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 exchange!
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……
December 5, 2004
Dan is a professional off-the-floor commodity trader residing in Texas and can be reached at email@example.com with comments.