T-Bond on Turning Point


Mervin Yeung Editor/Publisher

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The following article was written on Oct. 10, 1998. We were on the wrong side of the T-Bond market. As a result, we did a study to figure out what went wrong. The conclusion of this study was that T-Bond would enter a long-term bearish trend, which turned out to be correct. However, the deflation has not occurred due to the expansionary monetary policy by the Fed. This raises inflation expectation. Therefore, even if the expected capital outflow from the USA has not happened (yet), T-Bond has been in a downtrend for more than 1 year. (This short review is prepared on Dec. 15, 1999. )

I made a big fundamental mistake on my bullish outlook on US T-Bond. I made money for a while but eventually, T-bond was on a free fall.

  1. Market interest rates dictate bond prices. Rising interest rate causes bond price to fall. Falling interest rate causes bond price to rise.
  2. There are 2 components for market interest rate (nominal interest rate): real interest rate and inflation rate. The formula is: "market interest rate = real interest rate + inflation rate "
  3. Point 2 is only an approximation. The real formula for real interest rate is: r = (n + q) / (1 + q) , where r is real interest rate; n is nominal interest rate and q is annual inflation rate.
  4. Therefore, to predict bond price, we have to predict both the inflation rate and real interest rate. If real interest rate is stable, as in most cases, we only have to predict the inflation rate.
  5. I focused all my energy on forecasting future inflation rate. I ignored real interest rate and assumed that it should be stable, as it was in the past. Well, assumption is mother of all fiasco.
  6. During massive debt liquidation, there is a strong deflationary pressure. This may happen in the near future.
  7. It is a good idea of not having debts in deflationary period. In deflationary time period, you are repaying the debt with increasingly costly money.
  8. Even holding cash is profitable in the deflationary period. As the purchasing power of the cash increases, you are in fact earning interests even on dollar bills under the mattress.
  9. During deflationary period, high quality bonds, debentures, and also T-bills, will be very profitable because of the decline of nominal interest rates. However, this is true only if the local currency is strong.
  10. During deflationary period, low quality bonds, especially junk bonds, will be big losers. The interest rates will rise due to the increasing risk premium, generating large capital losses. And some companies will go into liquidation.
  11. Thus, the spread of high quality bond and low quality bond widens. The flight to quality occurs. Long Term Capital Management bet on the idea of narrowing spread between Italian government bond and German government bond. The result was disastrous.
  12. I studied Point 1 to Point 11 and I concluded that T-bond should go up. It indeed went up for quite a while. But, what happened to bond market last week? Why did it collapse??
  13. The answer is that I forgot another component: real interest rate. Please re-read Point 2. Currently, we have a low market interest rate in the US. The reasons are low inflation rate AND low real interest rate. Due to massive capital inflow to the US, real interest rate is suppressed and it is lower than it should be.
  14. The US has such a low saving rate that it relies on foreign capital on investment purpose. Without foreign capital inflow, real interest rate would be much much higher. Therefore, now I expect that we will have a deflation and a high real interest rate environment in the future.
  15. Capital outflow from the US may have started. Look at the USD / YEN cross. Japanese banks and hedge funds who did the Yen Carry now have to unwind the positions.
  16. The US national debt is more than 5.5 trillion dollars. According to Keynesian economy, you have deficit in bad time to stimulate economy and you use surplus in good time to reduce national debt. Currently, the US government seems to prefer "pet projects" to "national debt reduction". As debt increases in bad time and is not reduced in good time, credit rating (in abstract sense) of the government should be downgraded.
  17. Due to Point 14 to Point 16, I suspect that there is a possibility that for the first time in the US history, we will have a bear T-bond market in a deflationary period. In other words, US T-Bond will behave like a low quality bond. Please re-read Point 10.
  18. Walter Wriston of Citicorp asserted that "sovereign nations don't go bankrupt." They did, they do and they will do. Brazil, Mexico and some Latin American nations would have gone bankrupt in early 80s, if IMF had not put together a rescue package. Same for Thailand, Indonesia and South Korea in 1997.
  19. But, how about super-power? Can we say, "super-powers don't go bankrupt"? Before the US, British Empire (1588-1918) and Spanish Empire (1492-1588) were the previous world super-powers. Even before the destruction of Spanish Armada in British hands in 1588, Spain's finance was in trouble. In 1570, Antwerp, finance capital in Spanish Netherlands, defaulted on its debts. It could no longer stand aloof from the financial troubles of the Spanish Crown. Later, Spanish state bankruptcies occurred about every 20 years: in 1607, 1627 and 1649. Then, Spain sank from gold standard, silver standard to a copper standard of its currency. Spanish state bankruptcies occurred again in 1686 and in 1700, again and again throughout the 18th century, and in 1820, 1837, 1851 and 1873. British fared much better, but Britain had all those unpleasant experience of devaluation of the pound.
  20. This is highly speculative: the US may be next in line. High national debt, large current account deficit and low saving rate will be the cause. Foreign debt will increase suddenly and enormously with the expected dollar collapse. And the result is another Thai situation. At that time, flight to quality means "Get out of T-Bond and jump into German government bond, or even gold. "
  21. If Point 20 materializes, then my loss in T-Bond will be a good thing. I had 2 very different fundamental views on T-Bond: a) a bull T-Bond market due to deflation and massive debt liquidation; b) a bear T-Bond market due to high real interest rate and flight to quality. In case (b), the effect of high real interest rate overwhelms that of deflation and T-Bond behaves like a low quality bond in a catastrophic capital outflow. Before last Thursday, I strongly believed in case (a) because case (b) was so unthinkable. I thought case (b) was unlikely to happen because the US is the world largest, most diversified, and stable economy. I was proven WRONG. Now, I have to accept case (b).
  22. Anyone who goes short in T-Bond market (if he believes in case (b)) must be very careful. If US stock market crashes, Fed will add massive amount of liquidity to create a very rosy environment, instantaneously. This will cause a short term tremendous upsurge in bond prices and destroy every T-Bond short-seller. Of course, over the long run, I now believe in case (b)--i.e. a long run bear T-Bond market in a deflationary, high real interest rate, moderate nominal interest rate, flight to quality, massive capital outflow environment. This must be unprecedented for the US if it turns out to be true.

All of the above are for general information only, not for trading purpose.


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