Ambrose Evans-Pritchard: Bond bubble is accident waiting to happen

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By Ambrose Evans-Pritchard
The Telegraph, London
Monday, January 12, 2009

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/421821...

The bond vigilantes slumber. As the greatest sovereign bond bubble of all time rolls into 2009, investors are clinging to an implausible assumption that China and Japan will provide enough capital to keep the happy game going for ever.

They are betting too that debt deflation will overwhelm the effects of near-zero interest rates across the G10 and nullify a L2,000 billion fiscal blast in the US, China, Japan, Britain, and Europe.

Above all, they are betting that the Federal Reserve chief Ben Bernanke will fail to print enough banknotes to inflate the US money supply, despite his avowed intent to do so.

Yields on 10-year US Treasuries have fallen to 2.4 percent -- a level that was unseen even in the Great Depression. This is "return-free risk," said bond guru Jim Grant.

It is much the same story across the world. Yields are 1.3 percent in Japan, 3.02 percent in Germany, 3.13 percent in Britain, 3.26 percent in Chile, 3.47 percent in France, and 5.56 percent in Brazil.

"Get out of Treasuries. They are very, very expensive," said Mohamed El-Erian, the investment chief at the Pimco, the world's top bond fund, in a Barron's article last week.

It is lazy to think that China, Japan, the petro-powers, and the surplus states of emerging Asia will continue to amass foreign reserves, recycling their treasure into the US and European bond markets.

These countries are themselves bleeding as exports collapse. Most face capital flight. The whole process that fed the bond boom from 2003 to 2008 is now going into reverse.

Woe betide any investor who misjudges the consequences of this strategic shift.

Russia has lost 27 percent of its $600 billion reserves since August. The oil and metals crash has left the oligarchs prostrate. China's reserves fell $15 billion in October. Beijing has begun to fret about an exodus of hot money -- disguised as foreign investment in plant. The exchange regulator is muttering about "abnormal" capital flows out of the country.

China's $1,900 billion stash of foreign bonds is a byproduct of holding down the yuan to boost exports.

This mercantilist ploy is no longer necessary, since the currency is weakening. Beijing needs the money at home in any case to prop up the Chinese economy -- now in trouble. Even Japan has slipped into trade deficit.

Clearly, the US and European governments cannot rely on Asia to plug the $3,500 billion hole in their budgets this year.

Asians are just as likely to be net sellers of their bonds. Which implies that central banks may have to "monetize" our deficits.

James Montier, from Societe Generale, has examined US bonds back to 1798. Yields have never been this low before, except under war controls in the 1940s when the price was set by dictate.

That episode is not a happy precedent. The Fed drove the 10-year bond down to 2.25 percent, much as it is doing today with mortgage bonds. It helped America win World War II, but ended in tears for bond holders in 1946 when inflation jumped to 18 percent.

Mr Montier said yields have averaged 4.5 percent over two centuries, with a real return of around 2 percent. By that benchmark, the market is now banking on a decade of deflation.

Investors have drawn a false parallel with Japan's Lost Decade, when bond yields kept falling, forgetting that Tokyo waited seven years before resorting to the printing press. Mr Bernanke has no such inhibitions. He has hit the nuclear button in advance.

"Today's yields are woefully short of the estimated fair value under normal conditions. There maybe a (short-term) speculative case for buying bonds. However, I am an investor, not a speculator," he said.

Of course, we may already be so deep into debt deflation that bonds will rally regardless. Fresh data suggest that Japan's economy contracted at a 12 percent annual rate in the fourth quarter of 2008; the US, Germany, and France shrank at a 6 percent rate, and Britain shrank at 5 percent.

If sustained, these figures are worse than 1930, though not as bad as the killer year of 1931. The UK contraction from peak to trough in the Slump was 5 percent. Gordon Brown will be lucky to get off so lightly.

The Fed's December minutes reek of fear. The Bernanke team is no longer sure that stimulus will gain traction in time.

The Fed's "Monetary Multiplier" has collapsed, falling below 1. This is unthinkable. We are in a liquidity trap.

So yes, printing money is not as easy as it looks, but to conclude that the Fed cannot bring about inflation is a leap too far.

The Fed has only just started to debauch in earnest, buying $600 billion of mortgage bonds to force home loans down to 4.5 percent. US mortgage rates have dropped 150 basis points in two months.

My tentative guess is that Bernanke's blitz will "work" -- perhaps later this year. Markets will start to look beyond deflation. They will remember that the Fed is boosting its balance sheet from $800 billion to $3,000 billion and that it sits on an overhang of bonds that must be sold again.

"The euthanasia of the rentier" will wear off, to borrow from Keynes. That is when the next crisis begins.

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