Sell Bonds...Once More with Feeling

When Dallas Fed Governor, Richard Fisher, declared
yesterday morning, "We are clearly in the eighth inning of
a tightening cycle," cheers seemed to erupt from the bond-
investing crowd. As they rushed to buy long-dated
government bonds, they seemed to imagine that the interest-
rate ballgame would end decisively in the "ninth inning,"
perhaps with a "walk-off" rate hike by Alan Greenspan at
the June FOMC meeting.

But we are not so sure that inflation will slouch off the
field a loser as early as June 2005. Instead, we imagine a
tedious, extra-inning affair – perhaps with multiple lead-
changes – after which bonds end up the loser. And even if
bonds ultimately win, like in the 23rd inning, for example,
the victory might still feel very much like a loss to bond

Net-net, we suspect 10-year Treasury bonds yielding 3.89%
are better sold than bought.

Faithful Rude Awakening readers might recall that we have
rarely offered a kind word for the bond market, having
disdained it on several occasions as the bastion of
"return-free risk." Even so, about six weeks ago, we took a
brief hiatus from our habitual bearishness to advocate
buying municipal bond funds. Since then, the bond fund we
highlighted has produced a total return of nearly 6% (part
of which was tax-free).

Thus, an investor could have done worse than to buy
municipal bonds in mid-April. We do not congratulate
ourselves merely for the sake of self-approbation –
although we are not opposed to the practice – but rather to
establish our curriculum vitae as FLEXIBLE bears on the
bond market. Today, with the 10-year bond offering the
enticing yield of 3.89%, we are fleeing the camp of
temporary bond bulls.

We suspect we will discover, with the benefit of hindsight,
that the recent spike lower in bond yields had much more to
do with temporary, non-economic influences, than with
underlying macro-economic trends.

As we see it, three short-term factors created a temporary
surge of bond buying. Two long-term factors will bring the
buying to a halt, and will gradually reinstate an enduring
era of bond-selling.

The short-term influences were:

1) The credit downgrades of General motors and Ford;
2) The French "Non" vote against the European
Constitution; and
3) Short-covering

The long-term factors are:

1) The rising CPI and commodity price trends and;
2) The waning appetite of foreign central banks for
Treasury securities.

First, the short-term influences…

As a result of recent downgrades by the major ratings
agencies, about $450 billion in combined GM and Ford debt
was excommunicated from the investment-grade Lehman
Aggregate Bond Index yesterday. But this inevitability
became widely known several weeks ago; only the precise
timing remained a mystery.

It is interesting to note, therefore, that the price action
of the 10-year Treasury note over the last two months very
nearly replicated the price-action of the 10-year
immediately after the Russian bond default in 1998.
Investors with longish memories may recall that 10-year
Treasury yields dropped more than one full percent – from
5.4% to 4.16% – in the two-month span following the Russian
bond default, as investors fled high-risk, high-yield
securities for the relative safety of Treasury bonds.

Similarly, the 10-year yield has dropped three quarters of
a percent – from 4.64% to 3.89% – since General Motors’
credit woes became widely publicized in March. As the bonds
of GM and Ford tumbled into the "junk" category, many
investors shunned the high-yield market in favor of
Treasury securities.

We would point out that the "flight to safety" following
the Russian crisis ended almost as quickly as it began. Two
weeks after yields bottomed at 4.16% they rocketed up to
4.80%. One year after the crisis, yields had soared well
above 6.00%. We would not be surprised to see a muted
version of the 1998 scenario unfold in 2005 and 2006, as
frightened bond investors regain their moxie to buy risky
bonds, rather than Treasurys.

A second, temporary influence that may have chased
investors into the Treasury market resulted from a three-
letter French word: "Non." When the citizens of France
rejected the European Constitution last Sunday, the euro
plummeted against the dollar. By default, the greenback –
and "safe" dollar-denominated securities – gained some
allure. But all beauty is fleeting, especially relative

A third temporary influence, which may have enhanced the
effects of the first two bullish influences, was the fact
that investor sentiment toward long-dated bonds had become
extremely bearish. (Are you still with us?) According to
the CFTC’s Commitment of Traders report, "small
speculators" had amassed their largest net short position
in several years – a phenomenon that often presages major

But this temporary support has also eroded away. The
"shorts" have covered their losing positions. At present,
none of the groups tracked by the CFTC holds a large bet on
either side of the bond market. Hence, we struggle to
imagine where the bond market’s next temporary kicker might
come from.

Meanwhile, the longer-term impediments to rising bond
prices (i.e. to falling yields) remain as considerable as
ever. And we suspect that these potent factors will soon
begin to reassert themselves.

For starters, throughout the ages, bond yields and
commodity prices have tended to move up and down together –
not at every single moment, but over long sweeps of time.
Over the last few years, however, bond yields have strayed
from commodity prices like an unfaithful spouse. But we
expect this philanderer to return home fairly soon, in
which case, bond yields would rise.

A second long-term factor influencing bond yields is the
waning appetite for Treasuries by foreign central banks.
During the last few years, foreign central banks have been
gorging themselves of Treasury bonds. Should we be
surprised, therefore, if they are becoming sated?

Foreign central banks have been stuffing their vaults with
Treasurys, despite the fact that these securities have been
offering relatively unappetizing returns for several years,
especially when one factors in the currency losses incurred
from holding dollar-denominated assets. Indeed, buying and
holding Treasurys has merely served to undermine the
already-paltry return on investment that foreign
investments in the US produce.

Contrary to the popular misconception, the United States is
not a particularly hospitable destination for investment
capital. In fact, American investments abroad earn a much
higher rate of return than foreign investments here.

"The United States – famously – is a net debtor to the
world," explains James Grant, editor of Grant’s Interest
Rate Observer, "meaning that we own less of them than they
do of us. At last report, the difference totaled $2.4
trillion…Yet, in the fourth quarter, Americans earned
$103.7 billion on the assets they held abroad, while
foreigners earned $100.1 billion on the assets they held in
the 50 states. Like us, you may want to rub your eyes."

Those are the facts, folks. We earn more from them than
they do from us. Last year, to be exact, our foreign
investments earned 5.1%, while their American investments
earned only 3.5%. Perhaps, therefore, central banks and
other foreign investors will become somewhat less eager to
continue investing in low-yielding government notes and

Net-net, the rate-hike ball game might not end as early as

Fed Governor Fisher did allow that "we may go into extra
innings in the contest against inflation," but he
considered that a low probability. We aren’t so sure. The
Fed does not usually call it quits to hiking rates when
commodity prices are still soaring – crude oil rocketed
almost $3 higher yesterday – and when real short-term
interest rates are negative – i.e. when short-term interest
rates are below the rate of inflation.

If, as we suspect, this game goes extra-innings, the bond
market might be heading to the showers very soon.

Did You Notice…?
By Eric J. Fry

We’d love to embrace the recent oil stock rally…but we
just can’t. It’s like hugging a baby with dirty diapers. We
still love the baby, but we’d rather cuddle the little tike
when he’s got a clean diaper. We remain long-term oil
bulls, but a couple short-term trends worries us somewhat.

For starters, put-option volatility has compressed to very
low levels, suggesting that oil stock investors are feeling
pretty confident. Unfortunately, high confidence often
precedes sharp sell-offs. For example, the last two times
put-option volatilities on Exxon shares fell to their
current levels, the stock dropped immediately thereafter.

We are also troubled by the fact that oil stocks have been
rising, while trading volumes have been falling, which is
rarely a favorable development.

Please understand; we still love this baby, but we wish its
diaper weren’t so dirty.

And the Markets…



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