BATTLE ROYAL OVER BONDS
Jim Willie CB October 5, 2004
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A titanic battle is underway with US Treasurys. On the bond bull side is the gradually faltering US Economy, which spurs purchase of TBonds and TNotes to bring about lower interest rates. On the bond bear side is an incredible explosion in federal deficits and trade gaps, which is further aggravated by rising prices system-wide. The chart of the 10-yr Treasury Note yield, tracked by the TNX chart, is highly revealing. It displays the battle royal underway. Is there inflation out there, or deflation? Is the Fed's Reflation initiative succeeding to lift wages, reduce debts, or failing? Is secular deflation tightening its grip, or is the rise in commodity prices seeing a "cost push" work its way throughout the economy?
Secular deflation is still the beast in the east, as Asian production floods our nation to keep a lid on product prices, and as the growing outsourcing of jobs keeps a lid on wages. Debts are growing while wages are not keeping pace. Prices are surely on the rise, but mainly in the cost side of the equation, not the income side. Monetary growth is monumental, from both the federal budget province and the mortgage arena. We clearly have both inflationary influences at work against deflationary trends. The collection of economists in our land sound as befuddled as the outcomes of their policies are twisted wreckage in a sequence of busts. Central bank intervention to support the USDollar, and to prevent its rapid decline, is played out with US Treasurys as the primary vehicle.
DEMAND FOR BONDS FROM SLOW GROWTH
First is the demand side. Consumer spending has come down for four months. The Coke warning in early September was the latest confirmation after a spate of warnings this summer. Wages are unable to keep pace with rising prices. Wholesale inventory levels are building. Industrial production for August came in at 0.1% growth, flat, but in fairness that figure is largely due to reduced air conditioning in the entire eastern part of the nation during a mild late summer. Bear in mind the queer anomaly that the largest niche within our absent manufacturing base is electricity generation, perversely. The pinch of higher gasoline prices has taken a toll, despite Wall Street claims. It makes up a full 7% of household budgets. Other factors slow the economy at a household level. At a national level, huge trade gaps and growing inventories cut into GDP reported growth. As the US Economy slows, and incomes fail to offset rising costs, the demand for Treasury Bonds grows. These are the justifications for investment in bonds. With bond purchases come lower interest rates.
Government objectives might be more to confuse than to report, to sell Treasury Bonds than to permit the truth to be told. An old Austrian economist recommended that we look at unadjusted economic figures, not treated ones. Great care must be given to proper alignment of current data against a backdrop of previous seasonal swings, and previous price changes due to inflation. Havoc was seen in the data adjustment game in order to handle the turn of the millennium. That effect is seen as a veritable explosion in business, followed by a vacuum. One should be clear, it is a game.
It would be funny if not so pathetic and deceitful. We all concede that price inflation is much higher than the silly CPI, a convenient device to keep cost of living upticks manageable in federal payments. However, we do not make the immediate associated conclusion, that GDP is thus overstated !!! The GDP adjusts according to the Personal Consumption Expenditures index, a close cousin to the CPI. If it differed from the CPI too much, then questions would be raised. They are not. So the PCE is also artificially low. Raw GDP data is improperly adjusted, from insufficient adjustment of price inflation. GDP is reported too high, as some untreated price inflation is deemed economic growth. Beware of any assumptions of strong growth when making your own decisions.
Kurt Richebächer offers some simple arithmetic, which is way over the heads of both government officials and brokerage reporters, where adjustments, substitutions, and models have totally replaced simple math. The USGovt figures claim a Q2 rise in consumer spending of $19.5 billion. In sharp contradiction, simple math shows Q2 consumer spending actually declined by $20.6 billion. Details on this and other slowdown statistics are elaborated in my newsletter. The GDP can be broken into various components, all of which are consequently overstated, one being the consumer spending piece. Any 10-year old child is capable of doing this math, but not those who report on economic data.
SUPPLY OF BONDS FROM TWIN TOWER DEFICITS
Second is the supply side. The July federal deficit was $69.2 billion, the effect of which would ordinarily force rates higher, or crowd out buyers of corporate bonds. That has yet to happen. Liquidity in Wall Street is incredibly strong lately, especially in the face of unease, uncertainty, and confusion. Open market activity by the Federal Reserve provides some temporary hairballs during sales, but how bad can it be? The 10-yr TNote yield (TNX) had fallen below 4.0% in recent days. That magic number might be highly psychological, as a severe response has been elicited. The bond market was telling Chairman Greenspan that he is making a mistake in raising interest rates, as it disputed his view of a strengthening economy. Do not look for the Fed Funds target to go past 2.0% in the next few FOMC meetings. Another 25 basis points was ordered in late September, which was widely anticipated. Lackluster job growth and rising household debts make a series of Fed hikes very unlikely, even foolishly reckless.
The July trade gap rang in at $50.15 billion, to mark the second straight outsized month (June at $55.2B revised). The Q2 current account deficit measures money on a net basis actually leaving the country, a difference of trade gaps (goods & services) and capital investment (property, plant & equipment). The Q2 current account deficit was announced at $166.2 billion. Typically, the shortfall is made up by purchase of the most liquid instruments, US Treasurys. Most heavy lifting is done by the Bank of Japan and the Bank of China, where almost half of the trade gap originates. Both the federal deficit and trade gaps have created supply of US$-based financial securities, principally bonds, which grows astronomically. As twin tower debts escalate, which must attract foreign capital, the supply of Treasury Bonds grows. These are the justifications for selling off bonds. With such bond supply increase comes higher interest rates in ordinary times. These are not ordinary times.
BOND EROSION FROM INFLATION
One must keep in mind constantly the background erosion of value through inflation, and the embedded reward of higher interest yields offered to bond holders. The US Economy has seen enormous price rises. So far, increased prices for numerous items have yet to find their way to higher consumer prices for most finished products. The Consumer Price Index, faulty as it is, still provides bond market price mechanisms its guidance for pushing rates higher, to account for price inflation. In my analysis, China and Japan hold the key for releasing a flood of consumer price inflation. That key lies in the currency markets, and exchange rates for the Japanese yen and the Chinese yuan. The FOREX for the yen, and the pegged currency regime for the yuan, this is where the natural equilibrium is interfered with. It is the currency markets where shocks will be delivered.
If and when Asian currencies rise, the impact will be possibly very big indeed in a number of areas. The big impact in the USA will be with consumer prices and long-term interest rates. Fallout extends widely to housing prices and a fresh new force behind gold. GOLD NEEDS A FALTERING BOND MARKET. Asian floodgates will overrun long-term rates when they let loose. To date the Asian currency refusal to appreciate is a massive slipped clutch for the anticipated advance of gold. These complex currency factors are fully discussed in my newsletter. Inter-relationships among the United States, Japan, and China have never been more complex.
THE BOND CHART REVEALS THE CONFLICT
Bond demand continues amidst sluggish economic conditions, in the face of monumental additions to debt supply. Something must give. The titanic battle is being waged in the largest financial marketplace in the world, US Treasurys. The 10-yr Treasury Note yield (times ten) is tracked by the TNX index. Its chart serves as a wonderful example of three bull flags in a row. The USDollar and the gold price have shown their own hesitation, with clear pennant pause patterns to manifest the indecision. No reversal or continuation patterns here, although some argue a long-term reversal is possible in future quarters. The credit markets await the outcome of the bond battle underway, not yet resolved.
The TNX chart shows the progress of the battle being waged. Interest rates come down with periods of sluggish economic news of various strains. Interest rates fell in the autumn 2003 following the Qatar G-7 meeting of finance ministers. The March 2004 sudden upward reversal occurred when the wholly false economic recovery reports hit the airwaves, to garner much attention about an exaggerated recovery. My view is they were politically motivated, by a combination of Wall Street and Administration urging. Central banks intervene to prevent higher rates, which are extremely justified when federal budget deficits are absurdly out of control, and supply of USTBonds floods the entire world. World financial analysis has been turned on its ear by central bank interference. They have corrupted the entire bond price working mechanism, in a fierce attempt to defend an indefensible monetary system.
Notice the generally increasing uptrend channel in long-term rates, in a unique enclosure of the triple flag pattern. The name "flag" owes to its tendency to hang down like a flag unfurled. Violent in the reversals seen in June 2003 and in March 2004, sharp in the rises afterwards, a pattern within the pattern cries out. The most recent flag has become steeper in slope. Since the spring, when the Fed began its tightening cycle, rates have fallen as the economy has stalled. The current flag boundaries might be in the process of being broken, as bonds have sold off in the last week.
If the upper boundary of the steep blue summertime downchannel is penetrated, as seems to be occurring, bonds might sell off quickly. Data from the last couple weeks provided demand for bonds, as 10-yr yields fell below 4.0%. The weak Philly Fed report added fuel to bond demand. What sparked last week's bond selloff was a combination of two factors, in my view. The Q2 GDP was revised upward, evidence of growth not so weak. Also, probes have delved into Fanny Mae, which is most likely in receivership, on its accounting statements and on earnings props to assist executive stock option vesting. Bubblevision does not interpret it as bankruptcy receivership, only as probes. Certain reports make it crystal clear. The smoke in the air has led some to conclude that fire rages inside the mortgage finance quasi-governmental agencies. Notice the slow weekly stochastics cycle on the chart bottom, circled in red. It is attempting a crossover in extreme low territory with some follow through last week. More can be said on the 50-week moving average, and time spent above it.
Two conclusions can be made. First, volatility is on the rise with quickening slopes. The bond rally appears to have ended. Second, with a more long-term view, a reversal toward much higher rates appears underway. Evidence is the larger upchannel in black stretching over the past 24 months. Asians are getting restless and frustrated with their US trade partners. In fact, one could say the Asian community is getting uncomfortable with the US Welfare nation they have allowed themselves to support and become dependent upon. They control the outcome of the bond conflict much much much more than the US press & media tells us. Such is the consequence of losing our manufacturing base, and running up large debts held by foreigners. Credit masters are in control, and will continue to be. Understanding Asia is to correctly grasp big changes that lie over the horizon, a primary focus of my attention.
Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 23 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com.
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