We expect a combination of falling crude prices and disappointing economic growth to power a 50-100 basis point rally in the 10-year and 30-year bond yields in the next 6-9 months. For now, there are three factors keeping the long bond up in the 5.50% range despite the 3.75% fed funds rate and total absence of inflationary impulses. We discuss those three factors in the body of this piece. Bottom line: Our bullish case for bonds is built on the expectation that the various impediments to lower bond yields will partially dissipate, while the bullish factors for bonds will remain stable or strengthen. The chief obstacles to lower yields are as follows:
1. The intellectual orientation of the Federal Open Market Committee (FOMC), continues to be driven by academic Keynesians who believe growth to be inflationary. Bond prices are set by market assessments of what this particular Fed will do based on what its individual members have been saying and how they have been acting. The markets now seem to expect that once the economy bottoms, the Fed will end its rate-cutting cycle and drive base rates up in fairly short order. We see this in the March 2002 eurodollar futures contract, which is pricing in an 85% probability of a rate hike by the end of the second quarter of 2002. The yield on the two-year note, which continues to trade close to the fed funds target, even after yesterday’s rally, also indicates that market participants think the Fed is close to wrapping up its interest-rate easing cycle. Expectations of an economic rebound that brings with it higher benchmark interest rates still are very much priced into the treasury market. When growth disappoints on the low side due to the ongoing presence of dollar deflation and high real interest rates, these “Phillips Curve” expectations will at least partially subside, helping yields move lower.
2. If and when the current deflation ends -- signaled by a sustained rise in the dollar price of gold and a rebound in sensitive commodities prices -- there is no mechanism in place to prevent the adjustment from going too far in the other direction, from deflation to inflation. In the aftermath of both the 1982 and 1985 deflations, gold eventually skipped from below $300/oz. into the $500/oz. range creating a clear threat to dollar purchasing power. With gold trading in the $275/oz. range (up $6 today, by the way), deflationary pressures clearly are the most powerful negative bearing down on asset prices. Since the political discussion in Washington is erroneously focused on the false choice between a strong or weak dollar, instead of a non-deflationary or inflationary gold price, bond-holders must demand a higher interest-rate premium for the risk of an uncontrolled shift in the direction of the greenback. In other words, if the markets knew the Fed could control the shift and stabilize gold at $325 or so, they would be able to price out more risk.
3. Crude oil, while still in a downtrend from highs reached last year, continues to trade stubbornly above its long-standing equilibrium level against gold, which we calculate to be in the 15:1 range. At the current gold price of $275/oz., oil should eventually march into a long-run trading locus of roughly $18/bbl.
As the attached chart demonstrates, the rig count, which has been in a downtrend for some time, dropped to a record low in 1999, owing to the collapse of oil prices to $10/bbl in 1998. Estimates for 2001 show the rig count surging 60% above 1999 levels, as new capital investment chases after the high relative price of crude. Sustained crude prices above $20/bbl have made deepwater offshore projects and oilsands production economic; increased production will continue to push up crude stocks. According to the International Energy Association, non-OPEC production is expected to rise by 590,000 bbl/day in 2001 and 730,000 bbl/day in 2002 while “healthy upstream spending is expected to sustain production from mature producing regions” in Russia and North America. While escalating violence in the Mid East has contributed to a rise in spot crude and gas prices, we expect this to be a temporary phenomenon. Over the next six to nine months, crude prices should decline due to rising levels of non-OPEC production, the surge of investment capital from last year on, and lower than expected levels of demand growth. This should remove a good deal of the “noise” from the inflation indexes and reduce Fed rate-hiking risk, making ordinary treasuries more attractive relative to TIPS. Michael T. Darda
GREENSPAN RUMOR: The rumor that Greenspan, now 75, may resign by year’s end has been circulating widely. Whether he resigns will depend on what happens from September on, i.e. on whether the economic rebound being counted on by the Bush team actually arrives. If the markets continue to decline and economic recovery is pushed into the future, as we expect will occur if there is no rescue from the deflation, Greenspan probably will stick around instead of leaving in mid-mess. If things don’t look bad, though, he might be ready for golfdom. Another rumor is that Sen. Phil Gramm [R TX], who had been chairman of Banking before the GOP lost control of the Senate, would probably like to be Fed chair. I’ve known Gramm for almost 30 years and remember editing op-eds he wrote for the WSJ while a Texas professor of economics. We were friendly until I opposed his presidential bid in 1996 in favor of Steve Forbes. It is hard to say where he would take the Fed, but it would certainly be in a different direction. Lewis Lehrman, a gold-standard advocate, was a big Gramm booster in ‘96, which suggests promise. JW