THE
BEAR'S LAIR Why ever would you buy
bonds? By Martin Hutchinson
The Federal Reserve's unexpected
inter-meeting cut of 75 basis points in the
Federal Funds rate to 3.5% was accompanied by a
sharp rally in the dollar bond market, as the
10-year Treasury bond yield dropped to 3.4%. With
inflation well above 4% and rising, one can only
ask: why? Why would anyone buy the obligations of
a shaky deficit-ridden political system in a
currency that appears fundamentally unsound?
Usually, this column likes to answer the
conundrums it poses the reader, but I'm damned if
it has an answer to this one.
In the short
term, the specter of inflation is looming ever
nearer. Sharp reductions in interest rates and
insertions of liquidity into
the
system, as have been undertaken by all the world's
major central banks outside Japan, have increased
the supply of money chasing goods, at a time when
commodity markets are already stretched. Hence,
not only is the dollar likely to decline owing to
the extra liquidity, but commodity prices are
likely to rise further in terms of all major
currencies.
The result cannot fail to be
accelerating inflation; as I wrote last week, I
expect even reported inflation to hit an annual
rate of around 10% by the end of 2008.
If
inflation accelerates rapidly during 2008, bond
prices must fall. A 3.6% return is wholly
unacceptable in a currency suffering from 10%
inflation; returns of 2% in yen, 4% in euros, 4.5%
in sterling or even 13% in Brazilian real will
appear more attractive to the savvy international
trader. Consequently, at least in the short term,
accelerating inflation will bring declining bond
prices and rising long-term bond yields, even
though the Fed, the Administration and Wall Street
will be using every endeavor to prevent such an
unpleasant outcome, since it will wreck their
strategy for saving the housing market.
Since the problem will initially be
primarily one of inflation, it may be thought that
Treasury Inflation Protected Securities (TIPS),
indexed against inflation are an adequate
solution. Unfortunately, they are not. For one
thing their inflation index is subject to the
"hedonic pricing" distortion, whereby reported
inflation is adjusted for imaginary "hedonic"
benefits and hence lags true inflation by close to
1% per annum. Since TIPS are fully taxable and
currently yield only 1.3%, it can be seen that the
chances of getting a real after-tax return higher
than zero on TIPS is small.
In addition,
once bond yields have been corrected by the market
to provide a reasonable real return on ordinary
Treasuries, the yields on TIPS can be expected to
increase commensurately and their prices to
decline, providing investors with a capital loss.
At some point, probably around the
inauguration of the new President in January 2009,
the Fed's low interest rate strategy will have to
be abandoned as a hopeless and damaging attempt to
roll back the market’s tides. At that point, Fed
chairman Ben Bernanke will probably be forced to
resign, just as was G William Miller in 1979 (and
with much more reason than that unlucky and
generally inoffensive gentleman.)
To
replace him, a new Paul Volcker will be appointed
by the new president to deal with the inflation
crisis. The incoming president will be fortified
by the knowledge that the blame for inflicting
inflation-fighting pain on the populace can be
placed securely on the shoulders of his or her
predecessor, George W Bush, who will be reviled
much as was Jimmy Carter in 1981-82. It will be an
ideal time for a change that blames the preceding
administration, just as was January 2001, when an
intelligent incoming President George W Bush,
could such a thing have been imagined, might have
inveigled the Fed to raise interest rates, wring
the excesses out of the system, and blame the pain
on Bill Clinton.
The arrival of the new
Volcker (the original Volcker - otherwise ideal -
presumably feeling, sadly, that he is a little
past the job at 82) would cause a further
bloodbath in the bond market. While the long-term
value of US government bonds would be greatly
improved by the neo-Volcker's arrival, in the
short term the neo-Volcker would need to raise the
Federal Funds rate well into double digits, to
match the accelerating rate of inflation.
This would inevitably have a further
depressing effect on the prices of the outstanding
stock of Treasury bonds. A further depressing
effect would be caused by the budget deficit;
already running at more than $500 billion as the
new President arrived owing to misguided stimulus
packages and slow economic growth, it would
rapidly soar beyond $1 trillion as the new higher
financing costs caused a painful recession and
themselves raised the government's overall
borrowing expenses.
Thus the short-term
outlook for fixed rate US dollar bonds is dire.
Three factors, accelerating inflation, a sharp
rise in short-term interest rates and an exploding
budget deficit, all make them likely to slump in
price in the next 12-18 months. What of the medium
or long term? Is there a chance that a 3.6%
10-year Treasury bond, however battered in the
next year or two, might come to be seen as a good
investment before its maturity?
There are
three underlying trends that suggest that
long-term US Treasury bonds may be an even worse
investment in the long term than in the short
term. Combined, they suggest that a junk-level
credit rating for the US government may be
appropriate.
First, there is the social
security system, which has been providing over
$100 billion per annum towards plugging the
deficit gap in the last few years but is about to
stop doing so and then after 2017 swing into sharp
deficit. Contrary to Washington belief, this
problem will be exacerbated by a continued high
immigration of younger, less-skilled people.
Since poorer people require more services
and pay relatively less into the social security
system than rich people, the actuarial deficit
will worsen, and it will become clear that the
young and foreign-born are paying relatively heavy
taxes in order to support a large retired
native-born cohort with most of whom they have no
genetic, ethnic or cultural links. Inevitably the
political process will at that stage function in
order to relieve these younger voters of their
substantial net obligations, almost certainly
requiring further heavy government borrowing.
The second actuarial problem is Medicare,
whose costs are increasing considerably faster
than gross domestic product and have been for many
years. Theoretically, this problem could be solved
by delaying eligibility for Medicare sufficiently
that its books balanced - after all the medical
advances that cost so much are increasing human
lifespans and health. In practice, it is almost
certainly not possible to do this quickly enough,
in that by the time the problem has been fully
recognized the lump of retired beneficiaries will
have overwhelmed the system, and it will be
impossible to make them "un-retire".
Here
the political omens of 2008 are for a further
worsening of the situation. The Medicare fix
promised by the Democrat candidates would increase
costs more than revenues, thus worsening the
actuarial position, as well as removing the
opportunity to solve the program's problem by
delaying the eligibility age - if all are
eligible, there will be no escape from the
system's vast costs.
Finally, there is the
problem discussed in this column a couple of weeks
ago: that of the migration of an increasing
proportion of US jobs to the Third World, and the
consequent future decline in US relative living
standards and very likely in absolute living
standards. Moreover, emerging markets now possess
an increasing proportion of the world's capital.
Thus even in a period of tighter money, when the
US capital cost advantage would have been a most
salient competitive factor, the transfer of
manufacturing and high-level service jobs will not
be reversed, or even greatly slowed.
The
economics of this as it affects the US public
sector are clear but unpleasant. If it had
happened during the Coolidge administration,
before welfare entitlements had been established,
the transfer could have occurred smoothly, with
little additional US unemployment and only
moderate dissatisfaction in the workforce.
However, with public sector programs in place for
social security, Medicare/Medicaid and
unemployment insurance, there is a major
difficulty.
The US is currently in the
position of General Motors in about 1970, splendid
in its possession of a majority share of the US
automobile market and apparently invulnerable to
competitive threat, yet in reality burdened with
impossible welfare programs that a foolish
management had negotiated during the good years.
For General Motors, the future after 1970 was one
of steadily slipping market share, from 60% of the
US market to about 25%, of a steadily aging
workforce, and of a retiree health benefit
obligation that if valued appropriately is today
worth far more than the value of the company
itself.
Had GM not undertaken its
excessive pension and healthcare obligations, it
would have had more capital to compete
effectively, would have been less likely to lose
oodles of money in every downturn, and might still
retain primacy in the world automobile market
today, albeit by a lesser margin than in 1970.
For the US, the position is the same. Its
workforce will be older than its competitors' and
entitled to benefits that absorb an increasing
share of the national income as its relative
earnings decline. Importing new younger workers,
except at the very top of the skill pyramid, will
worsen the problem because they too will by
immigrating obtain rights to excessive social and
medical benefits.
The extensive US welfare
system will encourage early retirement and
periodic unemployment as solutions to individual
workers' income problems, rather than enabling a
smooth transition to a lower wage level.
Both Medicare and Social Security's
current assumptions include a rise in the US
workforce's real earnings at a steady rate beyond
2050; if this does not happen the programs'
actuarial deficits will explode. Doubtless the
government will attempt to solve the problem by
borrowing yet more money; it will be apparent only
too late that massive default lies at the end of
that road.
In summary, like General Motors
in 1970, the United States does not deserve its
AAA rating and its obligations, particularly those
denominated in the local "Bernanke pesos" should
be avoided.
Martin Hutchinson is
the author of Great Conservatives
(Academica Press, 2005) - details can be found
at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice &
Associates.)
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