In one of the most erudite, intelligent, and insightful conversations on the Bond bull/bear debate, David Rosenberg and Jim Grant go all out at each other, trading blows in this "Great Debate" which is a must see by all. As we pointed out yesterday, Grant is very bearish on bonds, and in a self-made prospectus has decided to downgrade the US, since the rating agencies, which have long been thoroughly incompetent, corrupt and afraid to disturb the status quo, will not do so until it is too late. Jim's point is simple: you can't resolve massive debt with more debt, and says Treasuries, which he calls "certificates of confiscation" are a surefire way to lose one's money. He points to the record supply of US Treasuries, makes fun of the SEC (who doesn't), and in a stunning move, cautions the Fed Chairman, whose ongoing dollar debasement, was once considered treason by the US. His conclusion: "watch your back, Ben Bernanke. Cycles turn" could not have come at a more opportune time. As a contrarian, Rosenberg discusses the McKinsey report looking at sovereign debt, and the Reinhart and Rogoff studies on debt default and highlights that there is a major disconnect between theoretical applications of sovereign default models and practice: in essence the US is still deleveraging as private debt is decreasing and public debt is surging but to a slower degree. In essence, David claims, the second largest monthly debt issuance in March of $333 billion is merely a side effect of ongoing deleveraging, which is a leading and/or coincident indicator of deflation: an environment in which the long bond thrives (Japan is a good reference point).
Agree or disagree, the fact that two of the smartest economists in the world can present very persuasive cases for either side indicates precisely the conundrum we are in, and is precisely why the Fed will pretend it is operating in the shadow of a so-called Goldilocks economy, even as it prints record trillions of new debt until one or the other is proven wrong. If, as many expect, Grant ends up being correct, than Bernanke will have gambled and lost the future of the United States.
Some of the more persuasive arguments by both include a refutation by Grant that the US economy now is in any way comparable to that of Japan, for a variety of reasons, namely the underlying domestic "dynamism." Rosenberg disagrees and presents the trend pricing for JGBs which, even with record ongoing debt/GDP and deficits, has seen a contraction in JGB yields by 70 bps, even after a round of downgrades.
For traders, the recent move wider in bonds, as well as the first ever observation of negative swap spreads is likely a warning signal that the 10 Y may finally be breaking out of the 3.20% - 3.80% range where it has been stuck for the past year. If yesterday's post NFP move is any indication, we will likely see a 4.00%+ print in the next week, after which the next resistance level is in the mid 4's.
Our personal take is that the key factor that is least discussed by pundits, is the demographic shift in both Japan and the US, with both populations ageing, and a record number of Americans entering retirement age over the next 5 years (and discovering that Social Security is bankrupt). To believe that this cohort will invest in equities is about as stupid as saying that IT is the current GARP sector of choice. What is the alternative? Corporate bonds may be reaching an adverse inflection point as both foreigners and Primary Dealers begin to pull out - is the slowest money, mutual funds, about to follow? Will the next big move be a derisking exemplified by a shift into Treasury funds and an increase of the Household purchases? Unlikely - we have seen that the savings rate has just dropped to its lowest level since 2008 of 3.1%. Consumers are once again running out of unvisitable cash, and instead are loading up on one-day fad trinkets like Kindles. On the other hand Primary Dealers, which usually are a harbinger of things to come, have increased their capital allocations to bonds dramatically over the past several months. Or will the shift be a derisking one? Also unlikely, due to the primary demographic observation highlighted above, and also with the majority of the population having sat out the bear market rally (intuitively aware that it is based on one-time, non-recurring fiscal and monetary stimuli), which is logical: just the richest decile of the population tends to benefit from blistering bear market rallies. To be sure, Uncle Sam is waiting on the other side with the IRS taxman to take his share. Also, domestic equity mutual funds have seen a substantial $3.5 billion outflow in 2010: why should that suddenly change?
In short - confusion prevails. We anticipate many more such very intelligent debates will take place in the future before we finally see a breakout either over resistance as inflation wins out (and cause massive losses to the Fed's SOMA portfolio at a $1 billion DV01), or below support, as the Rosenberg thesis of deflation finds the greatest number of followers. In either case, an accelerating move to either direction will be widely destabilizing and should finally break the trance that stocks have been in for the past year.