For the past two weeks, we have been subject to almost perpetual discussion about the relentless rise in bond yields, especially the march of the long bond to 5.66% from its late January low of 5.08%. With gold at $285 and the CRB index of commodity prices at levels not seen for decades, the U.S. government is having to pay higher real rates of interest to attract buyers for its debt. This should not be happening when global investors can see that our government is in the process of retiring debt as the federal budget moves steadily into surplus territory. With the supply of government bonds declining and inflationary expectations continuing to slide, one would think the long bond would do no worse than remain steady. In the 1980s, remember, the long bond came down from a peak of 13% in 1981 to roughly 6%, with the markets seeing colossal federal deficits as far as the eye could see. Of course, inflation expectations were then in decline as the Federal Reserve wrestled the gold price down below $400 and for the most part held it there ever since. What’s going on here?
At our client conference this weekend at The Breakers in Palm Beach, we spent a total of three hours kicking around this subject. It may be as simple as the market misreading Greenspan’s Humphrey-Hawkins testimony, but we rejected that possibility. We had a presentation from Professor Robert Mundell on the future of the euro, and while he did not participate in a special session on the topic, he did make his views known. Professor Reuven Brenner of McGill, another of the great supply-side economists in the world, came to the session and offered a theory of this mystery. The clients themselves chipped in with reasons for the undertow pulling down bond prices. Here is what we considered:
1. Mundell easily is the most influential economist of the past half century. It is not hard to surmise that Reagan would not have been elected in 1980 if Mundell had not revived the supply model as early as 1960. The euro also would not be where it is if Mundell had not written his path-breaking paper on optimal currency areas in 1960. Alas, Mundell is a theoretician, not an empiricist, and has not been thinking of the week-to-week movements in the markets. His one guess was that because the bond slide coincides with the euro’s introduction on January 1, there could be a market shift in preference at the margin for European bonds. He said we could check empirically by noting bond yields in Europe. Nope. Bond spreads have widened a tiny bit, but as European bonds have weakened along with the euro since it was introduced, there is no support for Mundell’s hunch. In his presentation, by the way, Mundell guessed that the gold price would be at $600 in 2010, a curious notion that we discuss later in this paper.
2. Reuven Brenner surmised that U.S. bonds may have strengthened last year through a flight to quality from security markets elsewhere in the world, and that because the “crisis” atmosphere has declined, the weakness in our bond market may be a mirror image. David Gitlitz would not accept Reuven’s surmise because any “flight to quality” argument must accept the fact that the long end of the bond market is the riskiest. If there were such a flight in 1998, we would have observed unusual strength in the short end of our bond market, where investors might park funds while awaiting renewed buying opportunities in their home markets. There is no evidence for any of this.
3. One longtime Polyconomics client suggested an arbitrage between stocks and bonds, but that only would be possible if there were clear signs of greater strength in equities than in fixed-income returns. The stock market has been a bit stronger at the top, although we observe new lows being established at a much higher rate than new highs, and the Russell 2000 still sags. The hypothesis fails when we note that the sharp falloff in bonds has coincided with a weaker equity market.
4. Polyconomics’ David Gitlitz ten days ago thought he saw how some of the puzzle could be explained by the gyrations in the Japanese bond market and the yen/dollar exchange rate [“Tokyo, Washington, New York: Crosscurrents and Crossed Signals,” 2/19]. It is clear the Japanese political establishment is trying to break away from interest-rate targeting in order to increase liquidity in the system. But whereas this activity might explain temporary wiggles in our bond market, Gitlitz abandoned it as a hypothesis when bond prices plunged last week.
5. My own hypothesis does not satisfy me fully, but I think the bond market is punishing Alan Greenspan for completely abandoning his interest in the gold signal. Before his Humphrey-Hawkins last week, the long bond already was at 5.35%, but it really hit the skids when he testified in the Senate Tuesday and the House Wednesday. For the first time in his 12 years as Fed chairman, he dismissed the gold signal as a leading indicator of inflation expectations and pronounced it as a good trailing indicator. He thus washed his hands of the global currency turbulence that took place under his nose as he allowed the gold price to fall by 25%, to its current $285 level from $385 in November 1996. A trailing indicator is worthless to a policymaker, as Greenspan well knows. There is nothing he can do about gold at $285. In addition, more firmly than ever he insisted there is nothing the Fed can do about problems outside our national economy. When asked about Russia, he explained that its financial crisis largely is due to the collapse in the dollar price of oil, but neither House Banking Chairman Jim Leach nor other committee members who had pressed him about the gold decline had the wit to point out that he had just connected Russia’s problem to the dollar, via oil. (After the session, I spent half an hour on the telephone with Leach, trying to get him to understand that the problems of his Iowa farmers inevitably followed the dollar deflation against gold. He insisted there was no connection, but that is because Greenspan and his staff assure him there is none.)
6. We get back to Mundell’s forecast of $600 gold in 2010. In September 1969, Mundell made the most spectacular forecast of our time, saying the world was moving toward a floating regime, and that by 1980 it would be so painful that it would begin moving back toward fixity. He based his forecast upon reading that the founder of the London gold pool, John F. Kennedy’s Treasury Undersecretary for Monetary Affairs, decided that we could no longer defend our gold reserves. Mundell believed this meant the intellectual and political will to keep the dollar as good as gold had snapped, but eventually there would have to be a reconnect with the dollar and gold. Now, he treats this as a hopeless proposition, if only because the developed world has learned how to manage currencies by the seat of their pants and with the help of high-speed computers. To him, a doubling of the gold price over eleven years would be an acceptable alternative, but of course that means the inflation rate would have to return to an average of 6% over that period for prices to follow gold to $600. The bond market may be worrying about the same scenario in assessing Greenspan’s break with gold. There also may be spillover concerns in the bond market that Congress will squander the opportunity it now has to use surpluses to fix the tax system, a fix that would be good for bonds.
At the conference, I was asked what I would think if gold were still at $285 three months from now, and I said I could not make a prediction based on one number. Our primary method of forecasting all markets is to assess the political and intellectual regimes of the countries we follow. We’ve warned against Mexico for years, for example, as long as Guillermo Ortiz is a power in the Zedillo government. He can hit pitching when things are going good in the world, but he always strikes out when the world throws him a curve ball. The most powerful men in the world -- Bill Clinton and Alan Greenspan -- are now throwing nothing but big, roundhouse curves.