 Alice in Bond-er-Land
Dan Norcini
December 6, 2004
"Curiouser and Curiouser" is the pithy and wondrous
expression we first meet up with in Lewis Carroll's classic,
"Alice's Adventures in Wonderland." Young Alice's decision
to jump down the rabbit hole introduces her into a world of bizarre
characters and strange encounters that leave her filled with
bewilderment and confusion. Nothing that she has learned seems
to apply in this strange place into which she has fallen.
I must admit
that I am beginning to feel like Alice did after her initiation
in Wonderland; especially after her encounter with the Hatter.
Nothing he said made the least bit of sense to the poor girl.
After what must have seemed endless hours to Alice attempting
to understand what in the world his twisted utterances were meant
to convey, she gave up in disgust and stormed off. She had had
her fill of the mad tea party and was ready to go somewhere,
anywhere, where the characters made some sense.
As a long time
student of the bond market, I suspect there are many out there
who look at the traders inhabiting the bond pit in much the same
way as Alice viewed the Hatter and the Dormouse. They live in
a world completely disconnected from reality and their utterances
of late make no sense whatsoever. The old rules no longer seem
to apply in this world; up is down; down is up; black is white;
white is black; sugar is salt and salt is sugar.
When entering
the bond pit, one gets the feeling that he has fallen down a
rabbit hole leading to some sort of mirrored hall in which ones
image is hopelessly distorted; at one time looking tall and thin
and another time, short and fat. As long as they reside in this
particular room, nothing will show itself in its true form and
reality is masked and hidden from sight.
In particular,
I am referring to the complete disregard being paid to the recent
collapse of the dollar by the bond market. Just as the Hatter
believed that he could make a deal with Time and ask him to be
whatever he, the Hatter, wished him to be, so bond traders seem
to believe that they can make a deal with interest rates and
make them be whatever they wish them to be, never mind the fact
that the currency backing them is coming unglued before the eyes
of the rest of the world.
There was a
time in my life when I admired bond traders as being among the
most sophisticated and learned guys in the trading world when
it came to understanding economic and geopolitical issues. They
would swiftly punish foolish monetary and/or fiscal policy and
made sure that the authorities were kept honest. No one was able
to pull the wool over their eyes or blow smoke in their face.
They were hard nosed realists who showed no mercy and who took
no prisoners. Not any more!
Today, they
seem to be as mad as the Hatter and as clueless as Tweedledum
and Tweedledee. In my opinion, I have never seen a group of bond
traders as utterly clueless and oblivious to what is going on
around them of late as this group of pit denizens. An apt comparison
would be a group of people in the midst of a movie theatre that
is blazing, calmly sitting in their chairs munching on ju-ju
bears and popcorn as if they haven't a care in the world. The
entire domestic house is about to come down on their heads and
there is not the slightest bit of worry or concern on the part
of bond traders. "Don't worry, be Happy," seems to
be the motto in the bond pit these days. Or, in keeping with
our Alice in Wonderland theme, they prefer to belt out some foolish
limerick and expect us to stand in awe of their creativity.
The reason
for the above somewhat sarcastic tirade is very straight-forward.
There is absolutely no way that the domestic currency of a nation
so heavily indebted and so heavily dependent on foreign capital
as the United States is can go into freefall and that same nation
can offer foreign investors lower rates of return on its debt
instruments. It simply cannot happen. Long term interest rates
MUST RISE at some point or the dollar will collapse so swiftly
on the foreign exchange markets that the entire global economic
system will descend into chaos.
A nation that
has no domestic savings pool of its own, must; has no choice;
will shrivel and die on the vine; if it does not offer foreigners
a good reason to buy its debt and therefore fund its operations.
The dollar has dropped 8.4% in value over a period of the last
two months. Why in the world would any reasonable foreign investor
buy an asset based on the U.S. Dollar that offers him or her
a fixed annual rate of return for the next 30 years of less than
5%? That is financial suicide.
Yet is appears
that is what the current bond market is offering foreign investors:
Tweedledum
and Tweedledee
Agree to give us a lower rate!
For Tweedledum and Tweedledee
Both say that seems just great. The problem
is that while the Tweedle Bond traders may pat themselves on
the back for a job well done, the U.S. has recklessly put itself
into the position of becoming the world's beggar nation since
it no longer has any domestic savings pool to speak of. We are
therefore not exactly in the enviable position of being able
to subsist without foreign capital.
A nation running
a current account deficit the size of the U.S. is in serious
trouble should its source of capital dry up for any reason whatsoever.
While the rest of the world makes noises about divesting themselves
of U.S. Treasury debt in favor of Euro Zone debt, the Mad Hatters
in the bond pit sit and spin out riddles among each other instead
of doing the ONE THING that can serve to at least slow the rate
of descent of the U.S. Dollar - that is - give prospective bond
and note buyers a HIGHER RATE of return on their purchases to
compensate them for their currency risk.
Let me state
what most traders understand when it comes to bonds and interest
rates. Long term rates are set by the marketplace and not the
Fed. Oh yes, the Fed's monetary policy has tremendous influence
on long term rates as it raises or lowers the Fed Funds rate.
But that is the short end of the yield curve. The bond market
itself is supposed to set long term interest rates by taking
into account a variety of factors, not the least of which is
the value or standing of the domestic currency involved.
For example,
if I am an investor looking to buy some fixed income assets in
a nation in South America, whatever government is interested
in doing business with me had better offer me enough of an interest
rate to make it worth my while to risk my hard earned money.
Think back to the crisis that Argentina experienced a mere couple
of years ago when its peso was collapsing on the international
forex markets. They were forced to hike short term rates in an
attempt to prevent foreign investment capital from fleeing the
country. In other words, if a currency looks to be in trouble,
investors will DEMAND higher rates of return before they lend
out their money to the government in question by buying its notes
or bonds.
This is axiomatic
and no amount of sophistry or "spin" is going to change
this. Of course, this then raises the question as to what in
the world is going on in the U.S. bond market? Why, in the face
of a collapsing dollar, are bond traders bidding up bonds effectively
lowering the rate of return?
The answer,
in my opinion, is that the Fed has snookered bond traders into
somehow believing that inflation is dead in the United States
and that a falling dollar will not have the least effect upon
the cost of imported goods. "We can have steady, sustained
growth year after year. The horizon is clear; not the least trace
of upward price pressures can be seen," or so they are soothingly
told.
I already know
what some who read this article are going to say, "But the
CPI is relatively tame, blah, blah, blah, blah." Anyone
who believes that the CPI does not woefully underestimate the
true rate of inflation is a candidate for the looney bin in this
writer's opinion.
I have read
too many articles over the past year dealing with cost increases
at the producer level and at the consumer level to believe one
bit of the current Fed-speak about tame inflationary pressures.
To give you
an example all we need to do is to look at the steel industry.
Ask the end users of steel if the price of this essential good
has not soared in the last couple of years.
A recent article
in the Financial Times detailed the demand for steel coming out
of Asia as its automakers gear up for increased production to
meet rising demand for automobiles in China to cite only one
country as well as modernization in the region overall. The article
goes on to cite how the cost of a cold-rolled steel sheet has
increased in Japan 23% year on year. Obviously we are talking
about Japan here and not the U.S. but this incredible surge in
demand has resulted in increased competition for available supplies
making steel shortages a very real problem not only in Asia,
but also in Europe and in North America. The result has been
that domestic users of steel here in the U.S. often find themselves
in a bidding war with foreign uses for available supplies. Throw
on top of that the fact that many businesses that use steel here
in the U.S. are forced to buy it from oversea sources with dollars
that are dropping in value on the global market and it is easy
to see why steel prices are soaring at the wholesale level.
Think for one
moment about all the products that use steel; automobiles, construction,
heavy equipment, industrial tools, etc. Now consider the military
itself - that is one helluva lot of steel that goes into one
Abrams tank not to mention the amount of steel in one aircraft
carrier or submarine.
I do not know
about the current generation of bond traders, but when I was
in school I learned that unless a company can pass on its increased
costs to the consumers of its products, eventually it will cease
to be a profitable entity. Companies that do not grow in profitability
soon do not exist at all. You can bet the ranch on this one -
sooner or later, if not already, producers who use steel in their
products will be raising prices and passing those costs directly
onto you Mr. and Mrs. Harry Homeowner.
The most obvious
price increases have of course come in the energy sector as the
rising price of crude oil has had its ripple effect across the
entire economic spectrum. Lately crude oil prices have fallen
sharply retreating some $13/bbl off its peak high but it is still
trading nearly $12/bbl higher than it was last year at this time
when it was in the $30/bbl range. Again, rising prices.
Another recent
Associated Press article by Theresa Agovino, detailed the rising
cost of health care. The article goes on to state that a woman
by the name of Caroline Steinberg, vice president for trend analysis
at the American Hospital Association said that said "hospital
costs were rising because technology is getting more expensive
and patients are older and often sicker than they were in the
past."
That same article
quotes a study by Paul B. Ginsburg who based on his research
concluded that,
"Even
if the rate of increase (on health care spending) does not jump
dramatically, he said, it is still at a level that outpaces inflation
and could lead to more employers' dropping health coverage."
Copper prices
have increased 50% since this same time last year. Wonder why
those new homes cost so much? Ask the builders how they expect
to recover their rising costs without raising housing prices.
Maybe they could just sell them without the wiring and help to
thereby do their part in keeping the official CPI numbers nice
and low. Who needs electricity in their homes anyway?
Most Americans
who do not live in Wonderland understand this all too well. The
list of things rising in price could go on and on and on and
on. Yet the bond market vigilantes have disappeared from the
face of the earth. All we hear is sweet crooning emanating from
the bond pit about the Fed's glorious victory over the fiery
dragon of inflation. Wonderland indeed!
These dupes
in the bond pit are convinced that the only possible way for
inflation to work its way back into the economy is for the number
of new jobs to increase at a faster pace thereby putting more
people back to work with more disposable income who will buy
more goodies and trinkets creating more demand which will lift
prices across the board generating inflationary pressures. Et
cetera, et cetera , et cetera...
That is why
the bond market is so fixated on the jobs report numbers and
literally cannot see past the noses on their own faces. They
apparently are oblivious to what Is happening in the real world
but are instead sitting at the Mad Hatter's tea party living
in their own make believe world. Well I have news for the Tweedledum
and Tweedledee bond pitsters - Inflation is already here and
roaring - Wake up and leave your La-La land dream world before
your utter stupidity leaves the dollar a mangled mess on the
floor of the foreign exhange!
Sadly, as the
dollar drops even more, upward price pressures will only intensify
as Americans are hit with rising prices associated with a weakening
currency on the foreign market.
Hell will freeze
over first before the dollar can fall and the U.S. not experience
imported inflation. Yes, as long as China maintains their peg
the cost of Chinese costs will not be affected in the least by
a falling dollar, but China is not the only nation that the U.S.
imports goods from. Even Japan, in spite of the quasi-peg that
it maintained earlier in the year, has seen the yen rising sharply
against the dollar some 6% + since this time last year. The Euro
has risen better than 11% from the same period. All of this will
result in the cost of goods from other nations such as Japan
and Euroland and a host of others rising in price due to currency
fluctuations alone - and we are not even making provision for
any of these foreign exporters to hike prices to compensate them
for the increased cost of their raw materials.
The conclusion
in quite simple and to the point - unless the bond market wakes
up out of its drunken stupor and moves to increase rates on the
long end of the curve soon, the dollar is going to continue its
descent unchecked and as it goes, it is going to create a situation
in which the once unthinkable is going to happen - foreign central
banks are going to begin disinvestment of U.S. Treasuries which
will create a vicious feedback loop in which selling will beget
more selling as there is a rush to exit before the next guy does.
This will result
in a violent surge upward in both short term and long term interest
rates as efforts are made to halt the carnage. The chilling effect
this will have on the U.S. stock market and the entire U.S. economy
will then become painfully obvious. This is the path of all current
account adjustments once they reach critical mass - there are
no exceptions.
One way or
the other we are going to have higher long term interest rates.
We can either do it in some sort of "controlled" manner
or we will have them thrust upon us violently and without mercy.
We are too deeply in debt and cannot survive without foreign
capital. It is up to the bond market to determine exactly which
way it is going to be.
It is similar
to the old Fram Oil Filter commercials in which the greasy mechanic
looks into the camera and remarks, "You can either pay me
now or pay me later."
Bond traders
- are you listening? Or will you continue to sing songs and quote
riddles to one another? Then Dream On Sweet Alice...
Dan Norcini
Dan Norcini
is a professional off-the-floor commodity trader residing in
Texas and you may send your comments to: dnorcini@earthlink.net
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321gold Inc
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