Bond Outlook [by bridport & cie, September 10th 2008]
We wish to take a somewhat different tack this week, calling our readers’ attention to the moral aspects of the GSE saga. The bailout, or nationalisation under another name (“conservatorship”) of Fannie Mae and Freddie Mac is the biggest in the history of capitalism. A transfer of assets and liabilities in the order of USD 5 trillion are being transferred from private to government control, while the Treasury's plan commits the Federal government to provide up to USD 100 billion for each firm's rescue, plus unlimited liquidity at least to the end of the year. The initial reaction of the financial markets was that the US Administration has done the right thing, had to act to avoid a collapse of the mortgage market and has protected the entire financial system in the USA and elsewhere. As the days go by, however, the real and very negative implications of the takeover are gradually sinking in.
The first question is how the situation could have reached this point. Problems over GSE financial reporting arose years ago, not just months. When history is written we expect it to be clear that both regulators and politicians were alerted to incipient problems some five years ago. Why then was nothing done earlier? The short answer is “lobbying”; the massively overpaid managers of the GSEs simply bought off the Congress which might have called a halt to the practice of borrowing cheaply because of an “implicit” government guaranty (which proved to be real) and lending at higher rates, all with leverage that no other financial institution would have got away with. In addition, there has been accounting manipulation, if not outright fraud. Did Sarbanes-Oxley not apply to the GSEs? Did the directors sign off on the truthfulness of the financial reports? We would expect some very interesting court cases to arise out of all this.
Action, belated though it be, by the Administration, has probably saved the US mortgage industry, but it has lost any claim the USA might make to moral leadership of the capitalist world.
Yet the moral issues raised by the GSEs fade into insignificance compared to the wholesale irresponsibility of American leaders in allowing the Federal Government and households to live far beyond their means. Last week we again raised the question of how long the US economy can base its expansion on ever increasing indebtedness. Many commentators and activists are now picking up that theme, including former Comptroller David Walker and a scientist turned gifted commentator called Chris Martenson, whose “Crash course” on www.chrismartenson.com we strongly recommend. We wish them every success in seeking a return to some modicum of responsibility among US leaders, including the two Presidential candidates. The US Federal government is not indebted just in terms of outstanding Treasury bonds, but also has massive growing liabilities in both Medicare and Social Security which push its net asset position into a negative USD 50 to 60 trillion. The moral aspect of this is that tomorrow’s generation will pay the price of today’s profligacy.
How will they pay? Consumption today means that the next generation will have to consume less – always assuming that they cannot put off the day of reckoning to their children, which we find hard to believe. Reneging on Federal obligations may be part of the remedy, e.g. reducing pension and medical cover, but the main mechanism has to be the dollar printing press. Inflation allows a government to get itself out of debt by much the mechanism adopted by Zimbabwe, with the same result, inflation (all right, not at the Zimbabwean level!). The belt tightening that the USA will go through will be brought about by higher borrowing costs and a lower USD pushing up the price of imported goods.
But when? Who knows? Maybe the Chinese do, as they are the main holders of USD, but we do not. What we would affirm is that the GSE bailout is another step towards a reduction in profligacy despite the attempts of the Administration, Canute-like, to prevent it. It is hard for us to maintain a view that the USD is fundamentally weak when is it going through a recovery, but we are talking here of a time scale beyond that of fluctuations over months. That same difference between short-term market sentiment and fundamental analysis concerning the USD applies equally to bond yields. The Fed will keep its target rate low – that is almost a given in this recessionary environment. But what about the long end of the yield curve? The US Treasury will have to borrow still more because of the GSEs. That should make the yield curve steeper. Yet so long as the market believes the day of reckoning can be delayed, long-term yields will stay low. Our task is to detect when perception catches up with reality and to flag long-term yields before they start to rise.
Watch Lehman Brothers, who look like they might be the candidate for next big bank failure that the IMF expects this year, plus how the CDS market will deal with the technical default of the GSEs, even though the net cost will be small.
(–) Germany: trade surplus in July of EUR 13.9 billion versus EUR 19.9 billion in June and EUR 17.5 expected. Exports fell 1.7% and imports rose 7.4% compared with June
(+) Greece: slight decline in inflation in August to 4.7% per annum, i.e. 0.9% less than in July
(–) USA: unemployment at 6.1% in August, its highest level since December 2003
(–) Emerging markets: BRL and RUB have fallen against USD since end July
(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question
Recommended average maturity for bonds.
No change after lengthening on USD, EUR and CHF, leaving Sterling unchanged.
|As of 16.07.08||2015||2010||2015||2015|
|As of 23.04.08||2011||2010||2011||2011|
|Dr. Roy Damary|