount window as U.S.-based institutions have.

            The other major constituency—domestic banks and other U.S. (and some Japanese) financial institutions—requires constant reassurance that the Fed won’t be taking the “carry trade” game away.  Lest I assume too much and confuse readers, let me explain:   a bank or other type of financial institution can borrow money straight from the Fed at somewhere around one percent, and invest those funds in longer-dated Treasuries paying between four and five.  The “carry trade” refers to this practice, as well as the difference—three or four percent—which the trader earns.  The Fed has seemingly made this a safe bet; and has thus been able to keep long-term market rates surprisingly low.  Instead of buying the Treasuries itself, though, the Fed has these other self-interested parties to do its work for it, which maintains the strong demand for Treasury debt.

            The Fed can ill afford to frighten away those playing the “carry trade” game.  Once you understand just how much this has kept long rates docile, you realize just how petrified, in fact, the Fed must be about the prospect of finally having to give in some day and start raising short-term interest rates.  Those who will call for such responsibility on the central bank’s part will say that—by raising short-term rates—the Fed will soften oncoming inflation pressures and actually cause long-term market rates to come down.  Instead, though—by taking away the carry trade—the Fed will actually increase the selling pressure on long-term Treasuries.  It knows this.

            So the Fed has decided that it must “sacrifice” those foreign investors still crazy enough to own U.S. Treasuries.  Japan and China aren’t about to curtail their huge purchases of U.S. debt any time soon, so the Fed and the Treasury don’t have to worry much about them.  The only significant group of foreigners that might leave are those predominantly European private investors and institutions that haven’t already; and who cares about them?  Those sissies didn’t support Bush’s war, anyway.

            All this explains why—for now—Treasuries are strong, even as the dollar sinks virtually every day.  It explains why Fed officials like Bernanke and Treasury Secretary Snow are so smug in making dollar-wrecking statements that some of us think are delusional, if not insane.  It explains why the Fed may end up not raising rates for most (or all) of 2004 after all—and why for the most part they just might get away with it.   But especially if they do, this all also means that the aftermath of the Fed’s latest—and arguably grandest—moves to postpone the inevitable will be that much worse for the central bank to have to deal with.

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