from Follow the Money

If Roach says 3.5% and Gross says 3%, someone else has to say 2.5%

June 3, 2005

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Roach and Gross could not stay among the most bullish on bonds for very long. From Marc Gilbert’s column today.

Gabe Borenstein, managing director of global investments at Investec Holdings Ltd. in New York, predicts a 10-year yield of 2.5 percent in the current business cycle, which has 18 months or less to run. Higher energy costs, renewed wariness among indebted consumers, and continued recycling of dollars into Treasuries by overseas investors will help drive down yields, he says.

That would really flatten the yield curve (check out this nifty graph)

The ten year is no longer at 3.80, as it was earlier today, but it is darn close to 3.9.

Obviously, the Nee and Non had something to do with the rally in Treasuries this week. The Euro looks less attractive than the dollar. I tend to agree with Stephen Roach though. The US current account deficit -- heading toward 7.0 to 7.5% of GDP -- will last longer than talk of the Eurozone breaking up.

Over time, I suspect that the risks associated with a likely US current account adjustment will be far more important in shaping relative returns in the global bond market than will be the more remote possibility of an EMU breakup.

Moroever, internal tensions in the Eurozone tend to be a bit larger when the Euro is strong than when it is weak -- so to me, renewed dollar weakness in the face of continued slow growth in Europe would be part of most likely scenario that leads the Euro to fall apart.

But for all the current talk about Europe, I also would not forget about my old friend: Asian central bank demand. As regular commentator Glory notes, someone was buying a lot of Agencies this week.

I am awaiting China’s May reserve accumulation data with great interest. Bashing your biggest creditor usually is not the best way to attract new capital inflows. But consider this possibility. The US ups the rhetorical heat on China. "Hot money" pours in, betting on a revaluation. Chinese reserve accumulation picks up, way up. And China is left with more money to invest in the US fixed income market.

That may be part of the story now. The Saudis and other oil sheiks also have lots of cash to put to work, or at least put somewhere. Judging from the market, they must currently prefer dollars to euros. That has to be part of the story. The really big current account surpluses today are in the oil exporters, and in the two oil importers who have not adjusted their dollar pegs for a long time -- China and Malaysia.

One final note: this dialogue between Gross and Roach from last fall is sort of interesting, at least in retrospect. I suspect this comment from Gross is even more true now than it was then, since the market seems intent on testing those historical lows, at least on the long-end.

Debt and its accumulation are rarely dangerous when lenders are willingly extending their funds or when the cost of those funds is low and/or declining. That has been the case for most of the past two decades, as the US and other G7 countries embarked on a journey of disinflation accompanied by accelerating debt. Corporations, individuals, and sovereign nations alike throughout most of the period gorged themselves at the table of cheaper and ultimately nearly free money — aggrandizing lifestyles, bringing consumption forward, financing peacetime and wartime projects of questionable benefit. The problem is that ultimately someone must pay. As interest rates move upward from historical lows, debt service costs reduce profitability, even productivity.

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