A great overview of the arguments on either side of the great Treasury bull-bear debate, courtesy of David Rosenberg. Rosie juxtaposes the perspectives of two of the most respect yields strategists currently: MS' Jim Caron, and Goldman's Jan Hatzius. A dose of Jim Grant is also thrown in for good measure. Must read summary for bond bulls and bears alike.
You really have to have a read of "Yield Views Couldn't Differ More" on page B1 of the weekend WSJ. It pits Jim Caron, a good pal and former Merrill rates-strategist colleague against Goldman Sach's Jan Hatzius, a former formidable competitor and I would argue runs one of the best, if not the best, economics houses on Wall Street. Jim is bond bearish, Jan is bond bullish. The world pretty well knows my view. The article talked more about supply than it did about inflation, which is the much more critical ingredient in any simulation of interest rate determination.
Jim Caron makes the claim that the US government has never before been raising so much debt to finance the bloated fiscal deficit and roll over existing obligations. But if truth be told, the US government never before paid down as much debt as it did previously back in that surplus year of 1999 and the Treasury market got hammered. Why? An economic boom absorbed all the slack in the economy and causes a brief episode of inflationary pressure. That was the cause. Just as in 2002 the deficit exploded, bonds rallied massively because deflationary risks moved to the front burner. Yes, Virginia -- deficits and deflation can co-exist for extended periods of time. Ask anyone who has lived in Osaka over the past decade. The two Jimmies (Caron and Grant) are entitled to their opinions but not their own facts, and I have run similar correlations as Jan Hatzius has and there is no comparison between fiscal deficits and inflation when it comes to bond yield analysis. If the deficits and bond issuance are occurring at a time when the economy is approaching full employment and private sector balance sheets are expanding, then for sure interest rates will be on a rising trend. But fiscal deficits that are designed to cushion the blow from a credit contraction, especially among households, generate far different results. With credit contracting, rents deflating, the broad money supply measures now declining and unit labour costs dropping at a record rate, it hardly seems plausible that inflation is a risk at any time on the near- or intermediate-term forecasting horizon.
Plus, keep in mind that the price-setter for the entire retail sector, Wal-Mart, just announced price cuts on 10,000 items -- you heard that right. That is deflation, not disinflation or inflation or any other 'flation. And just to show you the enormity of this announcement, the CPI contains 8,018 items!
The "Current Yield" column in Barrons also runs with the bond-bear theme ("Next, a Sharp Jump in T-Yields"). This time, and again, it focuses on the Morgan Stanley forecast of a 5.5% peak in the yield of the 10-year note. We are told in the article to throw away the econometric models of the past and rely solely on the supply backdrop.
Again, this logic defies how bonds rallied through most of the Reagan years despite all the bond supply used to spend the Russians out of submission in terms of military expenditure. We are also told that the consensus is underestimating the recovery -- another reason to be bearish on bonds. But to get to 5.5% we had better get one heck of a renewed expansion in bank lending and household balance sheets and a good dose of inflation. It sounds so outlandish. We didn't even get past 5.25% at the 2007 peak with a late-cycle economic boom, a record-high stock market, dramatic credit expansion, a tight monetary policy stance and sky-high deficits -- not to mention an unemployment rate closer to 4% than 10%.
And to top it off, the front page of the Sunday NYT runs with "U.S. Consumers Face End of Era of Cheap Credit". When the view of higher interest rates comes to dominate the media as much as it has in recent days, you know that something else is bound to happen. That NYT article stated that housing "has only recently begun to rebound" -- well, when you look at the chart of new home sales, housing starts and the NAHB index, it's very difficult to detect any rebound at all…
One reason why interest rates cannot rise is because if they do, there will never be a sustained improvement in the pace of economic activity. Housing is the classic leading indicator, and the most interest-sensitive sector, and until it revives, it seems highly unlikely that bond yields will rise on any sustained basis or that the Fed will embark on a path towards higher policy rates. For a truly sombre assessment on the prospects for a housing recovery, see what Robert Shiller has to say on page 5 of the Sunday NYT biz section. ("Don't Bet The Farm on the Housing Recovery").
Full edition of today's Breakfast with Dave here