Thursday, February 10, 2005


Joachim Fels of Morgan Stanley writes that low bond rates are here because of excess liquidity. As I have pointed out, Greenspan and company were afraid of deflation just a year or more ago. The FED pumped money into the banking system and helped the US avoid a major recession. President Bush helped by spending money like a rich kid in a candy store.

Mr. Fels reports that Central Banks around the world have participated and many have offered banks money at zero real interest rates. He notes that for many years, monetary aggregates have grown faster than GDP.

The result has been that asset prices (stocks, bonds, real estate, gold and oil to name a few) have been driven up and long interest rates have been driven down. He also notes that low rates have increased the net present value of pension funds and insurance liabilities. Federal regulations require insurance companies to "cover their bets" which means the demand for long-duration bonds has been steep. (An executive friend who is considering retirement just increased his payout by a very large amount as a result of the large decline in long rates.)

Finally, Mr. Fels notes that corporations have had plenty of cash with little reason to issue new long paper. (It is interesting how many merger deals are being done as stock swaps.)

Mr. Fels concludes that stagflation must be next. He sees slowing economic growth and higher inflation. After the blow off in bonds, he sees a steeper yield curve.

The low, low bond yields are not confined to the US. We now live in a "global economy". Warren Buffet is correct that in the short run, markets are like voting machines and in the long run they are like weighing machines. In this context, I believe it is true that the long-bond rally has reached a speculative blow-off phase. It has probably over-shot the mean. However, I believe it started moving in that direction based on fundamentals. Those fundamentals being that the world was experiencing slowing economic growth and low inflation expectations.

The combination of GDP and PCE deflator may be only 4% this quarter but today's trade numbers and employment numbers indicate that growth is picking up. The dollar has firmed for the past few weeks, again indicating that US growth may be stronger than expected. (Today's move is in the other direction.)

The current situation is not unlike what happed 10 years ago. The economy made a slow but nice recovery after the 1990 recession and then slowed in late 1994 and early 1995. Long yields came down in 1995 and the expansion phase was in full swing for the next four years. Long rates did not have as far to fall this time but have made an equally impressive rally. The yield curve steepened during 1996 but then flattened again for the duration of the expansion.

1995 was a very good year for stocks. It is true that the great run was set up by high short rates and therefore a weak market in 1994. This time we start with lower short rates and the risk that the FED will tighten more. The economy and stocks will do well even with one, two or three more increases in short rates.

With so many loans now tied to short rates, Greenspan has been practicing Chinese water torture on debt holders. Fuel price increases and short rate increases are biting now. So yes, GDP and inflation are slowing. The FED is aware and has little reason to tighten much more. The first hint that the FED will hold steady will be the hint to the stock market to lead us out of this slow economy. (I know, the most recent numbers show strong growth in the GNP, but the numbers are old.)



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