“The two most powerful warriors are patience and time.”
-- Leo Nikolaevich Tolstoy
As bearish as I am on Treasuries right now, in recent days I've heard some compelling arguments why it might be some time before inevitable inflationary pressures drive yields higher. Please don't think I've reversed my position, because I haven't; I still expect Treasuries and the dollar to fall apart when Fed policies finally reach the broader economy. Once the storm comes, the United States will never fully recover; the financial center of power will shift to Asia, and the dollar will collapse. In the meantime, however, Treasury yields may hover at historic lows.
The first argument has to do with the biggest U.S. creditors -- China and Japan. In recent weeks, I've pointed out many times that both China and Japan hold trillions of dollars worth of U.S. Treasuries. I've suggested that both governments might be losing their appetites for U.S. debt for several reasons:
1. Treasuries are paying absurdly low yields.
2. The U.S. consumes excessively and manufactures very little. It is the biggest debtor nation on earth. I don't care what S&P says -- the U.S. is a credit risk if ever there was one; China and Japan aren't stupid.
3. Both China and Japan are experiencing severe recessions, and their ability to fund U.S. debt has been curtailed.
4. Both Japan and China must fund their own economic stimulus packages, and one way of doing that might be to liquidate U.S. Treasuries at all time highs.
One question I frequently hear is this: "If the Chinese and Japanese aren't going to buy Treasuries, what will they buy?" Eventually, the answer will be commodities -- especially precious metals. Also, China, because of its increasing need for oil, will undoubtedly use its cash to increase its reserves.
In the short-term, however, there may be a more pressing reason for China and Japan to continue buying Treasuries. Both the yen and the yuan have been gaining value against the dollar and the euro in the last month -- indeed, the yen is bumping against all-time highs. China and Japan are both heavy exporters to the United States and Europe, and a strong currency is bad for exports, so China and Japan will likely do everything they can to weaken their currencies -- especially against the dollar and the euro. There are essentially two ways of doing this: the country can either print more money, or it can buy assets from the countries against whom their currencies are strengthening.
And this brings me to the first compelling argument I read today in an article from Reuters: both China and Japan may continue to buy U.S. Treasuries, as well as debt in Europe, in order to weaken their currencies. For instance, in order to lend money to the U.S. (through the purchase of Treasuries), Japan must sell yen and buy dollars -- thereby weakening the yen and strengthening the dollar. And while the argument makes sense, there is another aspect that may make it at least somewhat less viable.
Because of the severity of the global economic downturn, central bankers everywhere are slashing lending rates and printing money in order to "reflate" their economies. If you read my article yesterday, you know that these policies are bogus, and based on serious misrepresentations by the aforementioned central banks, but that is a discussion for another day. For now, suffice it to say that most countries are very pro-printing -- for lack of a better description -- and both China and Japan may choose to weaken their currencies by printing more. This would serve not only to create the "inflation" everyone is championing to "re-ignite the world economy," but it would also make their exports more appealing to Europe and America -- or so the theory goes.
The reason I keep putting "inflation" in quotes is that I don't agree with the definition most people try to assign the word. At any given moment on CNBC, you can see any number of reporters, analysts, CEOs, or politicians referring to "inflation" interchangeably with "price increases." It's something akin to the way people incorrectly use the word "impeachment" as a synonym for "removal from office;" I've said it so many times before: rising prices are not inflation, they result from inflation -- which is defined as an increase in the supply of money.
Do I think the Chinese and the Japanese will choose to print more currency over buying Treasuries, toward the objective of weakening their currencies? Probably not exclusively. In reality, both countries will likely implement a combination of the two policies for the near-term. And that might mean continued strength in Treasuries until the effects of the Fed's massive printing spree ripples through the economy -- at which point, nothing will keep Treasury prices afloat.
The second reason I think Treasuries might be able to remain at their current lofty levels is investor psychology . Before I go further, you should know that I believe there is a strong possibility equity markets will continue to fall -- possibly much further. In fact, it wouldn't surprise me if we don't reach bottom until we have given up 60% to 80% of the October 2007 highs. There are several things contributing to my pessimism, among which is my belief that corporate profits and dividends are going to fall dramatically in 2009. I keep hearing pundits talk about "historically low P/Es" and "historically high dividend yields." There was another time in the last century when P/Es and dividends were this enticing: 1930.
They didn't stay enticing for long.
Tied to corporate profits is another factor that causes me distress about the outlook of equity markets: the consumer. Who is going to consume? And where is this consumer going to get his or her consumptive power? They certainly aren't going to borrow it from their houses anymore. Credit card limits are shrinking like wool in a dryer, and defaults are on the rise. The consumer is, as they say, tapped out, which means corporations are going to suffer.
The final thing contributing to my reservations about equities recovering is the CBOE volatility index (VIX). It refuses to stay below 40, although I can remember a time not so long ago when a number above 40 heralded Armageddon. Not so anymore! So as long as volatility remains this high, it doesn't bode well for stocks, and I remain firmly bearish.
And this brings me to the second compelling argument why Treasuries might remain high for a little while: every time the stock market sells off, gold follows it down, and Treasuries rise. As I also mentioned in my article yesterday, this means that investors believe gold is a risky asset, and Treasuries are "safe." As long as the proverbial flight-to-quality means a rush for Treasuries, and a flight from gold, there can be no rationality in these markets. The day I see stocks and Treasuries falling together as gold rises, I will know sanity has returned. That might not sound sane, but neither does $8.5 trillion in bailouts and stimuli.
I really hate horror movies. Wake me when this one is over.
In the 1930s, we were on the gold-standard, and we were a creditor nation; we issued debt to get out of the Depression. In the 1970s, we were also a creditor nation, although not on the gold-standard. Paul Volcker took rates over 20%, and yet we barely kept inflation from running away with the dollar.
Today, we have gone into this recession as the largest debtor nation on earth. We don't even believe in gold. We are printing more money than ever before in history. I would say the dollar is toast, but at the end of this, I think toast will be worth more.
If you can afford to ride out the irrationality, short Treasuries and the dollar with alacrity; eventually you will be rewarded handsomely. If you can't sweat the volatility, though, you may want to wait a little while. In the meantime, just look for a rise in gold when everything else is weak. Then you'll know rationality has returned.
Then you will know it's time.
| Disclosures: Paco is short Treasuries through the Proshares Ultra Short 20+ Treasuries ETF (ticker: TBT). He is long physical gold, as well as through the Proshares Ultra long gold ETF (ticker: UGL) Paco has been a financial analyst and a portfolio manager for 18 years. He has been a passionate long-term advocate of Austrian economics for most of his life. You can buy his novel Discipline wherever books are sold. Or visitwww.disciplinebook.com to read sample chapters. You can also see and listen to interviews with Paco. If you like this blog, subscribe at the top of any page via email or RSS feed. You can submit this or any entry to Digg, Reddit, BuzzUp, and other news aggregators by clicking the appropriate icons on any page. Email your elation, respect, or abject disgust to questions@pacoahlgren.com. Copyright 2009, Paco Ahlgren. All Rights Reserved. |
