12/10/2010 8:21 PM ET|
Say goodbye to the bond bull market
Signs of a top in bond prices could set the tone for investors in 2011. The government may start having trouble funding its debt, taking away the Fed's printing press.
Just before Thanksgiving, I held a contest for readers of my website, fleckensteincapital.com (subscription required), challenging them to provide the best definition for the term "funding crisis," a potential problem I have worried about since early 2009 -- and a consequence of bailing out the financial system.
I am becoming more convinced that the various elements of a funding crisis will be picking up the pace and intensity sooner, rather than later, and they may well be the most important factors to consider with regard to investment decisions in 2011.
Before delving deeper into this topic, I would like to share a slightly trimmed-down version of the winning reader's submission:
A funding crisis refers to the inability of a country to finance itself without resorting to outright money-printing. This can lead to a vicious cycle of currency depreciation, rising interest rates, poor economic performance and poor investor sentiment, all of which feed on each other in a downward spiral. A funding crisis can end when proper monetary and fiscal discipline is restored, usually at the expense of severe economic hardship."
I have been using the term "funding crisis" regularly since the fall of 2008, and I penned the following definition in May 2009:
"If the dollar is called into question . . . and if the Fed's monetization cannot lower rates (and in fact causes them to rise, due to the consequences of money printing), then the Fed is trapped. The more it tries to solve the problem with money printing, the worse it all becomes."
Not to labor excessively over defining terms, but I think it is critical for investors to be able to identify the signs of a funding crisis.
To do that, they need to know what it means in the financial world -- in this case, the bond market, an arena that can be confusing to follow.
The key concept to understand is that a funding crisis occurs when the appetite of debt buyers (that is, bond buyers, aka lenders) for what the debt seller has to offer falls off significantly, or when potential buyers will risk lending the money (buying the bonds) only at a much higher interest rate.
Thus, a funding crisis is very much the free market's assessment of the debt seller's financial state of affairs.
For a real-world example, look no further than Greece's funding crisis earlier this year. In April, yields on Greek two-year bonds climbed to more than 13%, after being under 5% the month before. This means that people who owned Greek bonds lost a huge chunk of their value.
An audible from the ECB
More recently, of course, we have seen a similar situation in Ireland, where yields on 10-year Irish government bonds jumped from about 6% in early November to almost 9.5% near the end of the month. Keep in mind, though, that the predicament in both Greece and Ireland was, and still is, different from what the U.S. will face. Those countries can't print euros, while we can print dollars.
As events were unfolding a couple of weeks ago, I was in Europe having dinner with a friend, the source I've dubbed the Lord of the Dark Matter. I asked him how long it would take before Jean-Claude Trichet, the head of the European Central Bank, would decide to print enough euros to keep the currency from collapsing altogether (as perverse as that sounds). He surprised me by replying: "About three days" (i.e., Dec. 1). I had assumed it would take more time.
As it turned out, Dec. 1 was the day Trichet indicated he was leaning toward following in the footsteps of Federal Reserve Chairman Ben Bernanke in buying more government bonds (although, as is often the case with the ECB, the nature and extent of its commitment are not exactly clear).
Much was made of that development, but the bigger news is that yields on U.S. government 10-year debt have risen about three-quarters of a percentage point (from 2.4% to 3.2%) since their lows in October. Thus, the combination of a crisis in Europe and the Fed's $600 billion bond-buying program, dubbed QE2, both of which could have been expected to force interest rates lower, instead produced the opposite result.
The action of the bond market is a sea change and to me suggests that it has seen a top.
In other words, bond buyers now want a higher interest rate to compensate them for the risk of future inflation and/or a weak dollar. Thus they have collectively voted a big "no mas" with their wallets regarding U.S. Treasury debt, just as they did with Greece and Ireland.
That is one reason Bernanke made an unusual appearance on the Dec. 5 edition of "60 Minutes," in which he defended QE2 -- and in doing so made the outlandish statement that the Fed was "not printing money."
Less than two years earlier, in March 2009, he had described the first round of quantitative easing as printing money.
As I noted at the outset of this article, I expect 2011 to contain some elements of the funding crisis I've been worrying about for some time now, as our bond market comes under considerable pressure. A weak dollar caused by two rounds of quantitative easing (plus potentially more money-printing) will pressure the dollar, and at some point that will increase the pressure on the bond market. Quite frankly, if the euro were not in so much trouble, the dollar would already be much weaker.
No more printing press for you!
As 2010 winds down, it is not possible to know precisely how all of this will play out. But it is important to be mindful of the fact that if bonds continue to sink in repudiation of (or despite) all the Fed's easing, then the markets will have de facto taken the printing press away from the Fed.
That will have ramifications not just for bonds, but for stocks as well.
I don't want to get too far ahead of myself, because at this point that "conclusion" is, in essence, just a theory, not an inevitability.
As longtime readers know, I am always early in worrying about troubles caused by bad policies. But if bonds' best days are over, then next year will certainly see some further developments toward our own funding crisis. And that won't be bullish for financial assets.
On the air
Last week, I participated in another interview with Eric King of King World News; he believes it might be my "best one ever." Interested readers can decide for themselves here.
This column is a synopsis of Bill Fleckenstein's daily column on his website, FleckensteinCapital.com, which he's been writing on the Internet since 1996. Click here to find Fleckenstein's most recent articles.
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Uncle Sam will give you a ton of positive information. We need a little of the negative side to balance things out.. Used car salesman never gives negative stories.
Assume everyone is only giving half the story. Please give me the other side.
Bill Gross agrees with you too. See his Pimco article November 2010.
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