Perhaps, the last of the bond bears (excluding yours truly) has capitulated. Mr Stephen Roach of Morgan Stanley, who had been expecting the US bond market yields to rise along with the rise in short-term interest rates, has changed his views. He expects the US 10-year Treasury yield to stay below 4.0% and even drift lower towards 3.5%.
Recently, the world?s biggest bond managers, Pacific Investment Manage-ment (Pimco) also said the US 10-year Treasury yield would stay between 3.0% and 4.5% for the next several years. Not so long ago, they too had held the view that the US 10-year Treasury was overpriced.
The London Financial Times reports that bets on its yield drifting higher are being called the ?pain trade,? as managers who bet on rising yields were forced to cover their bets with the bond yield relentlessly drifting down in the last two months.
However, I remain unconvinced that the bond market yield reflects fair value in the light of the US economic strength and short-term inflation pressures. Argu-ments to justify the low yield have been around for the last few years: globalisation, global ageing, savings glut and Asian central bank purchase, etc. Yet, during those times, the US short-term interest rates were too low. Now, with the Federal funds rate at 3.0%, the 3-month USD Libor rate is at 3.3%. Given this, it must take a lot of ?smartness? to be willing to lend for ten years at 3.9% or even lower.
Further, if the bond market were rationally discounting pronounced weakness in the US, then the equity market and the foreign exchange market are making wrong bets on the US equities and the dollar respectively. That seems unlikely. Hence, the logical conclusion must be that, notwithstanding special factors, the US bond market is overpriced and has to correct, sending the yield higher.
? The US bond market is overpriced and has to correct, sending yields higher ? US economy will show strength and its current deficit will be financed ? Global major currencies have seen their best against the US dollar |
What is likely to happen, is that the ultra-low bond yield is going to re-ignite the US housing market. The Federal Reserve is already concerned about home price bubbles in a few centres in the country. The low level of mortgage yields ?the 30-year Fannie Mae mortgage yield came down by nearly 50 basis points in the last few weeks? will cause more concern, as it would further boost housing activity. The Home Builders? index in S&P 500 is already signalling that. The index is up, little under 20%, in the last two months.
However, to be fair, the US economy is beginning to show greater resilience than mere reliance on fiscal spending and home equity extraction-driven consumer spending. Factory orders are beginning to show strength and worker compensation growth is a healthy 7% plus. Some of it is due to the exercise of stock options. But excluding that, the growth rate in worker compensation is closer to 6%. Reinforcing that is the message from retail sales data in May, rebounding nicely from its April slump.
Readers might wonder if all this stellar economic activity would not further widen the US current account deficit. It would. Indeed, it remains to be seen how big the rise would be and whether there would be an investor fatigue, talked about for over two years. Yours truly too had predicted darker times for the USD based on the likely investor fatigue. However, I am less concerned now.
First, investors, whether in the public or in the private sector, continue to buy more American assets than required to finance the current deficit. Second, if economic growth in the US becomes more balanced and equities find their feet, public sector (Asian central banks) investors could be replaced or reinforced by private investors. Therefore, I do not see the current deficit as a source of instability for the US. If any, the willingness of Asian central banks?China in particular?to buy US Treasuries at any yield betrays their desperate dependence on the US economy?s strength.
Therefore, this might be one of the few years when, despite January being a negative month, the US stock market ends up in positive territory. The US dollar?contrary to widespread predictions of a decline?would be significantly stronger against the major currencies.
The Euro had collapsed in the last few days, as voters in France and the Netherlands rejected the EU Consti-tution for different reasons. Whether the constitution was an economic imperative or not, the referendum outcomes merely underscored the abject failure of the EU political leaders to sell their vision. Europe appears to have missed a historic opportunity. Now, there is no compelling reason to be long Euro against the US dollar.
The Australian dollar too appears to have seen its best days, as growth weakens and the current account deficit keeps rising. As a proportion of GDP, it is larger than that of America?s. Readers who remain sceptical that the fortunes of the US economy have changed dramatically, and are still unwilling to hold the US dollar, should keep some exposure to gold. The yellow metal has been remarkably resilient in the last two days of trading, despite the travails of the Euro. Perhaps, investors are finally beginning to consider gold not just as a USD alternative, but as an alternative to the fiat money system. If so, it is long overdue, but clearly it is too soon to tell.
The current global financial market environment is still fraught with danger. The above economic view, even if proven right, need not necessarily translate into financial market gains. We have already seen unusual behaviour in the bond market. Investors should be willing to cut their financial losses, regardless of the strength of their convictions, so that they have cash to buy when sanity is restored to markets.
The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views
