Dangerous Divergences in the Global Bond and Stock Markets
By Gary Dorsch
Once upon a time, many years ago, the US stock market lived in fear of a violent band of traders known as the "bond market vigilantes". Whenever the Federal Reserve's money supply measures grew too rapidly, or the US economy grew too strongly threatening to stoke higher inflation, the "bond vigilantes" would take matters into their own hands, by jacking-up 30-year Treasury bond yields as much as 25 basis points or short-term T-bill rates by 50 basis points in a single day.
Former US Treasury secretary Robert Rubin convinced his boss, President Bill Clinton that taming the "bond vigilantes" by reducing the budget deficit was the surest way to reach long-term economic prosperity. As Clinton's political guru James Carville famously put it, "I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody," he once quipped.
But during the first Bush administration, when the Treasury's budget was spinning out of control with a $445 billion deficit in fiscal 2004, the infamous "bond vigilantes" slipped into hibernation. Instead, a new band of traders with much deeper pockets, the Bank of Japan, the People's Bank of China, and the Arab Oil kingdoms were cornering the US Treasury market, and keeping yields pinned near historic lows.
Tokyo and Beijing acquired a combined $2.1 trillion of foreign exchange reserves, mostly held in US dollar bonds, thru massive intervention to keep the yen and yuan weak, and plowed their newly acquired dollars into US bonds. Today, Japan owns $612 billion of US Treasuries, after purchasing $334 billion US dollars in 2003-04. Beijing owns $420 billion of US Treasuries, and more than $500 billion of US agency and corporate bonds, with little regard for the outlook for inflation.
As crude oil prices more than doubled to over $65 per barrel, OPEC's oil revenue reached $968 billion in 2006 from around $300 billion in 2002, Arab Oil kingdoms invested about $314 billion into the US Treasury market thru their London brokers, representing one-fourth of the $1.3 trillion of petrodollars invested globally over the 3-years. Last week, the US Treasury said holdings of US securities by foreign central banks and governments rose to $2.3 trillion by the end of June 2006.
Perhaps, the most important single factor allowing the global economy to grow at 5% or more for each of the past four years has been historically low bond yields, courtesy of Asian central banks and Arabian petrodollars. Indirectly, abnormally low bond yields spawned $1.5 trillion of US mergers and takeovers in 2006, and $1 trillion so far this year, up 70% from the same period a year earlier. Globally, M&A mushroomed to $3.6 trillion in 2006 and $1.9 trillion so far this year.
Also behind the boom in global stock markets, hedge-fund assets tripled in the past decade to $1.57 trillion, and private- equity companies are bidding $447 billion for companies so far this year, versus $228 billion in the year-ago period. Corporate treasurers are exploiting the gap between the low yield on bonds and the earnings yield on stocks through record share buybacks, driving equity prices sharply higher.
The Bernanke Fed is also operating behind the curtain, inflating the broad M3 money supply at an annualized 12.2% rate, its fastest clip in 5-years. Each morning, before the opening of the NYSE, the Bernanke Fed buys Treasuries to accommodate strong loan demand from private equity groups and leveraged takeover artists, and prevent short-term borrowing rates from rising.
The global stock buying frenzy might not have been possible, if the "bond vigilantes" weren't sedated by Arab Oil kingdoms, China, Japan, and other central bankers.
But interestingly enough, when the Dow Jones Industrials climbed above the psychological 13,000 barrier for the first time, the "bond vigilantes" began to crawl out of their cave. On June 1st, the Treasury's 10-year yield rose to 4.98%, its highest level in nine-months. Treasury yields were rising despite news that the US economy slowed to a scant 0.6% growth rate in Q'1, its weakest in 4-_ years, largely due to a sharp downturn in the housing sector.
Fed officials believe the correction in the housing market is likely to "weigh heavily" on economic growth for the remainder of the year, but "the risk that inflation would fail to moderate as desired remained the committee's predominant concern," the Fed said on May 30th. So as hopes fade for Fed rate cuts this year, traders are dumping long-term T-Notes in favor of high flying US and foreign stocks.
The "bond vigilantes" might have greater room to maneuver in the months ahead, as Beijing observes its massive US bond portfolio, estimated at over $900 billion, slide into a free-fall, when depreciating US dollars are converted back into Chinese yuan. China's massive $233 billion trade surplus with the US last year is going up in smoke, even before the "bond vigilantes" have a good crack at the bat.
China controls $1.2 trillion in foreign exchange reserves and steady purchases of longer-dated Treasuries could evaporate, after the PBoC widened the trading band for the yuan on May 18th, allowing for a swifter devaluation of the US dollar. Beijing could decide to recycle its massive trade surplus into riskier assets.
But Fed chief Ben Bernanke is not worried about Beijing dumping US bonds in the future. "I think the cost to them of doing this would be greater than the cost to us. A substantial move on their part would be disruptive in the market in the short term, but in the longer term, the dollar and Treasury yields would largely recover," he told the Senate Banking Committee on Feb 14th.
"I do not believe China's substantial accumulation of reserves (recycled into US bonds) in itself represents a problem for the United States or for US monetary policy," Bernanke wrote on March 26th. "Because foreign holdings of US Treasury securities represent only a small part of total US credit market debt outstanding, US credit markets should be able to absorb without great difficulty any shift of foreign allocations," he said in a letter to Sen. Richard Shelby, an Alabama Republican.
"And even if such a shift were to put undesired upward pressure on US interest rates, the Federal Reserve has the capacity to operate in domestic money markets to maintain interest rates at a level consistent with our economic goals," Bernanke added. Would Bernanke speed up the printing presses to buy bonds from Beijing?
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