Happy Thanksgiving

This Thanksgiving we have much for which to be thankful. We live in the greatest country on earth. We have the love of our family and friends to brighten our lives and we (hopefully) have our health. There is something else for which we all should be thankful, foreign central banks. Thanks to indirect bidders (which consist primarily of foreign central banks), this week's treasury auctions (2-year, 5-year and 7-year) went very well. In fact today's 7-year auction was she strongest since last July. Not surprisingly, prices of long-dated treasuries rallied following the auction. What was surprising was the selloff of long-dated treasuries just prior to the auction. Did people really think that the auction would be a flop? For the past two months, predictions of waning interest among foreign central banks have been rampant. These predictions have been base on text book theory instead of reality.

Text books tell us that when a country lowers short-term interest rates, issues large amounts of debt relative to GDP and attempts to devalue its way out of a financial crisis, inflation and higher long-term rates are the result. The text books are correct in most circumstances, but not when it pertains to the U.S., not now. The U.S. is unique in that it is the largest market place for goods produced around the globe. This means that exporting nations need to moderate the dollar's slide by purchasing dollars (in the form of U.S. treasuries) which simultaneously results in selling their home currencies. Failure to do this results in exporters either raising prices (which could result in reduced market share) or smaller profit margins. Foreign central banks must either purchase dollars or peg their home currencies to the dollar as China has done. Pegging to the dollar has its own internal inflationary consequences so it is usually command economies, such as China, which engage in this practice as they can dictate prices and supply of goods to their consumers. At some point the U.S. may not be the dominant market place, but that day is not yet on the horizon. Look for continued strong buying of U.S. treasuries until inflation pressures resulting from growth take hold.

Growth driven inflation is not yet on the horizon because bank cannot lend the way they had in the past because they cannot securitize and sell low-quality loans to unsuspecting buyers (with the help of cooperative ratings agencies). Borrowers will have to prove their creditworthiness. Consumer borrowing will return to levels which were common before 25 years of rate declines and financial engineering by quants who have no clue why historical data was what it was, only that it was.
I had an interesting conversation with a financial adviser who was shocked that Moody's may downgrade bank preferreds, She stated that she believed that the bank troubles were past and that the stock market, oil prices and gold prices were up on string growth expectations. I explained to her that radioactive assets continue to poison the balance sheets of many banks, large and small and that commodity prices and the equity markets are rallying due to the weaker dollar. She was dumbfounded by my assessment. I am no genius. Most fixed income traders, analysts and strategists know exactly why certain assets prices are rallying. the problem is that most financial advisers are equity oriented. The U.S. treasury market is the best gauge of economic and inflation out look. It is what makes that market tick. The treasury market is telling us that economic will be unspectacular for some time. This is your father's economy. Get used to it.

Happy Thanksgiving.