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…

In recent weeks financial markets have relied on to the “green-shoots” thesis, rising smartly as an array of statistics turned out to be less dire than expected. Policymakers, too, have begun to sound less pessimistic.

Optimism may be fashionable, but there are plenty of reasons to fear it is premature.The danger is that too much emphasis on the stock cycle misses the underlying characteristics of this downturn. This is mainly a balance-sheet recession precipitated by a financial crisis. And it is a downturn that it is unusually synchronised around the globe.

Recoveries from globally synchronised recessions take 50% longer than other recoveries as an analysis in the IMF’s new World Economic Outlook makes clear.

Banks worldwide have written down their assets by $1.1 trillion. The final tally is expected to be double that or even triple !! The pain is only now starting to spread through commercial property and commercial loans and banks have been the “cheerleaders” of this ” green-shoots” theoretic recovery.

Maybe too much hope…

For four reasons, the deflation that started several months ago is quite likely to persist along with the recession, or at least until early 2010.

First, the collapse in commodity prices continues and past declines are still working their way through the system. Crude oil prices have collapsed from $147 per barrel to around $45. Steel semi-finished billet prices were $1,200 a metric ton last summer but now is $350. Iron ore costs per metric ton dropped from $200 early last year to $80. It takes time for steel prices to work through to final consumer goods prices such as for washing machines

Second, producers, importers, wholesalers and retailers were caught flat-footed by the sudden nosedive in consumer spending late last year and continue to unload surplus goods by slashing prices. All the giveaway bargains at Christmas still didn’t entice enough consumers to open their wallets. Spring apparel, ordered before consumer retrenchment, is clearly in excess and being marked down before it’s put on the racks. Retailers from Saks on down continue to chop prices. Branded food product manufacturers are willing to promote their wares alongside the private-label goods that supermarkets shoppers increasingly favor.

Third, wages are actually being cut for the first time since the 1930s

A final reason to expect deflation in coming quarters in the U.S. is the surplus of aggregate supply over demand. Notice that the supply-demand gap is an excellent forerunner of inflation six months later. And deflation this year is spreading globally. Japan is once again flirting with falling prices, Thailand’s CPI in January fell year over year for the first time in a decade. In Europe, inflation rates are rapidly approaching zero.

There is a lot of talk about the possibility of heading towards a ” New Great Depression” but we do NOT think so.

The good news is that we think  that we aren’t headed for the Great Depression, but the bad news is that we are in for the Great Recession, where household sector, the nonfinancial business sector and the financial sector will suffer a lot.

The contraction in asset values and debt will ultimately be pushed even further than they would normally have to go. So it is going to take years.

Here is a very basic fact about this period. Balance-sheet contraction makes it impossible for the private sector to generate the profits it needs to function, whereas balance-sheet expansion generates booming profits. Therefore, it isn’t a matter of getting rid of the bad assets from the bank, and then the economy is ready to go. This process involves not just cleaning up the banking sector, but also shrinking assets and liabilities.

We think that the earliest recovery would be in 2010. But we are not sure we are going to get a recovery then, based on the economic-stimulus plan that has been passed so far, although it is moving in the right direction. The enormity of what it is trying to overcome may be too great. It is very likely we will see additional moves by the government later this year, so there will be something added, mainly because of higher unemployment.

One of the problems for any government trying to deal with this situation is the expectation that, like past recessions, it is a problem that should get cleaned up and we should go back to some level of prosperity

Among the possible outcomes of this shock are: massive and prolonged fiscal deficits in countries with large external deficits, as they try to sustain demand; a prolonged world recession; a brutal adjustment of the global balance of payments; a collapse of the dollar; soaring inflation; and a resort to protectionism. The transformation will surely go deepest in the financial sector itself.

The proposition that sophisticated modern finance was able to transfer risk to those best able to manage it has failed. The paradigm is, instead, that risk has been transferred to those least able to understand it. 

Remember what happened in the Great Depression of the 1930s. Unemployment rose to one-quarter of the labour force in important countries, including the US. This transformed capitalism and the role of government for half a century, even in the liberal democracies. It led to the collapse of liberal trade, fortified the credibility of socialism and communism and shifted many policymakers towards import substitution as a development strategy.

The Depression led also to xenophobia and authoritarianism. Frightened people become tribal: dividing lines open within and between societies. In 1930, the Nazis won 18 per cent of the German vote; in 1932, at the height of the Depression, their share had risen to 37 per cent.

The impact of the crisis will be particularly hard on emerging countries: the number of people in extreme poverty will rise, the size of the new middle class will fall and governments of some indebted emerging countries will surely default. Confidence in local and global elites, in the market and even in the possibility of material progress will weaken, with potentially devastating social and political consequences. Helping emerging economies through a crisis for which most have no responsibility whatsoever is a necessity.

IMF latest analysis : http://www.imf.org/external/np/g20/pdf/031909a.pdf