06 December 2008

US Treasuries and our Horribly Distorted International Currency Exchange Mechanism

At some point as the Fed seeks to create inflation it will cut the reserve deposit returns to banks until they are forced to lend.

Can the Fed create monetary inflation? That is the question and Bernanke believes he has the answer.

It will require the cooperation of foreign buyers of US credit seeking to underwrite their mercantilism and low domestic wage and consumption policies.

The key to recovery is the median real hourly wage, not the further expansion of credit and the perpetuation of an economic system based on an inefficient drag on economic growth by percentage-taking banks and rent-seeking elites who add little or no productive value.

We have a 'chicken and egg' standoff between aggregate workers wages and profits at the moment which only the government can move forward, but with care.

The seemingly radical but all too obvious answer is to begin to tax imports from nations who continue to refuse to float their currencies. This merely reverses the decisions that were made by Clinton and Bush to allow China to devalue and fix their currency and still obtain favored nation trading status without consequence.

It was always the answer. It will disadvantage the global financial sector through the dollar, but will begin to breathe life into economic reform around the world. The key is not taxes, but a market free of draconian industrial policies such as that which spawned the long deflation in Japan.

Countries which discourage domestic consumption and wages to build up the wealth of the State on the backs of the workers in the name of growth, and manipulate their currencies to promote trade policies must be discouraged from doing so, as they will.

This seems a radical solution because it is a change from the accepted economic dogma of the past thirty years, more ingrained as slogans than sound thinking. Smoot-Hawley, classic error. It will make things worse. Rubbish. The tariffs and trade barriers are already in place because of currency manipulation and artificial fixes. Why do some countries accumulate destabilizing and enormous deficits and credit balances? Because of the artificial thwarting of the markets. One only has to work the math.

But the alternative to a structural reform is almost certainly economic stagnation and increasing global conflict.

At some point even mighty China will find itself sitting on a pile of useless bonds with fire in the cities, unless it accepts change and stops hiding behind a Great Wall of Paper.

This is not to say that the fault lies with China or Japan. The primary cause of our distorted global economy is in the dollar reserve currency arrangement that is the mother of commodity wars and artificial imbalances.

The solution may be the adoption of a trade balanced basket of currencies, including some commodities not so easily manipulated by the central banks such as gold and silver and oil, as the basis for continuing world trade based on market economics.

Financial Times
Insight: Return-free risk
By James Grant
December 4 2008

US Treasuries are the investment asset of the year. The less they yield, the more their fans adore them. Then, again, these fearful days, yield seems to have nothing to do with investment calculation. Purported safety is all.

“Super-safe Treasuries”, the papers call these emissions of a government that, this year, will take in $2,500bn but spend $3,500bn. “Toxic assets” is how the same papers characterise orphaned mortgage-backed securities—or, for that matter, secured bank loans, convertible bonds, junk bonds or almost any other kind of debt obligation not bearing the US imprimatur.

“There are no bad bonds, only bad prices,” the traders used to say. They should say it again, only louder. In the spring of 1984, long-dated Treasuries went begging at yields of nearly 14 per cent in the context of an inflation rate of just 4 per cent. Those, too, were fearful times, the recollected horror being the great inflation of the 1970s. Inflation was ineradicable, the bondphobes said. Now a new generation of creditors espouses the opposite proposition. Deflation is baked in the cake, they say.

The truth is that no investment asset is inherently safe. Risk or safety is an attribute of price. At the right price, a lowly convertible bond is a safer proposition than an exalted Treasury. Watching the government securities market zoom, many mistake price action for price.

Yes, Treasuries might conceivably redeem the hopes of their besotted admirers. Maybe a deflationary chasm is about to swallow us all. Never before has the US been so leveraged. And—just possibly—never before were lending standards so reckless as the ones that brought joy to so many astonished mortgage applicants in 2005 and 2006.

In their magnum opus Security Analysis Benjamin Graham and David L. Dodd advise that “bonds should be bought on their ability to withstand depression”. They wrote that in 1934. So far is that rule from being honoured by today’s financiers that not a few bonds—and boxcars full of mortgages – could hardly withstand prosperity. Two urgent questions present themselves. One: does something far worse than recession loom? Two: does that certain something definitely spell much lower interest rates?

We can’t know, but we can at least observe. What I observe is a monumental push to reflate. The Federal Reserve is creating more credit in less time than it has ever done before – in the past three months the sum of its earning assets, known in the trade as Reserve Bank credit, has grown at the astounding annual rate of 2,922 per cent. Are the bond bulls quite sure that these exertions will raise no inflationary sweat?

Evidently, they are—at least, forward swap rates betray no such concern. The market’s best guess as to what the 10-year Treasury will yield in 10 years’ time is 2.78 per cent, never mind the famous (and now, as it seems, prophetic) remark of Fed Chairman Ben Bernanke that the Fed could drop dollars out of a helicopter in a deflationary pinch.

The non-Treasury departments of the credit markets have crashed. No surprise then that prices and values are deranged. Market makers have closed up shop for the year, while hedge funds cower in fear of redemptions. You’d suppose that professional investors – doughty seekers of value – would be combing through the debris for bargains. Alas, no. Most seem content to lend money to Henry Paulson (subsequently to Timothy Geithner) at 2 per cent or 3 per cent.

In corporate debt and mortgages, anomalies and non sequiturs abound. They are especially prevalent in convertible bonds. More so than even the average stressed-out fund manager, convertible arbitrageurs have been through the mill. It was they—and almost they alone—who owned convertibles. Now many of these folk must sell them.

Few buyers are presenting themselves, however, though extraordinary bargains keep popping up. Thus, at the end of October, a Medtronic convertible bond with a 1.5 per cent coupon with the debt maturing in April 2011 briefly traded at 80.75. This was a price to yield 10.6 per cent, an adjusted spread of 1,600 basis points over the Treasury curve (adjusted, that is, for the value of the options embedded in the convert, notably the option to exchange it for common stock at the stipulated rate). Contrary to what such a yield might imply, A1/AA minus rated Medtronic, the world’s top manufacturer of medical devices for the treatment of heart disease, spinal injuries and diabetes, is no early candidate for insolvency. Almost every day brings comparable examples of risks not borne by people who, in this time of crisis, have come to define risk as “anything not guaranteed by Uncle Sam”.

“Risk-free return” is the standard tag attached to the government’s solemn obligations. An investor I know, repulsed by prevailing government yields, has a timelier description – “return-free risk”.

James Grant, editor of Grant’s Interest Rate Observer, is an editor of the newly published sixth edition of “Security Analysis,” by Benjamin Graham and David L. Dodd.