Bond marketers reverse Bush's praise deficit

By Michael Coote

Friday 14th May 2004

As the US presidential election campaign gathers pace, Democratic hopeful John Kerry keeps attacking incumbent George Bush for the latter's allegedly poor record on jobs and the Iraq invasion.

George W Bush has presided over the loss of millions of US jobs and is fair game to blame in election year, even though he came into office after one of the largest asset bubbles in history had begun to burst.

There is one type of job market that President Bush is the unsung hero of. He receives too little credit for his huge federal deficit and the way in which this debt mountain has revived the fortunes of those who work in the bond markets.

Reversing the praise deficit for President Bush the job creator, is Kumar Palghat, executive vice-president of global bond fund manager Pimco.

Palghat was in New Zealand recently as a guest speaker for Tower Asset Management.

He said that under the Clinton administration, there were budget surpluses projected out for years to come and talk of the end of the US bond market by 2007.

Then along came President Bush to the rescue by blowing the surpluses and plunging the US taxpayer headlong into an abyss of federal debt. Lo and behold, the bond fund managers could once more contemplate longer-term career prospects in the business. Markets awash with US government debt mean there is plenty to be getting along with for years to come.

Palghat reiterated Pimco's house view, commented upon in this column previously, that the US Federal Reserve is facing huge risk over 2004/5 in moving successfully from a reflationary to a neutral interest rate stance.

There can be little doubt that the Fed has created asset bubbles in bonds, stocks and housing by maintaining what are effectively negative interest rates after inflation.

What is so unusual about the Fed's current position, said Palghat, is that never before in his lengthy professional recollection have so many people hung on so anxiously to the central bank's every word for some indication, however ambiguous, of when and how the shift back to neutral monetary policy will take place.

Pimco's pick for where US interest rates are headed is that the Federal Funds rate will go to 2.5-3% nominal, or 1.5% real by mid-2005.

There will be a bear market for bonds but not as savage as the one of 1994, and US 10-year notes will hit 5-5.5% yield. Currency carry trades on the euro and Australian and New Zealand dollars will suffer with the narrowing of spread differentials.

Bond markets in reflationary economies like the US will underperform, whereas in pre-emptive economies like the UK, Australia and New Zealand they will outperform.

Palghat advanced the formula that the US current account deficit = working capital needs of world trade + changes in foreign central banks' reserves.

What is odd , he pointed out, about the US current account deficit at present is that it is growing at a slower rate than increases of foreign primarily Asian central bank US dollar reserves mainly held as US government bonds.

Over the past 12 months the increase in central bank reserves has been $US150 billion higher than the increase in the deficit. This suggests the deficit is now too big, relative to the need for working capital, to fund a marginal increase in world trade.

It also raises the question of what the Asian central banks, especially China and Japan, intend to do about their high US dollar holdings.

It appears the Bank of Japan has quietly dropped its plan of supporting the US dollar after having hit historic highs in dollar purchases over 2003/2004. Japan's central bank can probably bet that the country's ongoing economic recovery can withstand a higher yen.

It will have to hope that the recovery taking place is the real thing and not another false dawn like so many before in the land of the rising sun.

China has become a critical piece in the world economic puzzle, having accounted for a quarter of real global GDP growth over the past five years. The People's Bank of China has recently changed its own monetary policy to a pre-emptive tightening as it attempts to slow China's breakneck pace of growth. In Chinese CPI inflation by sector, standouts are a rate of 2.8% for residential property and 8% for food. Year on year producer price inflation was running at 3.5% in February, while manufactured producer goods prices rose 4.2% year on year. In response, the Peoples' Bank has hiked the upper limit on interest rates at which it lends to commercial banks and raised from 7% to 7.5% the reserve requirements of substandard financial institutions.

Central bank watchers have a new member of the heavy hitter's club to keep an eye on apart the usual suspects of the Fed, the ECB, the Bank of England and the Bank of Japan. What the Peoples' Bank of China decides about its monetary policy will have increasing global impact, as could become evident at a time when the US dollar is vulnerable to a current account deficit that has out-run trade requirements.

Meanwhile, fund managers like Palghat will be kept busy with the Bush war bond boom, bear market or "no in the offing."

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