Saturday, July 09, 2005

Bond bulls

Barrons presents the case for a bullish view on long bonds. As mentioned previously here, both Bill Gross of PIMCO and Stephen Roach of Morgan Stanley seem to have thrown in the towel, and are now bulls themselves.

The main question is: are rates low now because of Asian central bank buying of US debt (a very unstable situation), or is it due to a longer term secular trend of overcapacity and disinflation caused by economic globalization? Will we see 10y yields at 3-3.5% in the next few years?

...indeed the decline in long rates is a global phenomenon, belying the contention that the recycling by Asian central banks of U.S. trade and current-account deficits into Treasuries is the primary factor keeping American rates so low. Bond rates have plummeted to multidecade lows in much of Europe and Australia and in China, Taiwan, Singapore and Japan are below U.S. long rates.

...the game had changed dramatically with the fall of both the Bamboo and Iron Curtains and the "integration" (Greenspan's favorite word) of India into the global economy. Hence, inflation and inflationary expectations were likely to wither over a number of years as huge new reservoirs of productive capacity and cheap labor were unleashed.

As a result, Big Business and Big Labor, the oligopolistic bulwarks of the post-World War II affluent society, would lose their pricing power. Mass migrations of rural workers to higher-wage areas like China's coastal cities, South American and Indian urban centers and across the Mexican border to El Norte would continue unabated for years, putting a lid on labor costs. And the economies of scale now possible in today's vastly larger global trading markets would only bolster the disinflationary forces at work.

In fact, Hoisington and Hunt argue that the last time such an integrated global market existed was from 1871 to 1949, when long-term Treasury bond rates averaged 2.8%; annual inflation, 0.7%. This even with two World Wars and debilitating trade wars that flared up during the 'Thirties. But all of that ended with the onset of the Cold War in the late 'Forties and the splitting asunder of the global economy.

ADDING TO THE DISINFLATIONARY FORCES has been the capital-spending boom since the 'Nineties in the U.S. and overseas, which has created sharp rises in productivity and mountains of excess capacity. Hunt notes that from 1994 to 2004, real, non-residential fixed investment averaged 10.9% of real U.S. GDP, compared with an average of 7.6% from 1919 to 2004.

The other period that nearly matched this spate of investment was 1919-1928, when implementation of Ford assembly-line techniques and the electrification of industry and homes revolutionized American society. Meanwhile, Chinese capital spending recently hit an off-the-charts 40% of GDP.

"Look at the efficiency gains and disinflation that occurred after the 'Twenties capital-spending boom or even deflation that took place in the decades after the post-Civil War railroad boom, and one gains an inkling of what may lie ahead for the U.S. and perhaps the global economy," Hunt asserts. "It's certainly fair to expect that the IT [information technology] and Internet revolution of recent years will have as profound effect on inflation and interest rates."

Demographic trends inform much of David Rosenberg's bullishness on long-bond rates. As the Merrill Lynch economist sees it, aging baby boomers -- some 76 million strong -- are on the cusp of becoming huge buyers of Treasury bonds and other long-dated fixed instruments.

...The leading edge of the boomers hits 60 next year and begins to seriously consider retirement. Income will become paramount over growth. Thoughts will also turn to assets' staying power, with life expectancies anticipated to increase several years a decade from the current level of around 78. Finally, says Rosenberg, capital preservation will become an imperative. The time to make up any losses will be dwindling. "In short, no assets serve all these needs quite as well as Treasury bonds," he asserts.

If so, the transition could have a galvanic impact on future government-bond rates, according to Rosenberg. For one thing, the latest Federal Survey of Consumer Finances (done in 2001) shows that the boomers, in particular, are wildly overweighted in stocks and underinvested in bonds for the stage of life they are in. Secondly, the quantity of long-dated U.S. government bonds has dwindled since the Treasury suspended in 2001 the sale of 30-year maturities to $458 billion from a peak in 2000 of $562.5 billion.

...France in February issued 50-year government bonds and Germany is considering a similar move. The French issue was wildly oversubscribed, and has rallied sharply to a yield lower than the current U.S. 10-year bond. The U.K. also recently issued 30-year debt in response to market demand, and is mulling a 50-year issue.


Anonymous said...

What about inflation? A 3% 10-year is barely above inflation.

Anonymous said...

I forgot to mention, excellent, excellent post!

Steve Hsu said...


I think the bond bulls are forecasting that we will be flirting with deflation in the future, due in part to excess labor capacity from 2 billion Indians and Chinese joining the world economy.

As you note, the nominal yield is less important than the real value. You might have a 3% nominal yield and a 1% inflation rate, which would mean a real yield of 2% (compare to where TIPS are today).

I think the bullish point of view is still a minority view (the article notes this). Anyone who is long long bonds is taking big risks, but who knows, maybe they'll get paid...

Calculated Risk said...

Last year I seemed to be one of the few bond bulls around. I wasn't being a contrarian, I thought: 1) the economy was weaker than the headline numbers suggested, and 2) the foreign CBs would continue buying US treasuries and MBS.

I suggested the possibility that interest rates wouldn't break the housing market ... it would be the housing market that breaks interest rates! I know that sounds strange, but here is how it could work.

Best Regards!

Calculated Risk said...

Oops, bad link in the previous comment, try THIS.

Steve Hsu said...


It was my fear that the virtuous cycle you described might turn vicious that kept me away from long bonds over the last 2 years. (BTW, nice figures :-)

But the alternative thesis relating to overcapacity and deflation suggests other reasons for low rates. Admittedly, if there is a run on the dollar interest rates will spike, at least temporarily. But perhaps there is a long term secular trend at work as well.

Calculated Risk said...

Professor, I agree ... that possible vicious cycle I outlined probably wouldn't last very long (maybe a year or so) ... then we might see lower rates again and possible deflation.

But I don't think those lower rates will help housing. Once the housing bust starts, I think we will see lower housing prices for a number of years (5 to 10 years like previous down cycles).

I am positive longer term, but I do think there is a short to intermediate term problem with a high risk of a hard landing.

Interesting economic times.
Best Regards!

david bennett said...


In fact, Hoisington and Hunt argue that the last time such an integrated global market existed was from 1871 to 1949, when long-term Treasury bond rates averaged 2.8%; annual inflation, 0.7%. This even with two World Wars and debilitating trade wars that flared up during the 'Thirties. But all of that ended with the onset of the Cold War in the late 'Forties and the splitting asunder of the global economy.

I would think the fall of colonialism after WWII would be listed as a cause, but I'm pretty skeptical of this splintering. WWII did a lot, so did other things, protectionism was not a joke, so this "integration" strikes me as questionable.

I also think it relatively unclear that structural elites have lost their power to take signicant shares of the economy. Medical care seems to be pushing up towards 20% of the economy, significantly higher than in other industrial nations. Education inflation seems to be expanding that domain and while in some states public schools take less, the upper levls are increasingly expensive. There seems to be a long list of "professionals" who take increasing shares.

These do increase prices.

I am very skeptical of inflation figures as published. There are substitutions and skewed measurements. Just returning to medical care, if the 6% increases in cost we hear reported are true that's a 1% increase. Part of the mania for real estate and hedge funds is a sense that stocks and interest bearing investments aren't keeping up. We get huge sums pushed into junk bonds because of this.

And the traditional market result of putting more and more money into risky games is collapse of those markets and a reduction in availible money.

I think there are so many relevant and mportant variables involved that it would be neaarly impossible to put together a model listing even the simplest links and that simple changes in a few of them could flip the results in completely oposite directions. In other words I don't think the system can be predicted.

And I do think when individuals with a sell side mentality are pasting together historical sounding arguments to justify investments in bond funds or long term committments which are only slightly higher than the 3% one can get in a FDIC protected "money market" account then the case must be read with cynicism.

Deflation could happen, I expect it in real estate and stocks. But then again stocks essentially deflated in the seventies when other markets were highly inflationary. And housing didn't really start it's upward bursts until we were fairly deep into that process.

And strangely that can have major effects. One reason many kinds of insurance including malpractice and worker's comp are way up is that the insurance companies are getting less return on their investments. Now suppose they repeat the story of the nineties and really start to get into real estate as the market peaks?

Those prices will be passed on. they must be one way or another.

Now we get bond traders arguing don't worry, we will still have lower costs becuse a whole bunch of immigrants are going to push down prices in our factories, fast food places and among the people who mow our lawns and pretty soon we can use these people to replace more and more of our engineers and the other useless people who don't have an MBA. And we can even keep them over there and the skilled workers in China and India are going to be unable to get raises. And our interest rates and respect for our dollar are so high, it will keep it's value.

Maybe. I see lots of things pulling lots of ways.

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