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Rear View Mirrors and Lemonade

With the news of the pop in the CPI–much belated I might add, since we all know the gummit fudges the data– many observers are predicting the return of the bond vigilantes. But were there ever really bond vigilantes, or just a bunch of idiots driving in the rear view mirror?

Obviously there’s a loose correlation between bond yields and inflation over the long haul, but if you study the chart below closely you will see that there is usually a lag of months or years. The bond market, just like the schlock market, does not discount the future. Wall Street and its media lapdogs foster this notion that the markets discount the future. But neither stock investors nor bond investors individually, and certainly not in the aggregate, have any clue what the future holds. Markets aren’t all knowing. Markets are stupid. They measure liquidity, and liquidity can be growing or shrinking. It goes where it gets the love, and runs away from where it doesn’t, especially when it’s shrinking overall.

yieldvscpi.jpg

Investors base buy and sell decisions on whether they have cash or need cash. We call that “liquidity. ” They’re like little kids. When they have a little money, it burns a hole in their pocket and they want to buy toys and ice cream. When they need money, they set up a lemonade stand on the sidewalk on a hot day and sell it. That’s what Wall Street does.Investors decide on whether to buy or sell based on whether they have or need cash. They decide what to buy or sell based on the recent past, because that’s all they know, and all they are able to project. I call it driving in the rear view mirror. Consequently there are lots of “accidents” when the markets get a “surprise.” Investors are forced to lurch in a different direction because they didn’t see the future coming.

Today, with Treasury prices driven, and suppressed, primarily by the level of foreign central bank (FCB) dollar recycling, which has nothing to do with inflation, we need to be especially careful about the idea that bond yields are linked to inflation. It may look that way, but that won’t be the driver. I think that T-bonds will collapse, but mostly because the level of FCB dollar recycling will diminish as US imports of oil and Chinese junk diminishes. That should be followed by a deepening of the loss of confidence in the US Government which is already under way. As the credit worthiness of the US increasingly comes into question, Treasury yields will skyrocket. But not because of inflation.

There are some hot summer days ahead, and Wall Street will have more and more lemonade to sell, lemonade called “Treasuries”. But the kids in the neighborhood are short of cash. Rather than buying lemonade, they’re setting up stands to sell it too. As all the kids on the block compete with each other to get rid of their lemonade, bond prices will fall.

I can see sky high yields as the cooler weather begins to set in this fall. All that lemonade and too few buyers.

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6 Comments

  1. thefinancedude

    Lee: That should be followed by a deepening of the loss of confidence in the US Government which is already under way.

    In the long term I don’t disagree but it’s going to happen a bit slower than I think we believe.

    Pritchard is no USA cheerleader so when he’s pointing out this http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/07/17/cnfunds117.xml I tend to step back from the obvious and begin to examine the alternatives from everyone’s POV. Good read.

  2. zebra

    Lee,

    Any ideas on which will get hardest, short term on long term treasuries? I made a bit on SHY puts, but they don’t have LEAPS on SHY. Hard to play these kind of moves with short term options.

  3. Aaron Krowne

    One aspect I’ve heard no one mention is the inevitable effect FDIC bailouts will have on the bond market and government finances.

    The FDIC only really has about $5 billion in actual cash. The IndyMac failure alone will blow that away. But the mainstream media seems to not think this is a problem. I think it is.

    That is because the rest of the FDIC’s $50+B fund is… (drumroll) Treasury securities! (the fictitious savings vehicle of choice for government bureaus). If they desire to actually make good on all their IndyMac obligations, and then any other bank failures that come down the pike, they will have to do a lot of selling of Treasuries. This will be painful on at least four counts:

    1. It will be selling of Treasuries at the worst possible time, adding to the onslaught of supply and forcing yields up.

    2. It will be inflationary, monetizing a bunch of debt that was previously “sequestered” inside the FDIC.

    3. It will deplete the FDIC’s fund for (near) future crises.

    4. It will be very painful for banks in general and/or the government, as virtually no banks can afford the luxury of exchanging cash for Treasuries right now, and the Federal government can’t afford higher borrowing costs (and really doesn’t want to have to “print”, though it is barreling headlong in that direction).

  4. Plantagenet

    Aaron

    You note “One aspect I’ve heard no one mention is the inevitable effect FDIC bailouts will have on the bond market and government finances..”

    Please refer to the question I submitted to the Radio Free Wall Street group Sunday, July 6, 2008 at 11:28 pm.

    To wit: “Indymac got me thinking. The FDIC has 3B in cash, 40B in treasuries, and a LOC with the Treasury. It won’t spend the cash. Therefore from $1 through the end its payouts are sales of treasuries, on top of those for the deficit. So, in the next podcast, can you discuss … How much will the FDIC get hit with, and over what time period?
    Does the garbage collateral at the FHLB get liquidated or stored in the Milky Way?”

    I would be very interested in your answer to the second part of my question.

    Regards,

  5. PAPA BEAR

    95 percent of the people have no idea how bad the U.S. government finances are now and soon will be, because they have been told fairy tales about how foreigners love our IOU’s.

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