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

The yield on 10-year Greek bonds rose to 7.15 percent yesterday, the highest level since October 1999 and up from 4.99 percent on Nov. 30. The yield is more than 3.9 percentage points higher than benchmark German bunds, the biggest gain since October 1998.

The nation’s government bonds are the world’s worst performers in January, losing 4.19 percent in local currency terms and extending their decline over the past three months to 10 percent, Bloomberg/EFFAS indexes show. Credit-default swaps tied to Greece trade at about the same levels as Dubai when it got a $10 billion bailout from Abu Dhabi in December.

The cost of insuring the country’s debt against losses rose to a record yesterday, with credit-default swaps jumping 40 basis points, or 0.4 percentage point, to 414, CMA DataVision prices show.

The swaps have risen from 121.8 basis points in October, and compare with 433.4 basis points for Dubai in the weeks before it received cash from Abu Dhabi on Dec. 14 !!!

“I am not sure that a Greek default is inevitable, but the clock is ticking with regard to difficult policy choices,” said Marc Seidner , a portfolio manager at Pacific Investment Management Co. in Newport Beach.

“Any financial aid from other European nations would be conditional upon the government introducing new measures to clean up its public finances”, Le Monde said. Help would consist of bilateral loans from European governments in the absence of a mechanism for a euro-region bailout, the newspaper said.

Portugal and Spain, watch out !!!

We would like to present today  This Time is different from  Carmen M.Reinhart and Keneth S.Rogoff . They have catalogued over 250 financial crises in 66 countries over 800 years and then analyzed them for differences and similarities.

The book gives evidence that we have a lot of pain to experience because of the bad choices we have made. This is the entire developed world, and the emerging world will suffer, too, as we go through it. It is not a matter of pain or no pain. There is no way to avoid it. It is simply a matter of when and over how long a period.

In fact, Reinhart and Rogoff’s research suggests that the longer we try to put off the pain, the worse the total pain will be. We have simply overleveraged ourselves, and the deleveraging process is not fun, whether on a personal or a country basis.

And they say :

“But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.”

“This time may seem different, but all too often a deeper look shows it is not. Encouragingly, history does point to warning signs that policy makers can look at to assess risk – if only they do not become too drunk with their credit bubble – fueled success and say, as their predecessors have for centuries, “This time is different.”

Well, well, we have never believed that this time was different , and for sure, we advocate that this time it will take a lot of time, effort and courage  to navigate  through these turbulent times…

On January 1 , 2010 ,Spain took over the six-month rotating presidency of the EU. Spain’s biggest ambition for its turn is the launch of a “2020 strategy” for Europe. This is a ten-year plan for boosting competitiveness and growth to help pay for Europe’s generous welfare systems. It follows another ten-year plan, the old “Lisbon strategy”, which failed in its aim of making the EU “the world’s most competitive and dynamic knowledge-based economy” by 2010.

But EU members reaction has been unenthusiastic. Spanish unemployment is heading close to 20% (double the average among euro-zone countries), following the popping of a huge housing bubble,  worsened by a two-tier labour market in which a hard core of permanent workers is almost impossible to sack, passing the pain onto those on temporary contracts, all too often meaning the young and immigrants.

So please give us a break !!! Let´s start by applying to ourselves what we want for the rest of EUROPE.

IT IS DELEVERAGING STUPID !!!

The reason this recession is different is that it is a deleveraging recession ( depression kind ?). We borrowed too much (all over the developed world) and now are having to repair our balance sheets as the assets we bought have fallen in value (housing, bonds, securities, etc.). A new study by the McKinsey Global Institute found that periods of overleveraging are often followed by 6-7 years of slow growth as the deleveraging process plays out. No quick fixes.

The process of deleveraging from what is still a near-record debt overhang is going to take a long period of time and exact a toll on economic activity along the way.

As David Rosenberg says “ALL debt as shown in the chart above is going back to $60,000 in real terms, and if it’s going there, and we get a withdrawal of stimulus at any time, then the credit contraction is going to gain some serious momentum.  This is a big reason to be defensive and yield- oriented in the portfolio”.

And finally, FT in the Lex Column “it may be economically and politically sensible for governments to spend money on making life more palatable at the height of the crisis.  But the longer countries go on before paying down their debt, the more painful and drawn-out the process is likely to be.  Unless, of course, government bond investors revolt and expedite the whole shebang.”

So, who said this game was over ? Let´s see what Bond Vigilantes have to say…

“Security researchers said they have discovered software capable of stealing information installed on computers in 103 countries from a network that targeted government agencies.The software infected more than 1,200 computers, almost 30% of which were considered high-value targets, according to a report published Sunday by Information Warfare Monitor, a Toronto-based organization”. Said WSJ.

“Google has said it will end the controversial censorship of its search service in China and risk being thrown out of the world’s most populous internet market, following what it claimed were Chinese-based attempts to hack into its systems and those of other international companies”. Said FT

The apparent attacks are the latest to suggest cyberespionage is on the rise. Last year, Kevin Chilton, commander of the U.S. Strategic Command, said “military computer networks are increasingly coming under attack from hackers trying to steal information, many of whom he said appeared to have ties to China”.

PHOTO: AP  CRASH 1929

Today the prices of many assets are being held up by unsustainable fiscal and monetary stimulus.Interest rates of 1% or less in America, Japan, Britain and the Euro zone, have persuaded investors to take their money out of cash and to buy risky assets.

For all the panic last year, asset values never quite reached the lows that marked other bear-market bottoms, and now the rally has made several markets look pricey again.

Low rates have persuaded investors to move money out of cash. Investors withdrew $468.5 billion from money-market funds in the course of 2009. The “carry trade”—borrowing in low-yielding currencies to invest in high-yielding ones—is back in full swing. The Australian dollar has been a popular beneficiary.

But our problems still there. We still have banks too big to fail, we have not put the credit default swaps on an exchange, we have not reinstated Glass-Steagall Act, we keep in power the same people who missed the problems the last time, ETC,ETC,ETC…

So let´s be careful with the coloured glasses that we use to see the World because that may change…