Why Iraq is bad news for financial markets (page 1 of 2)

A word of caution: The September to November period is seasonally a weak period. Expectations in the US are now an extreme and reflect a very optimistic sentiment about an economic recovery and higher stock prices directly ahead.

Any disappointment could lead to a sharp sell-off or even a crash, which would temporary strengthen the bond market. A new high in the bond market appears, however, to be most unlikely.

I have recently taken a negative view about bonds... despite the almost universal consensus that bond markets around the world had reached a bubble peak and would from now on decline. The so-called 'reflation trade', which most strategists are advocating, implies that the selling of
bonds and the purchase of equities is the way to play of the day.

Recently, however, I received a study by Ray Dalio and Jason Rotenberg of Bridgewater Associates, an institutional economic service I highly recommend, which pointed out that whereas the twin deficits - the budget deficit and the current account deficit - exploded in the period from 1983 to 1987, and in the process weakened the US dollar, bonds continued to rally from their secondary lows in 1984 (the major low was reached in September 1981) until 1987.

Bridgewater doesn't buy the argument that the present bulging twin deficits, each of which will soon reach around 5% of GDP (a record, I might add), is necessarily be bearish for bonds. The Fed has the means to create sufficient liquidity to support bond prices and simply let the dollar slide in order to make the necessary adjustments.

Since I religiously read the research papers published by Bridgewater Associates, I did some thinking about whether bonds could resume their 22-year bull market and confound the consensus, while the dollar weakened much further. In the process, I discovered some important fundamental differences between the present situation and the economic conditions that prevailed in the 1984-1987 period, which permitted the bond market to rally while the dollar was tumbling.

First, when bonds began to rally in the fall of 1981, they had completed an almost 40-year bear market. In addition, the 1983-1984 renewed weakness in bond prices saw the yield on government bonds spike up once again to over 14%, whereas inflation had by then already declined to less than 4%. Thus, in 1984, bonds had an unusually high real yield, as the investment community still believed that inflation would reaccelerate at any time.

In other words, in those days, inflationary expectations were extremely high, because investors were conditioned by the highly inflationary 1970s during which it appeared that there was no end in sight to rising commodity prices and inflation rates.

However, when commodity prices continued to decline between 1984 and the summer of 1986 and the CPI declined to around 2.5%, while at the same time the Producer Price Index was briefly deflating, bonds staged a huge rally, bringing yields down from above 14% to less than 7.5%. Now, however, it seems to me that the very high inflationary expectations of the early 1980s, which led to record-high real interest rates on long-term bonds, have been replaced by widespread complacency about future inflation rates and, in fact, fear about outright deflation.

Another point that should be mentioned is that, whereas until 1987 the US had a positive net investment balance (it owned more assets abroad than foreigners owned assets in the US), this has today been replaced by a negative investment balance, which amounts now to around 25% of GDP and is currently growing by around 5% of GDP.