Bond Outlook [by bridport & cie, July 23rd 2003]

When it comes to wealth destruction, the recent fall in bond values must rival any thing that happened to the stock market when the bubble burst. For this contribution to mankind, investors can thank Alan Greenspan for an operation we might call the "greenscam". It involved him allowing investors to believe that the overwhelming risk was deflation and that all means would be used, including the Fed buying long T-bonds, to keep long-term yields low and support the "carry trade". Then Greenspan pulled the rug and investors all fell down, taking off the carry trade. We admit to being as much a victim of the greenscam as anyone else. At least we all know whom never to trust again.


Beyond the half-truths, the inherent contradictions and unproven optimism about the rolling "recovery in six months", our task is to weigh up the likely developments in the US economy as the starting point to what will happen there and elsewhere. Until last week we had "swallowed" the greenscam line that the economy could only recover or deflate. Since recovery with such a debt load looked impossible, we went along with deflation being the more likely scenario, although, in fairness to ourselves, we saw it as only a short-term phenomenon, as a weakening dollar would offset deflationary pressures in time (we overestimated the amount of time in making a "wild guess" of one year).


As of last week, because of a little publicised report that producer prices were rising at a 4.8% annual rate, we began to think of the third possibility: stagflation. Given our view that recovery is impossible until the US imbalances have been corrected (view we hold despite volatile stock market rallies), we see the debate as deflation vs. stagflation. The latter is understood to mean slow growth (only slightly above growth in working population), increasing unemployment, and rising inflation and interest rates.


The arguments in favour of deflation (already rehearsed in this Weekly) include excessive manufacturing capacity, global competition (including competitive devaluations) and the impact of the Internet in putting more price information in the hands of buyers.


In favour of stagflation are the weaker dollar and competition for funds from Government indebtedness pushing up interest rates. Stagflation is always "cost-push" not demand-pull. It can be because of runaway wage demands as in the 1970's. This time, however, it looks like resulting from rising costs of raw material and other inputs (whether priced in dollars or not). Since June of 2002, when each measure was at a low,


  • consumer price inflation has risen from 1% to 2% (but is now stable),
  • producer prices inflation has risen from -3% (!) to + 3% and is still rising
  • commodity prices have risen by about 14% (but are highly volatile).


A major question for the outlook in this stagflation vs. deflation competition is the future of the dollar. Bridgewater point out that, in past periods of high twin deficits, the dollar fell but bonds did not. They see the Fed producing "whatever liquidity is needed to shift some of the downward pressure on bond and stock markets to the US dollar" - hoping to attract foreign capital because the dollar is cheap (presumably with a view to its appreciating again). Up to that point we agree with Bridgewater's analysis, but we have to part company with them when they continue to see the deflation model and falling yields as the most likely scenario. Our view is towards the stagflation model, because of the force of argument from the indices and because the dollar looks likely to fall again.


Generally this is bad news for Europe, although beams (rather than just "rays) of hope are shining in Germany, as Schroeder wins victory after victory in his struggle for reform.


Despite our now leaning towards the stagflation model (yes, we changed our minds over the last few weeks - but the facts changed, too!), it would be inappropriate to recommend maturities other than those close to the bond index. Yields overshot on the way down and may well do on the way up. Besides the greenscam may not have run its course. New cash should wait on the sidelines or be used to buy instruments to counter a further rise in yields and inflation.


Recommended average maturity for bonds in each currency


Be market neutral until the stagflation vs. deflation issue is settled.

As of 02.07.03

Dr. Roy Damary
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