from Follow the Money

PIMCO is betting on the continuation of Bretton Woods 2

August 16, 2006

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At least that is how I read the latest Paul McCulley/ Andrew Balls paper.   By the way, Andrew Balls, welcome to the world of financial opinion journalism … otherwise known as economic analysis and market strategy. 

PIMCO has long believed that the increase in short-term rates would profoundly slow the economy – and thus expect the fed funds rate to “peak.”    And they consequently argue that long-term bonds are poised for a rally.    The lagged impact of the 400bp rise in short-term rates since early 2004 will slow the economy (housing will have a hard-soft landing), and as the economy slows, long-term bond yields will fall, driving up their value.

PIMCO also expects (I think) the dollar to fall, at least against some regions. 

In normal times, peak fed funds and a slowing economy would almost automatically lead long-term bond rates to fall.   That certainly seems to be the bond market's reaction to today's CPI and housing data.   10 year yields are below 5% again.

But in some sense we no longer live in normal times.   Since the US no longer saves, it depends far more on the flow of foreign savings into the US than in the past …

And if foreigners also expect the dollar to fall (or think big falls are a meaningful risk), why should they lend to the US at relatively low US rates?

As PC (a participant in the comments section) has noted, the bond conundrum could potentially become the bond conundrum in reverse.  During the conundrum, rising short-term rates did not lead to higher long-term rates.   As short-term rates rose through 4, they pushed long-term rates up – but the curve remained flat.    Perhaps not a conundrum.  But still something.

If foreigners lost confidence in the US though, lower short-term rates would necessarily translate into lower long-term rates.    At least not until after foreigners thought the dollar has fallen as much as it needed to fall.    That would be the conundrum in reverse.    A fall in the fed funds rates and no fall in long-term rates. 

PIMCO doesn’t think it will happen.

And the easiest way to explain why it won’t happen is that East Asia remains wed to the Bretton Woods 2 system.    As US rates fall and the US slows, folks will have even more incentive to bet on RMB appreciation.    But China won’t allow the RMB to appreciate much, so it will add even more to its reserves. 

Interest rate differentials will no longer pull private funds from Japan to the US, or support the dollar against a range of East Asian currencies.  But rather than appreciate against the dollar, a broad rate of East Asian countries will resume sustained intervention.

The Gulf countries may not like Treasuries (and China may prefer mortgage backed securities), but Japan’s central bank sure has liked Treasuries in the past. 

Stronger reserve growth in East Asia would increase total demand for US debt.  And increase East Asian demand for Treasuries.   It would be 2003 and 2004 all over again …

That strikes me as a reasonable bet.    A lot of countries have been far more willing to finance the US than I expected two years ago.  Why would that necessarily change? 

On the other hand, the risk that there might be a “regime change” doesn’t seem completely implausible.  East Asia might be a bit more reluctant to support an economy with a $900b current account deficit during a growth slump (the hard-soft landing) than it was to support an economy with a $500b or so current account deficit coming out of a recession.

We may get to see …

Incidentally, I recommend Mauldin' Outside the Box this week -- Richard Duncan's thoughts on the conundrum (a by product of shrinking agency supply combined with strong central bank demand for highly rated assets) are rather interesting.

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