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Commentaries & market updates.

Bond Bears Are Too Bullish.

Bond Bears Are Too Bullish.

With interest rates remaining at historic
lows, there is virtual unanimity among market watchers that interest rates
will rise in the not-so-distant future.
A contrarian, therefore, might be forced to conclude that interest rates
were about to fall. Not necessarily. It is also the consensus that any such
in rates will be mild, gradual, and occur within the context of a strengthening
U.S. economy. Therefore an alternate contrarian view, and the one to
which I personally subscribe, predicts that rate increases will be severe,
and occur against the backdrop of a weakening U.S. economy.

The conventional wisdom also asserts
that strengthening employment will be the driving force behind rate hikes,
such as March’s higher than expected
gain in no-farm payrolls. Here too the consensus is likely to be wrong, as
it is more probable that the actual impetus for rising rates will be speculators
unwinding carry trades, foreign central banks diversifying out of dollars,
and changing inflation expectations, as creditors become increasing more skeptical
of misleading government numbers which do not accurately reflect the true rising
cost of living.

Evidence that recent rumors of
foreign central bank’s curtailing their purchases of U.S. treasuries may
be true might is the fact that foreign holdings of US
debt in the Fed’s custody have declined for two weeks in a row following twenty-two
consecutive weekly increases. Also, Yesterday’s five year bond auction saw
the bid to cover ratio decline from 2.47 to 2.29, and the percentage of indirect
bidders (which includes foreign central banks) decline from 44% to 41%. Also,
last week the dollar traded below 104 yen, a new four year low, breaching the
105 level previously thought to be the unofficial BOJ “line in the sand,” without
any overt signs of intervention.

Since bond prices have not been supported by legitimate investor demand, but
by leveraged speculators and foreign central banks, when the former tries to
unwind its bets in an environment where the latter is no longer an aggressive
buyer, bond prices will collapse and interest rates will surge. Given the high
degree to which American consumers, U.S. corporations, and the Federal Government
are dependent on low interest rates, a sudden and severe rise in rates will
crush the economy. As higher rates transfer purchasing power form American
debtors to their foreign creditors, the U.S. economy will fare much worse than
the economies of its trading partners. As such, capital will flee U.S. dollar
assets, forcing interest rates to rise even further.

Rising interest rates and a falling
dollar will cause consumer price increases to accelerate. The “core ” CPI
will no longer be immune to such increases, as rising interest rates make
home ownership less affordable, enabling landlords
to pass on their higher costs, including higher mortgage rates, to their tenants
in the form of higher rents. Since rents represent 40% of the core CPI, the
Fed will finally be forced to officially acknowledge inflation, and either
aggressively raise rates to contain it or lose any remaining credibility.

As various forces interact in a
series of self-perpetuating, vicious circles, the U.S. economy will enter
a perfect storm of rising interest rates, consumer
prices and unemployment, falling asset prices, and economic contraction. The
conventional wisdom is that such an outcome is impossible because Alan Greenspan
would not allow rates to rise to that degree, and that he would certainly lower
rates if the economic “recovery” were to falter. The reality however,
is that Greenspan has very little real control over long term interest rates,
other than the powers of deception and persuasion. In an environment where
high inflation is obvious to all, and foreign central banks are no longer acting
as lenders of last resort, Greenspan’s ability to fool creditors will be severely
impaired, if not completely eliminated.

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