Smart and Thorough -But Wrong
© copyright View from Florida, 2009. All rights reserved.
Back on October 2, Zero Hedge put out a link to a 17-page piece by Bob Kessler (*) which I finally got around to reading at length this evening. He makes smart and thorough points about the economy and likely durability of the current rally. Many of them are “against the grain:” which is always interesting to find in this day and age of economist herding and everyone going along to get along. (Or going along to stay employed, as we often opine.)
However, one important but caught our eye:
“So we go back to basics. We remind our investors that the short end of the U.S. Treasury yield curve anchors all maturities governed by U.S. central bank monetary policy observed in its most basic form as a transparent Fed funds target rate. We contend that the long end of the yield curve is substantially governed by inflation (and only to a lesser extent the component inflation expectations), plus the available real rate of return (as calculated against measured inflation).”
Based on this foundation, he posits with “mathematical rigor” that long-term bond rates will inevitably stay low, and should be even lower, due to lack of CPI inflation. (He specifies CPI as his measure of inflation –several times.)
Since there is no history with today’s trillions in debt being issued, the “mathematical rigor” in his model is immediately suspect. (Even if the politicians do show some guts and rein in deficits, Treasury must still roll out unprecedented oodles of long-dated bonds for years to come.)
This alone doesn’t disprove his argument. A commentator I respect argues there will be plenty of safe-haven demand during a protracted bear market and “real men trade the long bond.” Despite predicting the same low-yield result for different reasons, both Kessler and one of my favorite commentators may be correct.
However, both overlook an issue not much in play during previous bear markets --currency valuation.
I could go on and on about the relevance of CPI. We could moan about the value of your 1930’s long bonds before and after FDR raised the price of gold from $20 to $35. If it wasn’t late evening, I imagine there are a half-dozen more points to be made…
The essential point remains, never before were global participants able to switch massive holdings back and forth among USD, EUR, JPY, AUD, CAD, etc. (Not to mention gold, oil, copper,) at the click of a mouse. Never before was there credible risk major USD holders might choose to hold something other than USD –or instantly –and quietly-- dispose of USD they hold. (Yes, we concede that just because they can switch doesn't mean they will.)
Long bond yields may or may not stay low. Citing CPI and inflation expectations as “mathematical proof” of this prediction ignores the risk of currency devaluation.
Ignore this consideration at your own peril!
Ps, this comment belongs over at ZH, but there are so many, many comments –often just rants—it feels like a waste.
*= http://www.zerohedge.com/sites/default/files/KESSLERcommentary-0820200KESSLER_9.pdf
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The above is not intended as advice to buy, sell or hold any stock, bond nor any other financial product. Invest at your own risk.
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