Why Bonds Will Continue to Rise in Value
Most analysts are baffled by the continuing strength in longer-dated bonds. For years they’ve been advising against them, at considerable cost to investors who followed their advice and missed out on the good returns delivered.
They’ve been wrong, and continue to be, because their thinking is locked in the past. They’re obsessed with inflation because in the past inflation did devastate bond values. They’re convinced that if enough money is “printed,” it must eventually create inflation in the prices of goods and services.
Maybe it will. In the long run. But in the long run, we all die. Meantime, inflation in the prices of goods and services is no problem, and isn’t about to become one. The major inflation being generated by money creation is in the prices of investment assets… including bonds.
And that is likely to continue.
Bond price strength and the US foreign trade deficit
As everyone knows, the US is running a huge and growing foreign trade deficit. That is partially offset by capital flows into the US by private investors, to acquire business assets, real estate or securities. To the extent that private inflows are not sufficient to cover the deficit, foreign central banks – especially in Asia -- come to the rescue.
To prevent their currencies appreciating, which would undermine their export-driven development strategies, those countries “print” gargantuan quantities of their own currencies, which they use to buy the surplus dollars generated by exporters. The greenbacks are then recycled back to the US, being mainly invested in the low-risk government and “agency” (semi-government) bonds.
It’s a kind of vendor financing – the Asians are lending money to the Americans so they can continue buying the flood of cheap manufactures pouring out of Asia’s new factories.
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Trouble is – as Richard Duncan revealed in a recent report for FinanceAsia.com – the US foreign trade imbalance is generating dollars faster than suitable bonds are being created to soak them up. There’s a dollar surplus, a paper shortage. So bond yields are being driven down, and bond values up.
Bond price strength and the dollar surplus
The imbalance, Duncan suggests, is probably going to worsen. If the US foreign trade deficit, which reached $666 billion last year, continues to expand, the quantity of dollars foreign central banks will wish to invest in US government and agency bonds will continue to expand.
However, the US budget deficit is expected to contract, so the federal government will issue less new paper. The same will probably be true of the giant agency issuers Fannie Mae and Freddie Mac, as a consequence of their accounting scandals.
“Under such circumstances,” Duncan argues, “there will not be enough new government and agency debt issued to satisfy the demand of foreign central banks. Consequently, they are likely to buy existing debt instead, which will have the effect of pushing up the price of those bonds and driving their yields down even further… regardless of what the Fed does to the federal funds rate.”
The consequences will be far-reaching…
By Martin Spring in On Target, a private newsletter on global strategy
