Pollyanna vs. Hank Paulson: "this time it's personal"

Events have rushed by in the last couple of months and frankly it's been difficult to put pen to paper in a timely manner without it becoming irrelevant. Our last note, back in June, discussed the overvaluation of the oil price and how it should revert from about $140/barrel to $100/barrel, and why bond yields should fall as a consequence. This turned out to be right. What we didn't foresee was the appreciation of the U.S. dollar against the European currencies. Established relationships have simply broken down for reasons that we will only find out about when the history of this era is written. Take a look at the USD/Euro rate and interest rate differentials; for years these two currencies have marched in lockstep, until six weeks ago that is (see chart). Clearly something is wrong here.

To be honest, this dislocation of theory and practice has been a painful experience. It cost us absolute and relative performance but in many respects, and without wishing to be Pollyanna1 about the whole situation, it's been worth it. The intervening events have served only to harden our attitudes about future events, mainly because the so-called reasoning behind the U.S. dollar's rapid rise has been so undignified and irrational. Should we really suppose that growth differentials between the U.S. and Europe really justify a 12% appreciation of the U.S. dollar? It could be argued that the future prospects of the U.S. have actually worsened as the U.S. authorities have bailed out their own financial system. In doing so, they have denied the natural forces of free market economics and they have favored short-term gains. How much credibility can we place on an administration which had reassured us that everything was alright, only to admit later that the financial system was within two weeks of a meltdown? What followed was a 'blank check' approach to the markets, precisely when accepting the responsibilities for one's own actions was the correct approach. Treasury Secretary Hank Paulson appears to have lost much of his trustworthiness and it might be argued that he is like Richard Nixon in that respect.

The bail out of Fannie Mae and Freddie Mac has had the effect of creating an open-ended funding possibility, which lies on top of a growing cyclical deficit and fixed expenditure related to defense spending. It was interesting to see brokers releasing estimates of fiscal deficits for the next couple of years which exceeded $600bn, with no certainty that these were the upper limits. There are comparisons with the Japanese economy in the 1990s, which fit until you realize that the Japanese opened their collective check books after years of having a 15% savings ratio. The U.S. simply isn't in that position and it appears to be gross folly to think that the U.S. can start flooding the world with bonds and dollars without there being consequences; anything that is over-supplied has a tendency to fall in price.

As we have said in these articles before, there is evidence that international investors (particularly the Japanese) are deserting the U.S.. To a large extent this has been masked by a new group of investors, which has excess reserves and an interest in 'stabilizing' the U.S. consumer. However, even this group will have the limits of its patience tested if it feels that there are better places to invest its money. For instance, witness how easily the South Koreans walked away from the bail-out of Lehman Brothers. The fact is that, if international investors feel that their reserves would be better spent at home, they will divert their money from the U.S. to their domestic economies and elsewhere. If that proves to be the case, the U.S. is heading towards a crucial funding gap precisely at a time when it needs the money most.

This brings us to our future bond and currency strategy for our global bond funds. The past few weeks haven't been a total disaster, as the underweight U.S. dollar position we have carried this year has been compensated for by our long-duration strategy. The two haven't exactly cancelled each other out; instead their combination has saved us from the worst of the possible outcomes. This has been the rhythm of the year; what was made on bonds was lost on currencies because what would logically happen in free capital markets just hasn't materialized. Although we wouldn't necessarily choose this as a starting place, it's probably the best we can think of: selling bonds at near their all-time yield lows and being overweight in currencies that have fallen 12% in the past six weeks (see chart).

As for bond policy, it is true to say that there is a degree of seasonality in the bond markets, particularly in the U.S.. Looking at averages over the past decade, there is a distinct pattern of bond yields falling in the latter half of the year, which in turn helps those seeking resets on their mortgages. If you plot what has happened since June against this current pattern, you can see clearly that this year the process has taken place faster than expected. Having had a long duration over the summer, it's time to take some of that risk off the table and concentrate on the currency allocations in the portfolio.