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.