Bond Head Fake

It has been an interesting two weeks in the bond market. The ten-year flirted with the key 4% level which would have indicated a breakdown in yield. A probable harbinger of "troublesome" deflation. In the long run, this may have been the preferable scenario, al least in my opinion. But in this over-leveraged world we live in, the consequences of such a development would have been worrisome to say the least. So it looks like the bonds have completed a successful test of recent lows, in yield, and we can look forward to long rates moving higher and the Fed being forced to respond at the short end of the curve, ramping rates up at their "measured pace". My call in previous rants for a Fed Funds rate higher than most anticipate was beginning to look questionable with the recent test of the 4% level, but since that level has held, I continue to anticipate that the Fed will be forced to raise rates more than most people may expect, ultimately 4.5% on the Fed Funds would be a reasonable target. With the present gearage ratio that most people embrace, that will probably be about all that the market will bear and will serve to do the job of flattening the yield curve, stabilizing the dollar and bringing the economy back down to a non-inflationary level of growth between 0-1%. By the time we get there, enough squawking about the pain of the Fed's "tightness" will be readily audible and will serve to usher in the new era of whomever will take the reins from the ignoble Alan Greenspan. I have previously forecast that the ten-year could reach a yield of 5.5%. I would now consider that more of a ceiling than a forecast, although I still think the odds are greater than 50% that we will see a spike up to that level, that could set us up for the next leg down in this bear market. The danger in this scenario is that if such a spike develops, the Fed, due to already being behind the curve, will follow this spike in long rates with a similar spike in short rates which could lead to an uncontrollable downward spiral. At this point, I would expect that a more likely scenario is that the Fed continues to raise rates slowly, until we see this spike at the long end, which may be accompanied by some dollar volatility, the Fed responds with a 50 basis point rate hike, the markets get the message and the yield curve flattens, markets weaken and we see a recession in 2006-2007 of a more normal variety, which leads to the next easing cycle and we get to do it all again. It will require a fine balancing act and a lot of luck (more and more luck is required with each of these reliquifecation cycles), but I see the potential for them pulling it off. Unfortunately, it makes it less likely and maybe even impossible, that the responsible middle road option of ZIRP (zero inflation rate policy) could be persued. This would be the best long-term solution of maintaining rates at a neutral level where the market would force some long needed reallocation of resources, inflation would fall to zero or even enter the area of deflation with a benign drop in price levels of 2% per annum or less. Instead, we are likely to muddle through for as long as possible until the boom and bust cycle either gives way to uncontrolled inflation or severe deflation or possibly both, at a time when we can least afford it. Such is the legacy of the Fed's action in the aftermath of the 1998-2000 stock bubble. It may be a legacy that all of us will have to live with for a long time to come.

What now?

After a rocky start to 2005, stocks seem to have found their sea legs. But they will have to do much better than Friday's anemic rally to turn things around for good. It is still possible though, but it will require a follow-through day sometime this week and the sooner the better. Volume should be 1.8B on the Big Board and 2.0B or better on the Nasdaq and the leaders of the rally should return to those roles and not look back. If we don't get a follow-through day this week, look for shorting opportunities in the following week, but don't jump the gun. If my hunch is correct, we will see another few weeks of this "rally", but there will not be the conviction to support it. Stay tuned.

The frustrating events are taking place in the bond market. Who really thinks that ten-year yields of 4% are a good deal? It seems ludicrous, but it could be frightening. It seems ludicrous since it is obvious that inflation has picked up and that the dollar is not looking like its old self and at this point in the economic cycle interest rates usually begin to rise as pricing firms and inflation gets some traction. But this is no normal cycle. There are crosscurrents at work in the global economy, some inflationary and some deflationary. Those who subscribe to the inflationary cause cite the excess liquidity floating around the system, while those of the deflationary bent point out the excess productive capacity on a global basis. Only time will tell which view is correct or if they both are wrong, but the signal that the bond market is sending is that the underlying weaknesses in the global financial system are starting to exert pressures that will contain growth and price appreciation. The danger in this case, is that the Fed does not see this and tries to "clean up" the excess liquidity which it is largely responsible for creating in the first place and continures to tighten, eventually bringing short rates above long bond yields and creating an inverted yield curve. This would be very bad news for an overleveraged and financially vulnerable economy. Just as the Fed overdid it by dropping rates so low and leaving them there for so long, they may overshoot on the upside and precipitate a nasty recession. Fiscally, all the signs point to slowing as Washington is going to try and rationalize the budget at least a little now that the pesky election cycle is over. So with monetary policy and fiscal policy getting tighter, does it not seem obvious that economic growth will slacken? The bond market may be saying that the economy is going to slow more and faster than many think. While it is too early to count out one last spike up in rates, any move below 4.0% percent on the ten year would cause me to become very bearish on economic growth, with the risk of an overleveraged economy becoming victim to an overzealous and short -sighted Fed. While the market may believe that the Fed will always be ready with ample liquidity to reflate, could it be that we are nearing the limits of the asset-growth dependent global economy. Or is there no limit to the number of condos the Chinese can build or the number of "investment properties" which Americans can acquire? Time will tell, but be on gaurd because nothing seems to be usual about this economic cycle. While most people would not say that $50 oil and 4% bonds go together, I would not count anything out in this strange world we have made for ourselves. So for now, cash is like royalty and the dollar may continue as the coin of the realm for a little while longer. Longer-term the dollar is doomed, but even in a historic, multi-decade decline, there will be sharp rallies.