After a bear market in US stocks, US bonds may well be next in line.

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After a bear market in US stocks, US bonds may well be next in line. When deflation has faded as a concern, there is little doubt that the US long-term bond market will experience its greatest price correction since the first quarter of 1994.

While I have not been as bearish on the world's largest economy as some others (Mr.Marc Faber, for example), I do see significant risk for global investors in holding on to US Treasury and US Corporate long maturity bonds. In my view, they are no longer the safe-heaven people have learned them to be, in recent turbulent times. If I was running a large investment fund I would want to be short US bonds of longer maturities! After immense wealth destruction in US equities the past few years, I see a similar destruction of wealth in the making through longer maturity bond prices. Bond market values are highly sensitive to interest rates and if these rise -market prices on long bonds will be market down considerably. The interest rate risk associated with bonds are generally not well understood by investors....and often not well enough explained by investment professionals, the world over.

The US housing market (also in a classic bubble, just like US bonds) could as well be negatively affected by a US rise in interest rates in year 2004 or 2005. While it is less clear how long high US housing prices are sustainable, they are far more leveraged then bonds or stocks. While touring the US, I met more people in the Home refinancing business, then any other profession. The US housing market is highly leveraged because so many home owners have borrowed the maximum allowed; and this on ever increased appraised market values. While owning a home there gives meaningfully tax advantages and while people "must live somewhere", there now is an alert risk that US home prices will come crashing down in value when US interest rates inevitably rise at some point. To me, in general, US housing prices seem unsustainable just as US bond prices. I remember how individual Swiss Housing prices collapsed in the late 1980's, then just as now, the elite & educated told us it would never happen. I thank Mr. David Hale for the good contribution below which gives more light and questions on this next "shoe" to drop. We will see.

 Paul A. Renaud

Can The Federal Reserve Prevent Deflation? Chicago, June 30, 2003 By David Hale

There is no way to know whether the Fed easing of 25 basis points last week was the final monetary policy action of this business cycle. The fact that the Fed failed to cut by 50 basis points produced an immediate reaction in both the equity market and the long-term bond market because many investors had been persuaded that the Fed would do more. But the outlook for monetary policy remains unclear because there are so many diverse factors which could influence policy.

The Fed probably decided to ease by only 25 basis points for three reasons. First, leaving the funds rate at 1.0% still gives it some room for maneuver if the economy experiences unexpected weakness or there is another terrorist attack which threatens to depress business confidence. Secondly, there is a widespread consensus on Wall Street as well as among many Fed officials that the economy will rebound to a growth rate of 3.0-4.0% during the second half of this year. If this scenario comes to pass, there will be no further need to reduce interest rates. Finally, if the Fed had cut the core funds rate to 75 basis points, it would have jeopardized the stability of the $2.1 trillion money market fund industry. The money funds typically charge 75 basis pints to administer their portfolios, so any further decline in the level of short-term interest rate would have wiped out their shareholders income or even jeopardized the tradition of always maintaining asset values at $1 per share.

While the Fed did not reduce interest rates by 50 basis points, its statement further reinforced other comments by Fed officials that short-term interest rates are unlikely to be increased under any circumstances this year or perhaps for much longer. The Fed has tried to provide strong reassurance about a long period of stable monetary policy in order to encourage a rally in the long-term bond market.

Mr. Greenspan has been prepared to give the market such reassurances because of his obsession with the risk of deflation. He once believed that it would be impossible to have deflation in an era in which central banks produced fiat money without the constraints of the gold standard. Yet, Japan has experienced five years of deflation while the U.S. inflation rate has dipped to 1.0% despite an extraordinary amount of monetary and fiscal stimulus since 2001. The weakness of the U.S. economy, coupled with the Japanese experience, has persuaded Mr. Greenspan that he must take significant risks on the side of accommodation to be assured that deflationary forces are held in check.

The bond market has so far endorsed this policy because the inflation rate is subdued while the economy has experienced three quarters of growth at annual rates below 2.0%. The bond market is also aware of the Japanese experience as well as the increasing evidence that Germany could suffer deflation during the year ahead.

It would not be an exaggeration to say that Mr. Greenspan's attitudes have produced a bubble in the U.S. bond market. At the trough two weeks ago the yield on ten-year bonds fell to 3.10%. American bond yields have been this low only twice since 1800's; the 1890s and the 1930s. The only countries in which long-term interest rates are lower are Japan and Switzerland. In Japan, bond yields have been trading in a range of 0.4-0.7% during recent weeks while the core money market yield is zero. In Switzerland, ten-year government bond yields are 2.08% while the 3-month interest rate is 0.27%.

It is surprising that Mr. Greenspan has been prepared to encourage a bond market bubble because the odds of the U.S. experiencing deflation are very low. The inflation rate in the service sector has been averaging close to 3.0%. Commodity prices have rallied during the past year. Shipping rates are firm. There is widespread optimism that the U.S. economy will recover this autumn.

The last period of deflation in American history was the early 1930s. During the period 1929-1933, the U.S. CPI fell from 100 to 75.7. There was also deflation in other countries during this period. In France, the CPI fell from 100 in 1929 to 75 in 1935. Britain and Japan experienced deflation during both the 1920s and 1930s. In the UK, the CPI fell from 100 in 1920 to 69.7 in 1923, stabilized for three years and then fell to 55.9 in 1933 despite the devaluation of the pound in 1931. In Japan, the CPI fell steadily from 100 in 1920 to 72.2 in 1929 and 53.9 in 1931. During the past five years, by contrast, the Japanese CPI has fallen from 100 (1998) to 97.3 last year.

In the 19th century, deflation was far more common. In the first decade, the UK price level fell from 100 in 1800 to 92 in 1810. It rose back to 108 in 1815 and then fell at an erratic rate for three decades, bottoming at 49 in 1850-53. Inflation revived during the 1860s and the CPI rose back to 92 by 1864. Prices then resumed declining gradually for three decades. The CPI dipped to 57 in 1880, 53 in 1890, and bottomed at 49 in 1901. Prices rose gradually during the early 20th century and dramatically during the First World War. The CPI peaked at 117 in 1920 and then resumed declining until the mid-1930s.

Germany also experienced deflation during the 19th century. The price level fell 27.5% during the period 1823-25, 26% during 1831-1834, 43% during 1847-50, and 24% during 1855-58.

The deflationary experience of the 19th century was driven by two major factors. First, there were huge increases in output because of the industrial revolution and the impact of new transportation technology on access to new food supplies from North America, Australia, and Latin America. Secondly, the growth rate of money supply was limited by the gold standard until large gold discoveries occurred during the late 19th century. The gold discoveries set the stage for a price recovery after 1900. The price level fluctuated but had a downward bias for much of the century because of both supply growth and monetary restraint.

In the modern era, the world is experiencing a large increase in output from low cost production centers such as China and India. This new supply has depressed the price of many tradable goods while encouraging firms to shift production to China. But there are no limits on the ability of central banks to respond to increased production of goods with faster growth of the money supply. There are no countries left on the gold standard. Many countries have formal inflation targets which would require their central banks to resist deflation. Other central banks have implicit economic growth targets which also would preclude tolerance of deflation.

The risk facing the U.S. bond market is that the consensus economic forecast for the next four quarters will prove to be accurate. If the economy does return to a growth rate of 3.0-4.0% on a sustained basis, there will be no further monetary easing and at some point during 2004 the Fed will probably be compelled to tighten policy. Long-term bond yields could begin to increase during the final months of 2003 in expectation of a policy change. If long-term yields rise sharply, they could then jeopardize the great boom now occurring in the housing sector. Not only have home sales risen to record levels - Fannie Mae now estimates that there will be $2.6 trillion of mortgage refinancing this year compared to previous peaks of $1.5 trillion last year and $750 billion during 1998. This mortgage-refinancing boom has become the primary mechanism through which monetary policy is stimulating the economy. The Fed has recently been trying to promote rising bond prices because of the influence of the ten-year Treasury yield on mortgage rates.

If the economy fails to revive this autumn, the Fed will probably switch to an alternative strategy of intervening in the long-term bond market to reduce yields, not merely trying to talk yields down. The Fed actively managed long-term interest rates during the Second World War and for seven years after. It could justify returning to such a policy if it was widely perceived that the economy was on the verge of deflation. The Bush administration would also probably support such an action because of its anxiety about re-election. The President's father has often blamed Greenspan for his failure to win re-election in 1992. Mr. Greenspan does not want to be blamed for a second Bush defeat.

The dollar experienced a modest rally after the Fed announcement of 25 basis points of easing, but it is doubtful that the dollar rally will go much further. The U.S. must still confront a current account deficit expanding toward $600 billion. The markets now perceive that the Bush administration favors a soft dollar to bolster exports despite the President’s comments that he favors a strong dollar. The news of insurgency from Iraq will continue to raise troublesome questions about the cost of the military occupation and the impact on America’s budget deficit.

The problem which America is experiencing in maintaining effective control over Iraq is not unprecedented. During the era of European colonial domination over the Middle East and North America, Britain and France had to spend heavily on military deployments. In 1920, there was a revolt in Iraq which cost the British exchequer 40 million points ($150 million). If we adjust for inflation, the cost would be $1.5 billion in current dollars. In the mid-1920s, France conducted a military campaign in Morocco which cost 950,000,000 francs ($50 million) together with 400,000 francs worth of war material borrowed from the home forces. In 1912, France's cumulative military expenditures in Algeria came to 4 billion francs ($800 million). The conquest of Tunisia cost France 100 million francs and budget support of 20 million francs per year for twenty years, a total of 500 million francs ($100 million). The Algerian war of independence in the 1950s cost France $11 billion despite the fact that she had been occupying the country for over one hundred years.

There is no way to predict exactly how much the U.S. will have to spend establishing an effective administration over Iraq but the cost is likely to average at least $5-10 billion per annum until the economy can recover. The performance of the U.S. dollar will have a major impact on the conduct of monetary policy in many countries during the next twelve months. If the dollar remains weak, it will continue to encourage competitive monetary reflation. Countries with floating exchange rates in Europe and the British Commonwealth will be compelled to ease monetary policy. Asian countries with dollar pegs will have to spend heavily on intervention and will probably not be able or willing to fully sterilize it. China’s money supply has been accelerating this year. Japan significantly expanded bank reserves during May as the MOF spent $30 billion intervening in the currency market to stabilize the yen/dollar rate. All of this monetary easing is likely to give a boost to global growth rates during 2004 and 2005. If, by contrast, the dollar experiences a major rally, the pressure for monetary accommodation in Europe and elsewhere will diminish. The weak dollar has become a benign factor in the world economy because it is forcing many countries to reduce interest rates while the fear of deflation is restraining American interest rates.

Despite the market's temporary disappointment at the magnitude of last week's Fed easing, the outlook for U.S. fixed income markets is likely to remain buoyant for the time being. There is no risk of any monetary tightening for a long time, so the current yield curve offers a strong incentive to remain long. American banks missed the great bond market rally as they had only 2.27% of their assets in Treasury bonds at the end of last year compared to levels close to 10% during the bond market rallies of the early 1990s and mid 1980s. American banks could emerge as large buyers of Treasury bonds if loan demand remains weak. The period of risk for the bond market will come during the autumn.

If the U.S. economy does return to a sustainable growth rate in the 3-4% range, investors will become more risk averse and start to discount Fed tightening next year unless Mr. Greenspan continues to make speeches about the risk of deflation. It is not clear what combination of data will eliminate Mr. Greenspan's concerns about deflation risk. But when he does concede that deflation has faded as a concern, there is little doubt that the long-term bond market will experience its greatest correction since the first quarter of 1994.