Pulling Mussels From A Shell

The tug of war between the bond vigilantes on one side (trying to pull long-term treasury yields higher to keep government borrowing (and spending) in check) and the Fed and our "trading partners (which are trying to keep consumer borrowing costs low and the dollar strong) continues. During my discussions with lay people and financial advisers alike it appears as though many people are not aware of the influence exerted by foreign investors (corporations and foreign governments alike.

Many in my audience are not aware that our foreign trading partners have vested interests in keeping U.S. borrowing rates affordable and their home currencies weak relative to the U.S. dollar. Why would they want their currencies weak versus the dollar? It comes down to purchasing power. Nations such as China, Thailand, Japan, etc, have export-driven economies. If the U.S. dollar weakens versus their home currencies, their goods become more expensive for U.S. consumers. There is a fierce global battle for market share and our foreign trading partners will do whatever they can to succeed. Thus the appetite for U.S. treasuries is large.

How large is the appetite for U.S. treasuries among foreign governments and corporations? Their appetite can be described as ravenous. Our foreign trading partners are flush with dollars from selling their products in the U.S. They simply invest those dollars in U.S. securities, most often longer-dated U.S. treasuries. This serves to give them a low risk investment, fairly good return and the added benefits of keeping long-term borrowing costs low and lend strength to the U.S. dollar. Oil producing nations are similarly incentivized. Until (or unless) our trading partners can generate significantly more internal consumer demand, there will be continued support for the dollar and continued buying of U.S. treasuries, but that would involve granting individual freedoms that many of our trading partners are not prepared to do. Last week's healthy three-year, ten-year and thirty-year treasury auctions indicate that foreign investors are very much in the game.

What about alternative currencies and markets? Alternatives are problematic. China will not permit delivery of its debt or currency outside of its sphere of influence. The Japanese are net savers. More than a decade if basically free money at nearly 0.00% interest rates have not been able to spark Japanese consumer spending. What about the EU? What about it?

The EU is a loose and fractious institution. Consumer spending is not on par with U.S. consumers. Also, its financial system and banks are in worse condition than those of the U.S. Imagine that!! Look for long-term rates to rise gradually in a two step forward one step back fashion. Absolute interest rates will also be limited by the Fed. If inflation or higher rates due to inflation fears get out of control, look for the Fed to become less accommodative. The Fed's problem has been the reverse of stopping rates from rising too far in recent years. Remember back a few years when the Fed could not get long-term rates to rise in spite of aggressive tightening. Greenspan's conundrum was no such thing. Foreign investors were keeping long-term rates low and Mr. Greenspan knew this full well. However, he could not state such as it would have exposed the Fed as being somewhat impotent. Remember, the Fed controls the short end of the curve, but it is the bond market, the so-called vigilantes, who control the long end of the curve.