New Trend in the Market: Sell Bonds and Buy Commodities

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What will the end of the 30-year bull market in government bonds mean for other asset classes? That is where we left off yesterday’s holiday-shortened version of the Daily Reckoning. We take up the subject again today. But first a quick look at a market that has become simply irresistible. Yes, we’re talking about interest rates.

It’s becoming a bit of an obsession we admit. Interest rates are the last thing we look at before bed and the first thing we look at in the morning (even before coffee). They have made for compelling viewing in the last month. And oh what a story they are telling about the decline of Empire and the rise of…something else.

For a change, it was not just ten-year U.S. bond yields rising on Monday, although they were up to 3.89% as bond prices fell. Even the little old two-year notes are facing rising yields. The yield on the two-year U.S. note rose 11% to 1.42%.

These little cracks in the bond market are like the first small fractures in a plate glass window. Investors have a look at large government deficits everywhere and the fracture gets deeper and wider and leads to other cracks.

Central banks begin quantitative easing policies to buy up debt (some corporate, some mortgage-backed, and some which is their own cooking) and then you see the whole window blossom into rivers and rivulets of cracks, both beautiful and highly unstable at the same time.

And then someone comes along with a hammer, taps the pane gently, and the whole thing shatters like so much glass.

Of course, long-term bear markets in an asset class don’t always happen so suddenly. They begin with a reversal (which rising yields indicate), and then they fight conventional wisdom, losing an occasional battle. Today, for example, the U.S. dollar managed to rally a bit, while gold and oil fell.

But we think the early votes are in on the new trend in the market: sell bonds and buy commodities. It’s an inflation preparation strategy.

And why inflation? The proposed global deficits to combat the recession and the sickly credit markets are simply too large to be funded by private investors. “It is obvious that the Chinese and other surplus nations cannot fund the [U.S.] deficit even if they were fully on board — which they are not. Someone else has got to write checks for up to $1.5 trillion additional Treasury notes and bond,” writes Pimco’s Bill Gross.

“The concern is that this can be accomplished in only two ways — both of which have serious consequences for U.S. and global financial markets. The first and most recent development is the steepening of the U.S. Treasury yield curve and the rise of intermediate and long-term bond yields. While the Treasury can easily afford the higher interest expense in the short term, the pressure it puts on mortgage and corporate rates represents a serious threat to the fragile ‘green shoots’ recovery now under way.”

“Secondly, the buyer of last resort in recent months has become the Federal Reserve, with its publicly announced and near-daily purchases of Treasuries and agencies at a $400 billion annual rate. That in combination with a buy ticket for over $1 trillion of agency mortgages has been the primary reason why capital markets — both corporate bonds and stocks — are behaving so well. But the Fed must tread carefully here. These purchases result in an expansion of the Fed’s balance sheet, which ultimately could have inflationary implications. In turn, nervous holders of dollar obligations are beginning to look for diversification in other currencies, selling Treasury bonds in the process.”

Gross finishes with this advice: “Bond investors should, therefore, confine maturities to the front end of yield curves, where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago.”

Got that? Be in short term bonds. Sell the dollar. Own commodity-based currencies (actually Gross doesn’t say that, but we do!). And reduce your expectations for total returns. Not very cheerful, is it?

Gross may be underestimating the amount of money punters can make in small resource exploration shares. That’s probably because he manages billions of dollars. That keeps him in the fixed income market. He is too big a player to have a punt in small Aussie resource shares.

But we know that inflation fuelled rallies benefit smaller commodity stocks the most. And fortunately, there is no shortage of investment ideas or speculative bets in Australia. If you had to live in a world where investment returns were expected to be lower for awhile, you’d want to be in the one market where the returns on offer are still pretty double-digit looking. That’s Australia.

Whether those returns materialise will depend on our good friend China. And according to some reports this weekend from China’s official Xinhua news agency, Australia had better send flowers to Beijing soon, or at least chocolate. And probably an apologetic text message over this whole Rio business. A teddy bear wouldn’t hurt either. With a big red bow.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Dan I have been reading (and enjoying) both yours and Bill Bonners editions of the DR for over a year. I have generally found myself in broad agreement with your analysis of global economic developments. However, I suspect many of your Australian readers will share my difficulty with the whole gold thing, firstly would I really want it around the house. Secondly nobody I know sells the stuff (except jewellers at a ridiculous mark up)and trusting some bullion house website is not a very attractive option. Thirdly gold mining stocks seem to be more volitile than the commoditiy itself. If you have some practical suggestions or comments I am sure many of your readers would like to hear them.
    Cheers.

    Stephen Hargreaves
    June 9, 2009
    Reply
  2. Dan: I currently expect triple digit returns for all my selected gold & energy holds within 12-18 months. If the resource base is there it has to be paid for (by the market) sooner or later.

    It’s unlikely that all stocks in the junior to mid-tier gold & energy sectors will move in unison or over extended periods of time. As we all know, upward (and downward) changes tend to be short, sharp, unpredictable and sometimes short lived.

    Assuming a punter’s company expectations are realistic, however, profits from companies that have moved can be taken then applied to those that are yet to move (at a high risk premium of course). Such a strategy may or may not work but it does create potential for truly massive gains (less capital gains tax of course) from a small outlay.

    On a note of sobriety, I agree that a bond market collapse could take out everything including gold and energy companies that lack rebound capacity.

    Cheers

    Coffee Addict
    June 9, 2009
    Reply
  3. You guys are ignoring the risk of a second bounce of the reversal of leverage playing out on the US hedge funds as the off balance sheet vehicle window closes on the banks and the US bank stress tests are found wanting as the US services economy stalls further. This could intersect with China topping out its stockpiles later this year. The finite TARP money book and misdirected lending into market making trading desks has to top out and we have already seen that any sign bad news on commodities and they run like startled chooks, the USD suddenly spikes up and the hot money runs home as resource stocks drop. Day trading based on variations coming into the day on the USD with the indexes XMJ/XEJ on one side and the XHJ on the other could be safer and more lucrative.

    Reply
  4. I hope you do well CA, partly because I have a similar game plan.
    In reference to your last sentence CA, would this be a good reason to keep and increase physical metal but also to play a rising PM market, in part through options,CFDs ie long gold/silver ie to limit exposure to stocks. Im struggling to understand these latter areas before its too late.
    On gold I note a significant shift away from short and into long at the Comex. Maybe a mega rise of price in next couple weeks/months. Go gold!

    Reply
  5. Dan, you imply ‘loss of face’ and I guess that’s an issue for China. We see representatives of both shades of the political spectrum (Barnett & Rudd) scurrying off to China, with flowers and chocolates. Is it really necessary? As DR has noted, weekly, China is actively seeking replacements for the USD: gold, stockpiling of critical resources, acquisition of key mining players…. .

    In reference to interest rates… the US and Australian situation are somewhat ‘poles apart’. Tens of thousands of unfortunate souls who locked into three-year fixed interest at around 9% in 2006 and 2007 are about to renegotiate their loans with MASSIVE monthly savings. Many will get 5.11%; as we do. This seems diametrically opposed to the looming interest rate hike many Americans face.

    Are we all aware that it’s now two years (this week) since the crisis began? I look for some indication that property in Australia has really been affected. Though we continually search for such treasure, we have located (and bought) just _one_ property which is the result of a distressed sale. And this was the result of a developer holding a nice block with water views, for a whole year, for a 457 visa holder who was never going to be able to attain the residential purchase criteria. Where is this promised property crash? For two years I’ve been reading about it… and it evades us… ! :(

    Biker Pete
    June 9, 2009
    Reply
  6. Great article…BUT…some well thought out views put forward by authors such as Prechter, Dent et al in the US which indicate deflation not inflation could be 2009/10 major event due to an impending contraction of credit. So does Joe Average in the street need an inflation or a deflation preparation strategy?

    Reply
  7. My comment is alomg the lines of Richo I am fairly new to investing but I am hearing conflicting strategies around deflation, inflation.

    The main one being buying long term bonds

    Reply
  8. Of course the smart money may not be in small cap Australian stocks at all. Maybe demand for many commodities will remain weak for years and smaller sized/higher costs miners may hit the wall? Perhaps China will simply source more of their iron ore from Russia or Africa for example?

    A lot of people appear to assume that Australia will continue to ride the commodities boom…maybe we will, maybe we won’t. But if you read more than Australian newspapers you will see that China and Japan are quietly looking to find alternative sources of commodities and might just be a touch annoyed that they were ripped off during the boom.

    Reply
  9. Richo, the answer to your question is a definite YES.

    Biker Pete
    June 10, 2009
    Reply
  10. Prechter thinks people will buy back into bonds as yields increase therebye averting the need for monetisation of debt. Is this really likely? Why would anyone want to buy into US debt now?
    How long till we see budget deficits increase by 50%? Who will want US bonds?
    Inflation will prevail eventually even if stocks take another dive short term. And after all its what Ben wants and hes the one with the keys to the helicopter.

    Reply

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