The week began with your editor wondering how the bond market would choke down another $81 billion in U.S. Treasury debt. On Monday, it swallowed $40 billion in three-year notes with gusto, and even belched in satisfaction. Demand, analysts said, hadn't been that strong since 1990-when the bond vigilantes used the bond market as a weapon to discipline government spending.
Then on Tuesday the market snapped up $25 billion in ten-year notes and yields fell. Sovereign debt? Big whoop! Whether it's the end of the year and investors feel safer in Treasuries, or some other reason, Tuesday's auction showed no signs of an impending "bond fire of the vanities." The bond bubble keeps getting bigger.
Today, though, the market gagged. In an effort to lock-in low rates for longer terms, the Treasury served up $16 billion in 30-year bonds. The market turned sour. Reuter's reports that demand for the 30-year was the weakest since May and that yields moved up as the weak auction triggered selling.
And then everyone seemed to lose their nerve. Stocks fell across the board. Gold set a new high at $1,123.40 in New York trading, before retreating. The weak 30-year auction has people thinking...what happens when Treasury supply overwhelms demand?
What will happen to bond prices then? To inflation? What should I do?
The rest of today's Daily Reckoning will be devoted to some constructive apocalysm. We may have left the impression yesterday that there was nothing but pain and heartache ahead for investors. But that doesn't have to be the case. But you have to start with the big picture. And that begins with the end of the bull market in bonds.
Check out the chart below from Ron Greiss at the www.thechartstore.com. Ron's chart shows long-term U.S. bond yields since 1941. Mostly this reflects the yield on 30-year bonds, although there were periods where 30-year issuance was discontinued. Either way, it shows a great cycle...which appears to be bottoming out.
What story does this chart tell? We reckon it shows you why the U.S. government (and so many banks and borrowers) are eager to sell as much debt now as possible. Rates are near historic lows. If and when they go up, it's going to make borrowing and servicing new debt even more expensive. Bond prices will fall and yields will rise again.
Now you could say that, according to the chart, there is room for another decade of low yields. The Fed, for example, could move to set rates further out on the yield-curve. It only sets rates right now for short-term debt. But the quantitative easing program has moved the Fed out to ten-year yields. It's done this to try and keep mortgage rates low, as mortgage-rates are keyed to U.S. ten-year yields.
But we reckon not even the Fed can keep yields low forever by supporting prices. It will have to wind down its programs eventually. For example, the U.S. government ran its largest October deficit ever last month, at $176 billion. Between demographics and existing debt, the Fed may not have the resources to support bond prices too.
Besides, you'd think markets would begin to tire of U.S. debt, given the lousy fiscal position of the American government. At least that's what we'd think. And if we were trading it, we'd look for put options on ETFs that track bond prices, or call options on ETFs that track bond yields. That would be the cheap trade.
The investment decision is to find assets that out run inflation as bond yields move up. Granted, this assumes there is going to be inflation, which is a whole other argument. But if you'll grant us the assumption, we'll continue with the strategy...of finding assets that beat inflation.
You don't have to look far. Gold...oil...iron ore...tangible assets are what you're after. Does this conflict a bit with our analysis yesterday that China's resource demand is more fragile than reported? Yes, it does. But it still pays to focus on those resources that will be in demand no matter how bad the global economy gets again. What do nation states really want to own? What can they not do without?
You know they can't do without oil. And you know more and more of them prefer to own at least some gold rather than rapidly devaluing foreign currencies. That leaves us where we began, buying oil and gold and selling U.S. sovereign debt. Production of the first two is hard to increase. Supply of the last one is growing.
"There is a strong case to be made that we are already at 'peak gold'," Barrick's Aaron Regent told London's The Daily Telegraph today. Regent was speaking at RBC's annual gold conference in London. "Production peaked around 2000 and it has been in decline ever since, and we forecast that decline to continue. It is increasingly difficult to find ore."
Gold exploration budgets are up. But with the exception of China, gold production from traditional stalwarts like South Africa and Australia has trended down. Alex Cowie at Diggers and Drillers recently wrote a report suggesting that the best Aussie gold stories are listed here in Australia but digging for gold in Africa, where they incur production costs in U.S. dollars and where there are more greenfield projects than recycled brownfield projects.
Frankly, we have no idea if gold production has peaked. Mine supply could grow this year for all we know. But finding and mining gold is not easy and it's not cheap. And even if the gold supply does grow, we'd take it to the bank that the global gold supply will not grow faster than global money supply.
And oil? Any scenario in which an economic collapse leads to falling GDP ought to mean lower demand for oil and lower oil prices. But the case for oil is not really about the demand side. You reckon that's bound to grow over time anyway, unless someone comes up with table top cold fusion. The real oil bull story is on the supply side.
Earlier this week the U.K.'s Guardian reported that, "The world is much closer to running out of oil than official estimates admit, according to a whistleblower at the International Energy Agency who claims it has been deliberately underplaying a looming shortage for fear of triggering panic buying."
" 'The IEA in 2005 was predicting oil supplies could rise as high as 120m barrels a day by 2030 although it was forced to reduce this gradually to 116m and then 105m last year,' said the IEA source, who was unwilling to be identified for fear of reprisals inside the industry. 'The 120m figure always was nonsense but even today's number is much higher than can be justified and the IEA knows this.'"
We remember writing about the IEA figure a few years ago. And we remember pointing out that producing 120 million barrels of oil per day would be a 44% increase on producing 83 million barrels per day. And you'd have to find that oil first. You'd have to explore, drill, and produce it. And you'd have to maintain existing production levels at the world's big elephant fields like Cantarell and Ghawar.
In point of fact, production at Cantarell has fallen by 25% since 2004. Energy expert Matthew Simmons says Mexico's days as an oil exporter will end in 18 to 36 months. This makes Mexico's government-which derives 40% of its revenues from oil sales-the most likely candidate for "next failed state."
By the way, if you think illegal immigration is problem in America now (and it is), imagine what would happen if the finances of the Mexican state imploded with a production catastrophe at Cantarell. The Obama administration would face another crisis, but this one right on its massive southern border.
Not everyone believes in Peak Oil. But it's not really a matter of faith. Either oil production is declining or it is not. It does not mean there isn't any oil left. In fact, technology has lengthened the life of productive fields. And technology has also made it possible to find and produce oil in increasingly hostile environments (deep water drilling, the Arctic, etc.)
Even rank and file petroleum geologists are mostly in agreement (and sometimes in disagreement with their corporate overlords) that Peak Oil is real and it's here now. But we make this point not to say that all is lost. It isn't. It's just the great changes in the world are afoot.
You have a secular bond bull that's long in the tooth. The post-war monetary system that supported the expansion of the fiscal welfare state through perpetual debt is failing. Energy, which has been getting cheaper and cheaper for years as we found more and more of it, may start becoming more expensive and harder to find.
That's going to make the world a slightly less friendly place. But for investors, there are heaps of opportunities. For example, right now Alex is looking at what the fallout from next month's Copenhagen summit is. It has opened the door to a great entry point for energy investments, but not necessarily oil. Fear not! Or fear a little. But prepare.
Dan Denning
for The Daily Reckoning Australia
P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.
Related Articles:
- Three Out of Four Economists are Wrong
- Between What Bond Investors Stand to Gain in Yield and What They Stand to Lose from Inflation
- Consumer Price Inflation has Spooked Investors Everywhere
- Everyone We Know Expects a Fairly Quick Up-move in Inflation
- International Energy Agency Rejects Possibility Crude Oil Output is in Terminal Decline
About the Author
Dan Denning is the author of 2005's best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 and has covered financial markets form Baltimore, Paris, London and, beginning in 2005 Melbourne. He’s the editor of The Daily Reckoning Australia and the Publisher of Port Phillip Publishing.
Comment by Docklenn on 13 November 2009:
Hi Dan,
I dont understand US Bonds. If US Bonds collapse what happens to US dollars? I am confused because i read that if bonds fall then rates rise which i thought we would positive for the dollar?
Comment by prozak on 13 November 2009:
Why do people ignore the facts?
Broad Money is not growing people! Wake Up! That is why all the central bank numpties are panicking!
It is broad money that matters.
US M3 YoY +<2% (shadowstats.com)
UK M4 YoY +2%
EURO M3 YoY -2%
The MoM figures are all negative.
Both the UK and US have had on average 8% YOY Broad money growth for about 10 years.... last few had been over 10%.
The economy gets hooked on broad money growth.... and it has to start growing more year on year than the previous year to get the same "hit".
Take that growth away and you start teetering on the edge of deflation.
High Inflation and HyperInflation are a long way from set in stone just yet.
Comment by prozak on 13 November 2009:
Docklenn (do you post elsewhere?),
In theory an increase in US I/R is USD positive.
But if the increase is due to inevstors shunning all forms of governement paper due to an oversupply of said paper (currency+bonds) and shifting dramatically to hard assets then the resultant higher interest rates wont necessarily save the dollar. (e.g. Iceland). It could cause a panick and collapse.
You can then add to that the US gov. then has a funding problem. Depending on how the Gov. decides to solve that problem it could exacerbate the USD / Treasuries decline.
Comment by Docklenn on 14 November 2009:
thanks prozak - and no i dont post anywhere else - this is my first go
Comment by prozak on 14 November 2009:
Docklenn,
no problem.
your name just sort of rang a bell.
here is some more detail if you have the patience to read it.
From "Inflation: Plus Ça Change" - by G Steele
"Fiscal monetarism differs from monetarism in directing attention upon the national debt which comprises the sovereign currency and various interest-bearing state liabilities (‘government bonds’). The value of a bond that is redeemable in currency is necessarily linked to the value of that currency. If the real value of the currency falls, then so too does the real value of those bonds. The central tenet of fiscal monetarism is that price inflation is not simply a consequence of growth in the supply of money but of growth in the overall volume of government indebtedness.
To understand this, it is important to recognise the difference between corporate borrowing and state borrowing. Upon maturity, corporate bills and state bonds are repaid in currency; but whereas corporate debt thereby falls, the redemption of bonds for currency merely changes the composition of the national debt, leaving its magnitude unchanged. From this perspective, the idea that bond-financed state borrowing competes against – and thereby ‘crowds out’ – corporate borrowing is too simplistic because, unlike corporate borrowing, state borrowing is not constrained by individuals’ willingness to save.
The ease with which the state can borrow rests instead upon the willingness of nongovernment agencies and individuals to hold state bonds and/or currency. The currency value of a bond (assuming, for simplicity, undated bonds) is obtained by dividing the annuity payment by the discount rate. Since annuity payments are financed from an excess of taxation over expenditure, there is an upper limit to state indebtedness. In theoretical terms, this is reached when (by their respective capitalised values) prospective annuity payments exhaust prospective fiscal surpluses. In practical terms, market-driven relative price adjustments constrain the real value of the national debt (as indicated, say, by the ratio of debt to national income) to remain at or below the level that private agencies and individuals are willing to hold.
Whenever that level is breached, there is simultaneously:
(a) An excess supply of government paper: the unwillingness to hold currency and/or bonds, drives down their value in relation to goods and services, equity, real assets and non-government financial assets.
(b) An excess demand for other items: the desire to purchase goods, services, equity, real assets and non-government financial assets, drives up their value in relation to currency and bonds.
With that debasement of currency and bonds, the value of the national debt falls in real terms to the level non-government agencies and individuals are willing to hold. It follows that general price stability is achieved only if the state accepts the discipline of an upper limit to the real value of its debt; it also follows that the relative proportions of currency and bonds held by non-government agencies and individuals are largely irrelevant. "
Comment by Docklenn on 14 November 2009:
Clear as mud
I think i get the gist though - too much supply and falling demand for US debt so the 'price' of US bonds/$$ will fall
But what happens if there is a correction in stocks and commodities like Dan is predicting? If everyone is selling US $$ and buying these assets and a bubble forms and then pops they have nowhere to put there money. They will have to pile back into US dollars because that is the only market that can take that amount of capital. There just isn't enough gold for sale
Also, i dont understand the theme of buying physical assets. Copper inventories are increasing quickly which suggests people are no longer buying it. However, if people buy copper because it is a physical asset then eventually people will own so much copper that when they try to sell it there will be too much supply and not enough demand and it will become worthless anyway
nothing really makes sense...