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A consensus is building among market observers
that bonds defy all logic. The falling dollar should make dollar bonds fall,
too. After all, bondholders stand to lose a large part of the value of their
original investment as a result of the depreciating dollar. Yet the bull
market in bonds that started almost 25 years ago is still intact. The
following comments may help put some of the logic back. As a preliminary I
would like to remind readers that a bull market in bonds is the sine qua
non of the deflationary spiral under the Kondratiev
cycle. Pimco's Bill Gross is premature in writing
the obituary of the bond bull. Other observers' opinion that a dramatic rise
in interest rates, which appears to be imminent, is likely to serve as the
trigger for the Kondratiev winter is probably wrong
as well. On the contrary, I shall argue that a continuation of the bull
market in dollar-bonds will do that particular trick. I consider any
weakening in dollar-bond prices a bear-trap.
Here are my premises. The perspective on the
bond and foreign exchange markets is distorted by the smoke-screen
surrounding a gigantic speculative scheme known as the yen carry-trade. This
is how it works. The Japanese are printing yens, not to support productive
enterprise but to finance speculation. Next, the ball is in the Fed's court.
The Fed obliges and prints dollars, again not to support productive
enterprise but to serve as a drop-off point for speculators. Japanese
interest rates being so low, speculators can borrow yens at around 1.5%, sell them for dollars to be invested in US Treasuries
yielding 4 to 5%. The speculators pocket the difference without performing
any useful service whatsoever. The yen carry-trade is firmly in place,
allowing the US debt markets to defy gravity. The question is when this
scandalous charade might end. To answer it observers look at another key
market, that of the dollar, and conclude that the obvious bear market will
spell the end of the yen carry-trade. As the dollar falls, the Japanese and
the Chinese may threaten to start dumping it and to put an end to its reserve
currency status. Only a dramatic rise in interest rates may save the dollar
as the world's reserve currency.
This is where I take issue with the
conventional wisdom of those observers who, like myself,
think that the deflation threat is serious. What they miss is the fact that
the bear market in the dollar actually helps rather than hurts the yen
carry-trade. The terms of trade for those who sell yens to buy dollars is improved immensely by the fall of the dollar. The yen
carry-trade can be described as arbitrage with short leg in the yen bond
market and long leg in the dollar bond market. Profits on the long leg
increase far more than losses on the short as a result of the
dollar-devaluation. The faceless bond speculators are sitting on a huge pile
of profits already that have been accruing for a quarter of a century. They
can well-afford to prevent Humpty-Dumpty (read: the dollar) from having a
great fall from its perch as a reserve currency. This particular cash cow can
be milked yet for quite a bit longer with careful husbandry. It would be a
folly to let it be slaughtered just at the time when milk (and honey) output
is at peak.
What I am suggesting is that bond speculators
are calling the shots, and central bankers willy-nilly play balls with them.
The alternative is sudden death. Without bond speculation the regime of
irredeemable currencies would have come to a sad end thirty years ago.
Speculators well-understand the dynamics of competitive currency
devaluations. The present round started ten years ago when the yen was
devalued 50%. In the intervening years the ruble
collapsed along with other Asiatic currencies. Right now it is the turn of
the dollar. It will be interesting to watch whether and when the euro will
succumb to the temptation, as I predict it will, in spite of the brave talk
we are hearing from Brussels. This is just a replay of the 1930's with the
yen playing the role of the leading currency. To recapitulate, if the yen
carry-trade was profitable during the last ten years of a weak yen, then it
would be a hundred times more profitable during the next ten years of a
strong yen.
It is a mistake to look at the falling dollar
as the result of the profligacy of the American consumers, and a direct
outcome of the American trade deficit. This is just a decoy. Admittedly, it
is a clever one as far as decoys go. It is designed to divert attention away
from the real culprit, which is the yen carry-trade
and its obscene profits. The falling dollar is part of the big picture of
competitive currency devaluations, or of the even bigger picture of the Kondratiev cycle. But let us not forget that at the same
time it is a powerful booster for the yen carry-trade. Let the public buy the
nonsense of Milton Friedman that the falling dollar is just the manifestation
of the adjustment mechanism balancing the American trade account. Or let it
buy the equally fallacious Quantity Theory of Money predicting that the dollar
will be printed into worthlessness. The truth is that there is an
insatiable demand for dollars, especially for falling ones, by bond
speculators.
According to the 19th century French economist
Frederic Bastiat, economics is a game of distilling
what you don't see from what you do. In the present case what you see is the
American trade deficit, which can easily be blamed on the appetite of the
gluttonous American consumer. What you don't see is the accumulating profits
of the faceless bond speculators, sucking the life-blood from the world
economy. This is exactly the same point that was missed in the Great
Depression of the 1930's by all economists. They are going to miss it again.
The world is going to repeat all the mistakes it made then, because it has allowed
the government and the economists' profession to fabricate a theory of the
Great Depression that puts the blame squarely on the gold standard. The price
has to be paid for pushing gold out, not just from the monetary system, but
also from the research agenda of universities and think-tanks!
It is not hard to predict the further course
of the ongoing depression if you can divine the strategy of the faceless bond
speculators. They will definitely want to keep the irredeemable dollar as a
reserve currency for as long as it serves their purposes, which may be for
another decade or so. The dollar is not going to have a precipitous fall. It
will decline further, but the decline will be controlled. The important
decline determining the course of deflation, however, is not that of the
dollar, but that of the American rate of interest as it follows in the
footsteps of the Japanese with a ten-year delay. The twin deficits will
continue to baffle commentators who are too dim-witted to understand that
they have fallen victim to clever prestidigitation.
It reflects woolly thinking to talk about a
repetition at this stage of the Volcker-miracle, 1980 vintage, in saving the
dollar from sudden death by applying the shock-therapy of high interest
rates. In the present situation the real miracle will be to save the
dollar by a falling rather than a rising interest-rate structure.
Remember, 1980 marked the blow-off phase of the inflationary spiral, and the
beginning of the deflationary. Right now the world is entering the depths of
the deflationary spiral, and vintage therapy is out of place.
I define inflationary spiral under the Kondratiev cycle as the decades-long rise of prices and
interest rates, and deflationary spiral as their similarly long fall.
Interest rates may lead and prices may lag, or the other way round. The
important thing is the linkage. Prices and interest rates are inevitably
linked. Linkage epitomizes a huge oscillating money-flow back-and-forth
between the bond and the commodity market. When the money-tide begins to flow
at the commodity market and ebb at the bond market, we have the inflationary
spiral. When the tide is reversed and it flows at the bond and ebbs at the
commodity market, we have the deflationary spiral.
These tides must run their course. They are
too powerful to be diverted by contra-cyclical monetary policy. Central bank
intervention is counter-productive. It acts only to prolong the cycle and to
make it even more devastating. During the inflationary spiral the main worry
of the central bank is the high and rising rate of interest. To combat it,
the central bank resorts to open market purchases of bonds in order to put
money into circulation, hoping that it will flow to the bond market to bid up
prices there. But speculators know better, and they divert the flow of money
to the commodity market. Prices rise. Linkage will then make interest rates rise more, contrary to the wishes of the central bank.
During the deflationary spiral the main worry
is low and falling prices. To combat it the central bank once again resorts
to open market purchases of bonds in order to put money into circulation,
hoping that it will flow to the commodity market to bid up prices there. But
speculators forestall the central bank in buying the bonds first. Interest
rates fall. Linkage will then make prices fall more, contrary to the wishes
of the central bank. To recapitulate, in the inflationary phase of Kondratiev's cycle the central bank wants to bring down
interest rates but, instead, causes prices to rise which leads to still
higher interest rates. In the deflationary phase it wants to raise the price
level but, instead, causes interest rates to fall which leads to still lower
prices. The contra-cyclical policy of Keynes backfired in either case,
because Keynes was ignorant of the linkage.
Some years ago I put forward a new theory of Kondratiev's long-wave cycle* revealing its cause as the
fluctuation in the propensity to hoard. This fluctuation is in turn caused by
the centuries-old wrong-headed policy of banks, aided and abetted by the
government, in obstructing the flow of the gold coin to the saver whenever he
finds the rate of interest unacceptably low. The flow of gold in and out of
the banks is the mechanism whereby the saver regulates the rate of interest
under a gold standard. You cannot take away the saver's right to control bank
reserves with impunity. Gold is the natural conduit for hoarding. If you
obstructed gold hoarding, the saver would have recourse by hoarding other
marketable goods. This would, however, have some serious side effects. It
would generate the Kondratiev cycle with its
devastating flow of money back-and-forth between the bond and the commodity
market.
The tide of money in the commodity market
triggered a tsunami in 1980 when it dawned upon owners of commodities that
their hoards could no longer be financed at high interest rates in view of
high prices. When they panicked and ran to the exits, most were
trapped. A painful process of decades-long inventory liquidation began. We
are at the stage right now where businesses must reduce high inventories at
falling prices, while speculators make a killing in bonds.
February 28, 2005
Dr. Antal E. Fekete
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