June 30, 2004

Bonds, Gold & Oil: More of the Same


Bulls expect rates to trend higher due to economic growth while bears expect rates to skyrocket on the back of a falling dollar. I see things differently.

While the common sense view of higher rates is indeed the likely outcome in time, and while I rest in the camp that says that rates will go a lot higher than most expect, I also think this outcome is likely to occur much later than most believe.

I’m of the opinion that although the Fed will indeed raise rates today, and that it will likely be the first in a short, not long, series of hikes, and that it will amount to a test of the economic recovery we’re supposedly experiencing, a test that will ultimately fail as we find the “recovery” largely rests on the low interest rates to which we’re going to try and say goodbye.

Recent evidence shows that the Fed just doesn’t have far to go; as rates rose in April and May in response to a heightened awareness of inflation, interest rate-sensitive sectors got hammered. For example, take a look at the recent action in the Dow Jones REIT index:

As interest rates jumped in that April/May time period, REITs cratered… it’s just one small, but clear, example that says to me that all of the interest rate risk most of us worry about does indeed exist; this market/economy cannot tolerate higher rates, at least not meaningfully higher rates. The same sort of action was seen in the homebuilding stocks, the Morgan Stanley Retail Index and other investments that are not only closely tied to interest rates, but are today’s areas of meaningful economic strength.

Given the increasingly short-term, variable nature of so much of our economy’s debt, from consumers’ adjustable-rate mortgages to our entire national debt, the coming “cycle” of Fed rate increases will almost certainly have to be aborted, most likely after just a couple of hikes (for which there is precedent in previous cycles); the more interesting question is: what about long-term rates, which the Fed doesn’t directly control?

As they are now buying approximately ½ of all new Treasury issuance, foreign central banks could indeed have a huge impact on our long-term interest rates—if they stopped buying, look out! On this point, I also differ from most who, as I do, consider themselves skeptical about our overall economic picture; most bears think rates are going to the moon, and going there fast.

For this to occur, however, foreign central banks would have to make a conscious decision for pain. By buying up our debt and funding our deficits, they subsidize our ability to consume. Since we’re consuming the goods they produce, then by halting their purchases of our bonds they would wave ‘bye-bye’ to their largest customer and, in so doing, likely bring as much economic pain on themselves as we would experience thanks to the resulting higher interest rates.

The Reagan/Volker combination was an anomaly, ladies and gentleman; I don’t see political leaders anywhere in the world today who would choose that sort of economic pain, healthy though it would be in the long run.

My prediction: more of the same… we’re witnessing what I would call a managed, deniable monetary inflation on the part of central banks around the world; I think it’s likely to continue until the point in time when it’s no longer deniable.

BONDS:

To me, the recent spike in long rates we recently witnessed looked a lot like what we saw last summer. Take a look:

I look at the recent spike, compare useful short-term momentum indicators (top and bottom of graph), and notice how the rally even broke upwards through “resistance,” and I see a head-fake, not a sustainable trend. At the very least, the jury is certainly out as to whether rates are headed higher for good.

Now, I’ll admit, there are some smart people that disagree with me, believing a sustainable trend in higher interest rates is indeed upon us. Consider the following comments: Actually, I’m pulling your leg a bit here: each of the comments above was issued over the last two weeks of July, 2003, precisely when the last spike in long-term rates was peaking! Then, as now, everybody—I mean everybody—was declaring the bond market dead.

I think there are too many powerful interests that simply can’t afford meaningfully higher rates, so I don’t buy it. Again, more of the same: generally low-ish interest rates on both the short- and long-end of the curve and creeping inflation, which brings us to:

OIL

Very quietly, oil has pulled back 15% from its recent highs at $42/barrel just a few weeks ago:

Far from being a change in trend, I view this pullback (indeed the pullback in the overall CRB index) as evidence that the Fed, believe this next statement or not, can actually become more inflationary in its future monetary policy!

When it raises rates today, a few interesting developments may result: ...giving the Fed room for an even more inflationary policy down the road, if necessary.

Look, there’s risk to this scenario: if I’m wrong, then rates will head much higher, and it’ll be based on runaway inflation because the Fed is so far “behind the curve.” However, the look of commodities-related charts just doesn’t say “runaway inflation,” though… I just don’t see it—yet. Creeping inflation seems more likely.

GOLD

Same thing here. While, on the one hand, gold has recovered from what looked like a classic shakeout (May’s pullback to $375), it also hasn’t sky-rocketed back to new highs:

So, gold looks like oil to me: there’s a long-term bullish trend in place here and I do believe both will be significantly higher in time, but it’s going to take just that: time. To ward off the general economic malaise that, regardless of today’s headlines, still grips the U.S. and, by extension, most of the rest of the world, the Fed will have to get more “stimulative.”

In conclusion, I believe that whatever near-term rate hikes we do see will have to shortly thereafter be unwound and the Federal Reserve will have to continue its current course of monetary inflation as well as its grand experiment of testing whether a once-great economy can consume its way back to prosperity.

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