US Bond Market Upheaval and Confusion

By: Jim_Willie_CB

In late March, an article pointed out the massive powerful cross currents in the USTreasury bond world. We are seeing the forces described finally at work. The aftermath has generated more questions than answers. In “Cross Currents for USTBonds” (click here ), several bullish factors were cited for bonds, but also several bearish factors were cited also. This will be a short review of relevant points, since the Vancouver Gold Show is this weekend.

The June issue of the Hat Trick Letter will be out this weekend, chock full of all the relevant points cited below. One thing is certain: my forecast of 4.0% on the long bond is wrong. A revolt is underway, combined with a credit market vomit episode which might last for a long time, like into 2008. The revolt has some logic behind it, moving in step with failed mortgages, which have a direct umbilical to the government bond arena.

What is going on with USTreasury Bonds?
The answer is not the least bit simple. Both above ground factors are at work, and hidden factors we are not privy to seeing regularly. We must surmise, infer, and use some guesswork. Each of the points requires a few pages to fully examine and analyze, not to be done here. They are all possibly highly relevant and at work to disrupt the US credit market. My analysis is within the June report. However, a tipoff of where the stinky scent leads is shared. No need here to attempt to assemble the main points in any order. Doing so might present the wrong picture. There is no order in either a bubble or the unraveling of that bubble.

The Euro Central Bank continues to raise rates.
The German Bund long-term rate has risen steadily, now at 4.6% or so. No way Jake would the USFed permit the GBund to surpass the USTNote 10-year yield!!! If the USDollar is to survive, the USTreasury yields must now match the gains in the ECB and Bund long-term bond yields. The bond yield differential seems to be managed. Perhaps the US Federal Reserve stopped some of its massive monetization of 10-year USTNotes. For three years, the US bond yield has been far higher than the European yield. Since the USFed has been on hold for twelve months, the ECB has continued to hike interest rates. The beneficial bond yield differential used by bond speculators is vanishing. So US long-term bond yields must rise, otherwise the USDollar heads to the dustbin of history. The ECB is not finished raising rates. This will continue.

The US Gross Domestic Product, officially distorted and stated, showed a pathetic 0.6% revision in 1Q2007. When a national economy depends upon $3 billion per day in foreign capital, AND it is slowing to a recognized crawl, foreigners might be exiting, stage anywhere. The lowly USA Today reports that the full 2006 federal deficit was not the $248 billion promoted with fanfare, but rather $1300 billion in red ink. The method used was standard corporate accounting practices, not pro-forma garbage methods intended to deceive. The Leading Economic Indicators are almost all negative, except those related to massive monetary inflation (money supply) and stock indexes (see the Plunge Protection Team). As deficits are expected to continue until removal of both the Executive and Congress via public referendum, USTBonds are exposed from a flood of supply. Foreign capital inflows have changed lately, turning dangerous negative. This will continue.

Trade and financial system negotiations with China are going nowhere, plain & simple.
The US is dictating terms. The Chinese hold all the cards, found in export trade. Most of the trade surplus with the Untied States is derived from US firms and their Chinese subsidiaries. A large slice of the surplus comes from businesses which do not even have manufacturing on this side of the Pacific Ocean in the Northern Hemisphere. The yuan is the improper focal point, since labor cost in the Middle Kingdom is an order of magnitude lower. Shame on Paulson for picking up the political stick. The US lame ducks in power want to cut off the Congressional trade protection legislation. Yet not a single Congressional member sits in with negotiations.

The US side prefers not to notice how the impact of sudden currency upward revaluation would inflict dislocations and severe disruption in China . My guess is the US wants precisely to knock China off its newfound legs, and see it embroiled in a crisis. China made big news with its $300 billion investment account, to siphon money out of its SAFE forex reserves account. Despite a suspicious $3 billion in Blackstone (to avoid disclosure, to curry favor), the trend is clear that sovereign wealth funds are crucial in the investment arena. China might have taken its hand off the BUY button with its massive trade surpluses to purchase USTBonds for a spell. This might continue.

The Illuminati met in Turkey . They made decisions on mankind and the order of things, making sure that plebeians could neither participate nor observe from a distance. They are unhappy about the World Bank activities, and its mismanagement, and the US dominance in its appointments. Maybe they are attempting to get the USGovt's attention. This might continue.

The share of USTBonds held by foreign central banks is the biggest and fastest growing component to such bond ownership. It approaches 50% alarmingly. In general two themes are strong within foreign central banks. The first is vested interest to keep the USDollar from a failure. The second is displeasure with the USEconomic fundamentals. They might not be able to hold the paper clips, rubber bands, band aids, chewing gum, and spittle in place to prevent the USTond from faltering. They might not be able to intervene to the extent necessary anymore. This might continue.

Spain is melting down from a housing crisis of their own.
They are selling off gold in large quantities. They are selling almost everything not nailed down, all available reserves. No rescue process or mechanism exists for the European Union to come to the aid of Spain . The ECB reserves are smaller than most major nations who stand as members. The Banco de España are most likely selling a lot of USTBonds. This will continue.

Mortgage bonds are causing problems from their bond hedge schemes. Negative convexity dictates the sale of bond futures in the absence of cash flow, and in hedge book management of losses. The mortgage debacle might be finally hitting the US credit market on a wider scale, despite knucklehead amateurish claims of no contagion. The closeout of bond spread trades would see buybacks of USTBonds. But convexity in hedged risk management produces the opposite, leveraged bond futures sales. The distress in the BKX banking stock index only begins to tell this story. This will continue.

The Persian Gulf nations are aligned within the Gulf Coop Council (GCC).
Lately, dissension has come from Kuwait , with the United Arab Emirates probably next. Kuwait broke from the USDollar direct peg link. The UAE is signaled to do the same from the forward futures market in the Mideast . These nations are dealing with strong price inflation directly from a falling USDollar, since they import so much outside of energy. The Saudis might be the only player left in the party, after all the guest and sponsors go home. The Saudis have the deepest ties to the USGovt in the protection racket, which endorses oil sales in US$ terms, but keeps the Saudi royals in power to continue tapping the national treasure. In the downstream of agreement to forge a GCC unified currency, the USTBond might be forced to adjust to the reality of regional financial disintegration of firm tight US$ support. This will continue.

The mortgage bond world might not be so easily contained through vested interest collusion.
The ratings agencies (Moodys, Fitch, Standard & Poor) and broker dealers have a wink system to prevent debt downgrades, with tremendous conflict of interest at work. These three firms are sitting on their hands or asleep on the job, not responding to delinquencies and foreclosures which have a direct bearing on collateralized bond performance. Big downgrades might be imminent, just around the corner. Delinquencies, defaults, and foreclosures seem not to matter to the price structure of asset-backed bonds such as mortgage bonds, to the mystery of many experts. Watchers and insiders might see this underway. They might be adjusting USTBond holdings accordingly. This might continue.

USFed Chairman Bernanke threw a wrench in the entire bond engine works.
His message was quite clear, that no official interest rate cut is likely in the foreseeable future. The trouble is, these guys cannot see any better into the future than Mr Magoo, who sired Alan Greenspan. One can quickly infer that the USFed will defend the USDollar, not housing. With no rate cuts coming, the bond market was forced to adjust on the low-end maturities in direct response. Also, forecasts probably changed overnight to anticipate some continued USEconomic slowdown without the needed stimulation. Bonds throughout the entire USTreasury spectrum must adjust to a more salty reality. This will continue.

Bond derivatives in my opinion have been in the midst of numerous small accidents behind the scenes. THREE SIGMA EVENTS HAVE OCCURRED BUT HAVE BEEN CONTAINED. The mortgage debacle is behind most of the costly errors in the leverage game. As schemes unravel, USTBonds are affected. Some enlightened bond experts regard the bond bubble has run its course finally. Disruption comes next, with widespread selloffs difficult to explain. The impact on credit derivatives is unknown, but clearly they will be affected detrimentally. This will continue.

Little New Zealand does not like its Kiwi Dollar high currency exchange rate. Hey, check the high bond yield on your bonds! So they have been engaged in a USDollar intervention of some size, in an attempt to bring down the Kiwi$. Are they selling some gold to finance the intervention? Maybe. Their bond market is out of kilter. This will continue.

Talk is ripe of systemic price inflation working its way into the system. Maybe the investment community is dismissing the official nonsensical Consumer Price Index, since it is probably 8% lower than reality lately. See the Shadow Govt Statistics guys for a glimpse of reality. Food & energy do matter. The core CPI is not deserving of sole focus, since it ignores the entire commodity boom. Year-over-year CPI figures could soon rise above the long-term bond yields. Risk is finally being priced back into the bond market. This will continue.

The Jobs Reports are sounding more and more a part of a fairy tale story. The Birth-Death model accounted for 520 thousand jobs in April and May alone. The bond market might more smartly detect this fraud and conclude job loss means trouble with federal deficits will worsen. Economist Jan Hatzius of Goldman Sachs correctly points out that in the midst of cyclical swings, the B-D model tends to produce badly erroneous estimates of jobs created from new businesses. Most economic forecast become woeful at cyclical swings, since they assume no change in continuity, as in continued view through rear view mirror. Cars and trucks do make turns. Higher unemployment could be triggering some bond sales, not the typical response. It could be a huge upcoming supply issue of USTBonds. This might continue.

Suspect that central bank gold bullion sales, massive in volume recently, are being used to stem the bleeding in USTreasury Bonds generally. Switzerland just announced their plans to sell 250 tonnes of gold before the end of year 2009. Are their bond speculation schemes going awry? Probably. Do they own more US mortgage bonds than they want to admit? Probably. They might be big sellers of USTBonds, acting in self-interest. After all, overnight trading shows huge USTBond sales, rescued the next morning by New York . This might continue.

The United States and Russia are locked in a battle which exposes a new link between the energy world and nuclear missile architectures. See the Lithuanian Druzhba oil pipeline dispute. Putin is hopping mad angry. His central bank owns a scad of USTBonds. They might be realigning their ratios, and selling some USTBonds. The G8 Meeting of finance ministers was an exercise in nothing immediately important, with global greenhouse gases (although vital) dominating the agenda, not global financial imbalances. This might continue.

The Canadian Dollar rises progressively toward parity. Given their sizeable trade surplus bilaterally with the Untied States, they have been coerced into large scale USTBond purchases in sterilization efforts. Since the new year, a ‘hands off' attitude seems evident. The loonie has risen toward 95 cents in exchange rate. The Bank of Canada might have ended a program to purchase USTBonds lately. This might continue.

IF ALL THIS DOES NOT MAKE YOUR HEAD SPIN, IT AINT SCREWED ON PROPERLY.
In the year 2000 the world came to grips with a stock bubble. The same world now must come to grips with a bond bubble. This time though, interests of the bond market are aligned together with those of the USGovt and major central banks. The reality is that price inflation is rising, wages are rising, costs are rising, risk is rising, mortgages continue to crater on the fringe and closer to the core, credit derivatives have grown unmanageable, and revolt against the USDollar is more broad that the financial press admits. Two key nations are slowly on a path hostile to the Untied States, Russia (for some time) and China (more recently). Rising price inflation and bond yields usually go hand in hand with a rising gold price. However, in a liquidity nightmare, nothing fares well. The second half of 2007 is lining up to be rather challenging, intriguing, and nettlesome. Beware of desperate measures used to defend the ailing USDollar. We are in a land of many unknowns.

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By Jim Willie CB
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