The Case for Going Long Treasuries

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By MrPlunger
August 18, 2004

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Seems to be a quiet spot so I thought there wouldn't be too many groans if I slipped in a longish post here. I do think there is a good opportunity right now as it is clear that the US economy has escaped the very deep seated problems that we have previously discussed yet market prices have not nearly recovered to levels that price this in.

The main issue is that the essential build up of debt at a greater rate than GDP growth requires ever-lower real interest rates to sustain it and is ultimately deflationary. Even a small hike � or market positioning for a hike � is already destabilizing stocks and corporate bonds. Will the Fed risk also destabilizing housing? Clearly this discomfort should be good for precious metals since there must be ever more discussion of the difficulty of debt repayment and the options available to debtors. Creditors may therefore nervously look elsewhere for wealth preservation.

Given that the futures market is pricing in 1.5% of hikes over the next 15 months, there is the trading opportunity for this to be unwound. Of course the market has to see something to put this risk averse pricing in ... but I would ask whether any of the following issues have really receded - - - or have they in fact actually now become more prominent?

1. Still very low US domestic capacity utilization means still downward pressure on wages. Further, globalization creates additional capacity at a low price and so further downward pressure on developed country wages. Anecdotes and regional surveys suggest that most new jobs are low wage service industry positions, compared to high wage, high-benefit jobs that are still disappearing abroad

2. Commodity price speculation is rapidly unwinding ... but we must ask ourselves if commodity price inflation ever was an issue for the Fed anyway? Maybe the Fed can only deal with US value added inflation and there are no resource constraints there. Should they induce a recession to reduce the global price of copper? Why?

3. China slowing is most immediately an issue for Japanese export growth. However in the medium term, the extent to which China's high savings rate can only be absorbed by an unsustainably high growth in investment and capacity makes China look like Japan in the late 1980s. A kind of "Capex Ponzi" that feeds on itself but once sated, is hugely deflationary for the world as there is no longer any productive use for capital and excess savings.

4. In the USA, roughly 50% of mortgage re-financings are now at a variable rate, and interest only. This suggests: desperation for cash-flow, that the Fed will get more leverage than anticipated from adjusting short rates and so any move need only be very moderate, and that US consumers are unable to repay debt. Debt which is not depreciating against wages either and so the constriction against disposable income and so spending lingers.

5. Consumers are already tapped out with little ability to increment spending � for example with an estimated 30% of auto loans worth more than the value of the car they are collateralized by, where will marginal extra spending power come from?

6. Housing starts are now higher than new home sales, whilst vacancies in residential and commercial properties are already at a multi year high, exerting downward pressure on rents.

7. Oil and unleaded gas in particular are stealing purchasing power.

8. Fiscal stimulus is receding already for individuals. Personal tax rebates are now history. Why would businesses increment investments with no prospects of increasing consumption?

9. In the medium term backdrop, the move from pay-as-you-go to asset-based pensions requires asset gathering in place of consumption. All countries are moving in this direction. In addition aging means that people feel the need for more assets than heretofore, and so are less willing to consume, collapsing economic activity. Corporate defined benefit plans, in real economic terms horrendously under funded, need asset prices to remain high and will still require large diversions of corporate profits away from spendable dividends or productive real investments.

10. In addition to pensions and aging, there are further reasons the global propensity to save is rising.

� Asia, with its cultural savings bias, is growing relative to the world economy.

� There is a clear increasing division of wealth in developed western economies as represented by the ever rising level of debt � one side's asset and the other's liability. As we know, the rich do not spend a large proportion of their income, whilst the poor are now in aggregate heavily indebted.

I believe in its cutting program in 2001-2003 the Fed was actually having to follow and accommodate asset price gains not to cause them, because they are reacting to the other side of the equation � the softness in consumption and economic activity caused by an excess of savings over investment. Has anything really changed? Note China's investment slowdown may be critical to this balance as the recent investment boom must have been absorbing much excess savings, just as the US housing construction boom is. But does the world really need both to be shut down? If US consumption demand slows even a little, Capex in China will collapse.

11. Lastly and most immediately, stocks are soft in the face of rate hike talk as high P/Es are only consistent with low rates.

The analysis does suggest that the Fed will be reluctant to hike rates aggressively or risk causing financial chaos and aborting the "recovery" as they did in 1937 and as Japan did in 2000. Thus the perceived negative real rate should continue to push capital into real assets.

The prices in the market have corrected and show value against this backdrop now.

Apologies to Mish if it seems to be a copy of his. I actually wrote most of this in early May but as the Treasury market was in free fall at the time it didn't seem to be much use to anyone so I held off posting. However with the market trend now reversed, these may be the themes that play out over the next 4 months or so.


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