Treasury Bonds

Since 1990 Treasury bond yields have steadily moved downward in line with a more benign inflationary environment (Chart 6). Those yearly declines in yields continued last year with an average interest rate of 4.07% versus 4.28% in 2008.

To remain fully invested in long Treasuries in this high volatility environment requires a simple discipline based on the academic literature which demonstrates that over time bond yields move in the same direction as inflation (Fisher equation).

Van R. Hoisington and Lacy H. Hunt have a very interesting opinion about it :

“Presently, we view the inflationary environment as benign because: 1) the U.S. economic system is overleveraged and academic research confirms that this circumstance leads to deflation; 2) monetary policy is, and will continue to be, ineffectual as efforts to spur growth are thwarted by declining asset prices, loan destruction, and adverse regulatory influences; 3) the federal government’s spending spree will necessarily cause taxes and borrowings to rise, further stunting any economic growth. These factors ensure that inflation will be quiescent. Interest rates easily can and do rise for short periods, but remaining elevated in a disinflationary environment is contrary to the historical experience. We are owners and buyers of long U.S. Treasury debt.”

Treasurie´s Holders

The United States government borrowed more money than ever before in 2009, but its largest lender — China — sharply reduced the amount it was willing to lend.

The United States Treasury estimated that last year China raised its holdings of Treasuries by just $62 billion. That was less than 5 percent of the money the Treasury had to raise.

That raised its holdings to $790 billion, leaving it the largest foreign holder of Treasury securities — Japan is second at $757 billion and Britain a distant third at $278 billion. But China’s holdings at the end of November were lower than they were at the end of July.

Meanwhile, Japanese Institutions are becoming the new buyers, seeing 10 Year Tresury Bond at 3% yield in June !!!

Who is right ? We think that Japanese know a lot better what happens when a Financial credit buble burst…

Europe’s leaders are struggling to avert the biggest financial disaster in the euro’s 11-year history…

Whether the EU has time is an open question. Credit Suisse says Greece must raise €30bn (£26bn) in debt by mid-year, mostly in April and May. Greek banks have been shut out of Europe’s inter-dealer markets, forcing them to raise money at killer rates. They are suffering an erosion of deposits as rich Greeks shift money abroad. This could come to a head long before April.

French banks have $76bn of exposure to Greece, the Swiss $64bn, and the Germans $43bn says Bloomberg. But this understates cross-border links. There are large loans between vulnerable states. The exposure of Portuguese banks to Spain and Ireland equals 19pc of Portugal’s GDP. Interlocking claims within the eurozone zone are complex. Contagion can spread fast.

The rescue of Greece marks a new wave of the global financial crisis. The first was about the solvency of banks; this one is about the solvency of sovereign countries.

As Ambrose Evans Pritchard said  ” There was an element of bluff in Thursday’s accord, as if the EU leaders hope to muddle through with “constructive ambiguity”, fingers crossed that their vague political pledge will never be tested. Bluff is a valid tool of statemanship, but in this case their bluff could be called very soon.”

We would like to come again to This Time is Different by Rogoff and Reinhart and how the authors enumerate the possible factors bringing Deflation :

” First, financial imbalances occur when aggregate domestic debt is excessive relative to income, regardless of whether the government or private sector is accumulating the debt. Once debt becomes excessive, countries do not grow their way out of the problem; they must go through the time consuming and often painful processes of debt repayment and increased saving.”

“ Second, whether the domestic debt is externally or internally owed is not as critical as the excessiveness of the debt.”

“ Third, government actions, even involving sizeable sums of money, are far less helpful than they appear. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is.”

Fourth, Reinhart and Rogoff cover countries in debt crisis with a host of different conditions, such as growth and age of population, political regimes, technology status, education, and other idiosyncratic features. Nevertheless, economic damage as a result of extreme over-leverage has remarkably similar results, whether the barometer of performance is economic output, the labor markets, or asset prices.

Fifth, further increasing leverage to solve the problem only leads to greater systemic risk and general economic underperformance.

The real question for financial participants is whether all these influences result in inflation or deflation, and the authors’ research details both outcomes.

According to Reinhart and Rogoff the norm is that major economic contractions lead to deflation. Importantly, they call our present economic circumstances the “second great contraction.”

Thus, not only has the historical “qualitative” research on the subject of deflation chronicled the deflationary impulses emanating from overindebtedness (Fisher’s 1933 “Debt-Deflation Theory of Great Depressions”), but also modern “quantitative” methods have now essentially confirmed this conclusion. Over-indebtedness and major contractions lead to deflation.

How Europe chooses to deal with the problems of the countries on the edge, among them Greece, Spain, Portugal and Ireland, may determine the future political shape of Europe, and the future of the euro itself.

World markets sank Thursday in the face of signs that skittish investors were growing more fearful of lending to Portugal. That country had to scale back a short-term borrowing plan, something Europe is not used to seeing.

If investors were to walk away, or demand truly exorbitant interest rates, that would put pressure on France, Germany and others in the euro zone to decide just what they would do. Would they bail out their troubled neighbors? Or would they simply allow them to default — an outcome that would have major repercussions for Europe and financial markets worldwide?

For a long time ( 10 years aprox.)  optimistic forecasts said  that European countries, faced with the unavailability of currency devaluations, would liberalize their economies to make them more competitive but that proved to be wrong.

If anything, the opposite happened. A common currency, with closely linked interest rates, made it possible for countries to postpone changes, or to try to do them so gradually that they made little difference.

It is not easy to persuade politicians to take steps that are likely to lead to them being voted out of office !!!

If the euro problem does turn into a crisis, however, 2010 could turn out to be the year of the currency fights. The United States and Europe are both showing more irritation at China’s refusal to allow the Rimminbi to appreciate against the dollar, a decision that makes the Chinese export economy more competitive when it is already running large trade surpluses.

So turbulent times with many possible outcomes… Watch out