To Hell in a Bond Basket

Drag Me to Hell!

That’s the title of the first horror movie with a credit crunch theme. No kidding. We just read about it in the Financial Times.

The idea of the movie is simple enough. A young woman is a mortgage loan officer at an LA bank. She wants a promotion…but to get it she has to prove that she’s tough enough to say ‘no.’ So when a creepy customer comes in and asks for an extension of her mortgage, the woman rejects the proposal…perhaps a little too coldly.

Then begins the horror.

But just look around. There are plenty of frightening and unnatural scenes going on.

Broadly speaking, it’s a merciless war between inflation and deflation. But there are many different attacks, ambushes, counterattacks, feints, and massacres going on.

The Dow retreated 173 points yesterday. Typically, following a major fall in the stock market, there is a ‘reflex rally’ that lasts several months. Our rough guess was that it would carry on until summer. Most analysts thought it would exhaust itself sooner. Who knew? But yesterday, it looked as though the rally may be nearing an end.

The rally itself is a part of a larger battle between two contradictory body parts – the heart and the mind. The heart wants to believe that the worst is over. It reacts sentimentally, remembering the glory days of the great bubble era and wishing they were back. Higher consumer confidence readings sent the stock market higher on Tuesday – the heart ruled.

But on Wednesday, it was the head’s turn. The head looks at the facts: housing and employment are still going down. People will spend less money. Businesses will make less money. Ergo, no reason to expect stocks to go up. Instead, they’re more likely to go down. The Dow scurried back to the lines it occupied at the beginning of the week.

The head noticed, too, that the Treasury market is getting slammed by higher yields. The long bond yielded 4.56% yesterday – up from well below 3% at the end of last year.

“Treasury yields give cause for concern,” says this morning’s Financial Times.

“Rising Treasury yields threaten to stifle economic recovery,” continues another article in the same paper.

But has the top of the bond market really passed? Is the credit cycle now in full retreat? Will homeowners and businessmen be tortured with higher interest rates?

Those are the questions the head was asking yesterday. And it didn’t like the answers. If there were any green shoots, it reasoned, higher interest rates could crush them.

And then at least a few heads began thinking about what this meant to the big strategic issues…and how this flick will turn out.

At the end of last year, America’s great buddy, China, changed its policy. Instead of buying long-dated US debt, China began buying the short stuff. China’s top man openly wondered whether the US would be able to protect the value of the dollar and keep its promises to foreign lenders.

“We have a huge amount of money in the United States,” we quoted China’s premier just yesterday. He reminded the US that China had entrusted a lot of its wealth to US paper and went on to request that America respect its obligations to bond buyers. Obviously, the Chinese must wonder if the US is capable of protecting its currency while still funding its war against deflation.

Tim Geithner promptly responded. “Yes we can!” But the Chinese cogitated on the matter… “No they can’t,” they began to think. Then, they switched to buying short-term US debt, leaving the longer-term bonds to other buyers. Since the Chinese were the biggest buyers at US Treasury debt auctions, this switch in policy had a quick and noticeable effect. Bills rose. Bonds fell. The yield on bills fell to below zero, while the yield on the 30-year bond has gone steadily up.

If America’s supply lines to cheap credit have been cut, she is at a great strategic disadvantage. Or rather, her pre-existing strategic disadvantage is becoming more apparent: she depends on foreigners just to be able to continue living in the style to which she has become accustomed. As the president of the United States of America acknowledged this week:

“We’re out of money now.”

But how does this affect the war between inflation and deflation?

The US is on the side of inflation, of course. It put its whole economy on a war footing and has earmarked more resources (in real terms no less), to the fight than it spent on WWII.

In a larger sense, the US is at war with capitalism…and with nature herself. Markets have natural rhythms. They go from boom to bust…from inflation to deflation…from expansion to contraction naturally. Trying to stop the bust is futile. It is a fight against Fate…a losing proposition. And it is diabolically unnatural. You have to take the bad with the good in life. There’s no going to Heaven without dying. And you can’t rebuild a house without tearing down the old one. Mistakes must be corrected. Old, worn-out businesses have to go out of business so that new ones can take their places. Bad investments need to be deflated…liquidated. Failed managers and failed business models must be eliminated. Bubble delenda est.

The feds can’t beat nature. The bubble can’t be reflated. They can’t make the situation better than it would be if they left it alone. But they can make it a lot worse.

They still have the nuclear option. Then we’ll all be blown to Hell…

What’s the nuclear option? It’s the Zimbabwe Solution…pioneered by Gideon Gono, head of Zimbabwe’s central bank…and recently proposed for the US by Harvard professors Rogoff and Mankiw. And they’re not the only ones.

Of course, there is no need to exaggerate. The facts are outrageous enough. So, let’s calmly look at what has happened so far…and where it is likely to lead.

As you know, the battle between inflation and deflation is going badly for the feds. Deflation is winning. And yesterday, the Eastern Front collapsed.

Germany announced that consumer prices are now 0.1% lower than they were a year ago. Germany is in outright deflation. The rest of Europe is probably not far behind.

In America, the trend is probably in the same direction. The money supply – M1 – grew at an 18% rate over the last 6 months. But taking just the last 3 months, the rate of growth has fallen to only 1.8%.

Meanwhile, the US Treasury is borrowing hudreds of billions’ of dollars in order to close the gap between what the US spends and what it receives in taxes. Even if the Chinese are willing to fund that borrowing in the very short term, it just pushes forward the inevitable day when the list of willing lenders is shorter than the list of US Treasury bonds to be sold.

When that happens, the Chinese can bend over and kiss their reserves goodbye. Because there is no way the US government is going to forego spending money just to protect foreign bondholders. Instead, to raise money, it is going to turn to its very own bond buyer of last resort – the Fed.

The Fed will “monetize the debt” – by buying Treasury debt and converting it to dollars in circulation. At least, that’s the plan. The risk is that it will cause consumer price inflation. Everyone is aware of the risk. Few doubt that it would happen.

But that’s where Gono, Rogoff, Mankiw and many others, come in.

Caroline Baum reports:

“Harvard University’s Ken Rogoff and Greg Mankiw think more is better when it comes to inflation.

“Rogoff said he advocates 6 percent inflation ‘for at least a couple of years.’ That would alleviate the strain deflation imposes on debtors, including the U.S. government, who have to pay back their loans in appreciated dollars.

“In the Middle Ages, they threw people who failed to repay their debts into debtors’ prisons. Today debtors are rewarded with all kinds of government perks. Look how far we’ve come!

“Borrowers took out mortgages they couldn’t qualify for to buy homes they couldn’t afford. When the housing market collapsed, they were rewarded with government-subsidized mortgage modifications and, in some cases, partial forgiveness on their loan balances. And now, under Rogoff’s 6 percent solution, debtors would see more of their burden lifted.

“And we, the savers, get screwed again.

“‘Zimbabwe Solution’…

“And who says the Fed can orchestrate 6 percent inflation and not let it get out of hand? You know what would happen to those well-anchored inflation expectations: Ahoy, matey, it’s out to sea with you.

“‘Trying to manage a slight increase in the rate of inflation in a discretionary way is not practical,’ says Marvin Goodfriend, professor of economics at Carnegie Mellon’s Tepper School of Business in Pittsburgh.

“Mankiw didn’t specify his preferred inflation rate in the Bloomberg story. He was too busy to give me an interview, directing me instead to his New York Times column from last month where he proposed the idea of negative interest rates: not negative real rates, adjusted for inflation; negative nominal rates.

“The idea is ‘to make holding money less attractive’ so people will spend it.”

Needless to say, we can’t wait to see what happens. The Chinese already seem to think that holding dollars is less attractive than it used to be. But Geithner and Bernanke assured Wen Jiabao that his money was safe. We wonder what he’ll do when he realizes they played him for a fool.

Until tomorrow,

Bill Bonner

The Daily Reckoning