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The Daily Reckoning | Monday, November 29, 2010 Liar, liar bond market on fire: betting on Helicopter Ben's "success," A battle of creditworthiness: John Q. Mortgage-Holder vs. Uncle Sam, Plus, Bill Bonner on casus belli in Costa Rica, blundering bailouts in Europe and a cold breeze blowing through London... -------------------------------------------------- Truth in a Bull Market The Long and Short of Treasury Bond Yields Eric Fry Reporting from Laguna Beach, California... "Prices are liars," says Passport Capital's investing ace, John Burbank. But even liars sometimes tell the truth. Trying to discriminate between the liars and the truth-tellers is every investor's most essential - and most difficult - task. Some bull markets are the real deal; others are simply bear markets that would fail a polygraph test. Consider some of the bull markets of the moment... Stocks, gold, bonds, grains, oil, Chinese real estate and Sarah Palin's popularity have all been in rally mode for months, if not years. Which ones are lying? Your California editor has no definitive answers, but he has a few heartfelt guesses... The truth-tellers: gold, grains and oil. The little-white-liars: stocks and Sarah Palin's popularity. The pathological liars: Chinese real estate and bonds. Jim Chanos, the insightful short-seller who has amassed a fortune by identifying - and betting against - fatally flawed companies like Enron and Tyco, considers the Chinese real estate market to be a disaster in the making. "It is Dubai times 1,000...or worse," says Chanos. "Bubbles are best identified by credit excesses, not valuation excesses. And there's no bigger credit excess than in China." By extension, Chanos believes Chinese stocks are better sold than bought. His arguments are persuasive. But today's edition of The Daily Reckoning will not address the validity or fallacy of the bull market in Chinese real estate. Instead, your editors will turn their skeptical gaze toward the bull market in bonds - and in particular, the bull market in Treasury bonds. The US Treasury market has been rallying - more or less - for the last 30 years. Back in 1981, when then-Federal Reserve Chairman, Paul Volcker, was battling to contain hyperinflation, 30-year bond yields topped 15%. Twenty-seven years later, during the crisis of 2008, the 30-year yield plummeted to an all-time low of 2.55%. Over this identical timeframe, one-year T-bill yields plummeted from a high of 14.93% to a low of 0.19%. That is a bull market! But a fascinating - and perhaps telling - divergence has developed between the 30-year yield and short-term Treasury yields: the 30-year yield is climbing, short-term yields are not...at least not very much. As a result the yield curve - i.e. the spread between long- and short- term rates - has reached its steepest level in three decades. To express this divergence a little differently, the 30-year yield hit its all-time low two years ago, and has soared from 2.55% to 4.17%. The one-year yield hits its all-time low two weeks ago, and has barely budged since then. According to dusty, old economics textbooks, a rapidly steepening yield curve portends resurgent inflation. But according to the esteemed academic, Ben Bernanke, a steepening yield curve is a sign that his battle against deflation is "succeeding." We trust the textbooks more than the academic...especially because the academic insists on fighting an enemy that he, alone, can see. Most of the educated world considers the threat of deflation to be as real as the threat of fire-breathing dragons. Nevertheless, Ben Bernanke, our well-intentioned knight, draws his shimmering QE2 from its sheath and strides into the T-bond market to vanquish his mythological enemy. Ben's quest will certainly "succeed," but he will probably lop off the head of the bond market in the process. Remember, prices are liars. And in the Treasury bond market, the short end of the curve can lie much more easily than the long end, thanks to Bernanke's QE2 campaign. Because Bernanke's bond-buying quest is focusing on the short end of the curve, he is distorting prices. "The Federal Reserve's plan to buy $600 billion of US government debt will focus about 86 percent of its purchases in notes due in 2.5 years to 10 years," Bloomberg News relates, "leaving the so-called long bond as the security that most closely reflects expectations for inflation." "We live in a time in which market distortions are higher than usual," our colleague Chris Mayer observes. "This thought really hit me when I saw something that I probably never should have seen: For the first time ever, the rate on 30-year mortgages slipped below that of 30-year Treasury bonds. In effect, the market was saying that an individual looking to borrow against his home is a better credit risk than the US government." This "market distortion," Chris explains, is the direct result of the Fed's meddling at the short end of the curve. "The usual spread between 30-year mortgages and the 30-year Treasury bond has been around 1.3 percentage points in recent years," says Chris. "Therefore, assuming the Fed can't continue its manipulations forever, it's a good bet that mortgage rates will rise after QE2 wraps up." It's also a pretty good bet that long-term rates will continue rising as Bernanke's deflation-fighting escapade "succeeds." In today's edition of The Daily Reckoning, guest editor, Steve Belmont, provides the A-B-Cs of betting against the bond market. The Daily Reckoning Presents Time to Sell Bonds Steve Belmont Every time a frightening headline jolts the financial markets, investors flock to the relative "safety" of US Treasury bonds. But just how safe is a "safe" Treasury bond? The most insidious and dangerous part of the global debt story is hiding in plain sight. US Federal debt is now roughly 85% of American GDP, according to "official" figures. But after including the present value of future liabilities like Social Security and Medicare, US debt- to-GDP soars to nearly 500%. This kind of debt could push even the world's most powerful nation down the slippery slope to default. If China, Japan and other big foreign American creditors abandoned the Treasury market, bond prices would plunge and bond yields (which move inversely to price) would soar. Tellingly, bond prices have been dropping already, despite the Fed's massive $900 billion quantitative easing ($600 billion of new money and $300 billion from maturing securities) initiative designed to keep bond prices high and yields low. US Treasury debt was once regarded as the safest in the world, but that is changing faster than most realize. Earlier this month the yield on 30-year Treasury bonds climbed briefly above 30-year fixed-rate mortgage securities. This bizarre configuration still persists, which means that the market views John Q. Mortgage-Holder as a safer credit than Uncle Sam. This is not a bullish development. The Fed's announcement of its $600 billion quantitative easing (QE) program was a shot aimed squarely at China in retaliation for the Middle Kingdom's refusal to let the yuan float. In effect, the Fed is "exporting inflation" to China. Here's how: Low interest rates and a cheaper dollar encourage assets to flow into China, pushing up the prices of Chinese stocks, commodities and real estate. This causes China's workers - the source of cheap labor responsible for the bulk of China's growth - to demand higher wages, thereby reducing China's competitive advantage. Chinese CPI has accelerated to 4.4% on an annual basis and is quickly becoming a big problem. China's criticism of Helicopter Ben's latest round of quantitative easing is directly related to the inflation the US is now exporting to China. Ben has given them a choice: increase the value of your currency or inflate. Neither choice is very attractive. The Chinese need exports to maintain a high growth rate, currently 9.6% per year. They also need rapid growth to dampen potential domestic unrest. The vast majority of Chinese are rural and poor. Until these folks are integrated into the economy, China will remain trapped between the need for growth and the threat of growth-killing inflation. Like a cornered animal, this makes China potentially dangerous - especially when the policies of one of its biggest customers are fueling this inflation. The Chinese are already busy trying to counteract the inflationary effects of Ben Bernanke's QE2. They've raised both interest rates and reserve requirements at banks - the latter numerous times. They've also tried to slow the influx of foreign money through capital controls and to slow inflation through price controls. The one thing they haven't tried is selling their massive holdings of US Treasury debt. At almost $900 billion, China is the biggest holder of US Treasury securities. Selling some of this hoard would send some return fire Ben Bernanke's way. We can't think of a better way for China to rid oneself of dodgy US debt then to sell it right back to the American Federal Reserve. Should China start selling, bond prices could drop fast. Perhaps the best clue to the future of bond prices is the market itself. Bond prices began falling in August after Ben Bernanke's infamous Jackson Hole, Wyoming announcement of the Fed's QE program. Subsequent rallies have failed to take out old highs, establishing a new downtrend in the process. The proper way to trade a downtrend is to use corrective rallies as selling opportunities. Short-selling US Treasury debt is difficult to do for individual investors. However, we can use the T-bond options traded on the CME to construct a trade with both limited risk and the potential for a nice return. Our 115-00 downside objective is not unreasonable, especially when you consider that this is precisely where T-bonds were trading back in April of 2010, just prior to the "flash crash" in stocks. Longer-dated options in bonds can be a bit thin, so patience may be required. Regards, Stephen Belmont, for The Daily Reckoning Joel's Note: Steve Belmont is a founding partner and Senior Market Strategist for the RMB Group. He is also managing editor of the exclusive alert service, Options Edge, as well as author of the popular RMB Short Course in Futures and Options. A featured speaker at many investment conferences, Steve has traded commodities and commodity options for over 25 years. In association with Options Edge and Income Booster, he provides exclusive research and recommendations to RMB Group customers. Six BETTER Ways to Save Your Financial Future Steamed by what those idiots in Washington are doing? Then I urge you to watch this special new video presentation. Because it gives you a "road map" of SIX stunning events that could soon improve you're life - without a handout from DC! Just click here to discover the SIX EVENTS about to change your life forever. Before we dive into our Reckoner-in-Chief's daily musings, here's Addison Wiggin, with an important announcement from our Baltimore HQ... Addison Wiggin As you may know, we've been filming a documentary on entrepreneurship in the bailout and stimulus period after the Panic of '08. We've been following, among other folks, the trials and tribulations of undersea salvage superstars Greg Stemm and Mark Gordon, in their quest to win the rights to market $500 million in coins they've recovered from a shipwreck off the coast of Gibraltar. As longtime readers of our various publications well know, the Odyssey story is pretty fascinating in its own right... But tomorrow you have a chance to catch part of the film production in action. Working with Dan Rodricks, host of "Midday", a show on WYPR, our local NPR station, we've invited a panel of "experts" to answer a timely question: How can we re-ignite the fires of entrepreneurship that made America "the most competitive economy in the world" for much of its history? Among the guests are two Vancouver favorites, president of Odyssey Marine Mark Gordon and venture capitalist Juan Enriquez. Mr. Enriquez, among other groundbreaking projects, helped finance the mapping of the human genome nearly a decade ago. Also joining us on the panel, University of Virginia professor Saras Sarasvathy, whose work details the process by which founder of the Grameen bank - a gentleman who won the Nobel Prize for developing a program of "micro-loans" to women in Bangladesh - overcame seemingly insurmountable roadblocks to achieve his dream of providing capital to the world's poorest citizens. The show airs live tomorrow between Noon and 2 PM EDT. If you want to listen in, here's where to go. We'll have cameras whirring away in the background. You just won't be able to see them. The podcast will be available after the program, if you're not available to stream it "live". Bill Bonner Cutting Expenses to Borrow More Money Bill Bonner Reckoning from London, England... It is very cold in London. "This is the coldest it's been in 25 years," said a colleague. People are bundled up in scarves and hats. There are patches of ice on the sidewalk. Heck, it could be Baltimore or New York. London is usually milder. It snows occasionally, here. But rarely do you get such a severe cold snap. Still, we take the world as we find it. So, let's see... What do we find in the financial world this morning... Ah... The prime minister of Spain gave speculators a little advice. Don't sell short Spanish debt, he said. As far as we know, government officials give investment advice that is at least as unreliable as the advice you get from anyone else. But that doesn't mean Jose Zapatero will be right. As we go to press, investors are not paying much attention. They seem to think they can find a better place for their money than Spanish bonds. But how cometh the elected chief of a major European government to be giving financial commentary? That's our job. Here at The Daily Reckoning nobody pays us for it. But we do it anyway. The other night, we had a dream...that we had been elected to Congress. It was a nightmare really. We wanted to demand a recount. We arrived in Washington to take our seat and we couldn't figure out how the voting machine worked. The other members were voting on expensive, preposterous bills. We wanted to vote "no." But we couldn't make the voting machine work. We've never been very good with gadgets, but this was maddening. Hour by hour, they were proposing and disposing...while we couldn't do anything about it. They were running up trillions in new financial obligations...more wars...more health care benefits...more farm subsides... More meddling. More world improvement. More intervening. The US was already broke. Still, they kept on spending. Hey, wait a minute... This was no dream. This was no nightmare. This was real life! The difference between Europe and the US is that the Europeans have begun to get their voting machines to work properly. The latest news is that the Irish have committed themselves to lop another 20% off of state spending. The Greeks, Portuguese and Spanish are all headed in the same direction. They're acting like responsible citizens. In order to convince investors that they're good for the money, they've got to cut spending. If investors lose confidence, they won't be able to borrow money at low interest rates. Hold on... Let's get this straight. They're cutting expenses so they can borrow money? Yep. If they don't cut expenses, they won't be able to borrow at decent rates, right? And then what? Then they'll have to cut expenses even more. So why not just balance their budgets now, so they don't have to borrow at all? What, are you some kind of nut, dear reader? Balance the budget? Spend only what they can raise in taxes? Don't make us laugh. In America, federal deficits are projected from here to eternity. There is no plan to balance the budget ever again. At least the Europeans are trying to get their budget deficits down - to 3% of GDP. Ireland pledged to do so as part of its rescue deal. And to cut 25,00 jobs from the payroll - 10% of its entire workforce. That was enough to bring out the protestors - even in this bitter cold. And more thoughts... Let's look at how the European debt situation developed. When Europe brought out the euro in 2002, it changed everything. All of a sudden, you could lend money to Ireland or Greece without having to worry about the Irish pound or the Greek drachma. They were all using the euro, which was managed by the Germans. So why not lend to one of these peripheral states of Europe and earn a little more interest? Things began to change fast. Interest rates in Spain and Ireland dropped. People started buying houses. Builders began putting them up all over the place. Prices were going up. It was similar to what happened in the US, but amplified. Ireland, for example, had always been a relatively poor country. But by 2007, rising house prices had turned the Irish - on paper - into the richest people in Europe. Bust follows boom. Always has. Always will. And when the bust came to Europe, its banks were holding a remarkable amount of mortgage debt. The trouble was, debtors didn't have enough income to pay it. In a panic, investors dumped bank stocks...figuring the banks would go bankrupt. But in stepped governments. They tried to halt the correction. They gave guarantees. They made commitments. The told the world that they would make sure senior lenders got their money. But how? The governments were deeply in debt themselves. But that didn't stop them. They went ahead - to varying degrees - and guaranteed bank debt. And so here we are. Ireland guarantees its bankers' debt. Europe guarantees Ireland's debt. And who guarantees Europe's debt? And why do they bother? Why not just let the speculators take their losses? "There will be no haircut on senior debt," said Olli Rehn, EU commissioner for economic and monetary matters. They made the decision to invest of their own free will. It's gone against them. Shouldn't they be permitted to learn from their mistakes? Why not? We have never heard a good explanation. And we have a suspicion that no one else ever has either. Instead, it is more of an implied threat...whispered...too terrible to think about. "Pssst... They're TOO BIG TO FAIL." Oh yeah? Why? What, exactly, would happen? Weak banks would fail. They'd be quickly taken over by stronger banks. Government debt that was too closely connected to the weak banks would fail too. Paper currency may even collapse, if people feared "the whole system" was coming down. Governments may have to come out with a gold-back currency - one that people could trust. Then, unable to borrow more, they would have to live within their means. And the surviving banks would know better than to take risks bigger than they could cover. Would that be so bad? *** Well, this is a first. Danny Ortega, president of Nicaragua, has given casus belli to Costa Rica, on the basis of Google maps. He looked at Google and realized that part of what is now Costa Rica should really be Nicaragua. So he sent armed Nicaraguan forces to claim the land. At least, that's how we heard the story on CNN en Espagnol. Our Spanish is far from perfect, so we might have gotten the details wrong. But the gist of the story was confirmed for us at Thanksgiving dinner. "Hey Dad," said one of the boys, "I hear you're going to Nicaragua for Christmas." "Yep..." "Uh... And you're going to fly into Costa Rica, and then cross the border?" "Yep..." "Do you realize that you could be going into a war zone? Danny Ortega is getting a lot of flack in the country, because his policies don't work very well. And people don't like the fact that he is twisting the constitution to suit his own purposes - just like his pal Chavez. And he has an election coming up next year. So he's stirring up trouble with Costa Rica in order to get the yahoos behind him." Regards, Bill Bonner for The Daily Reckoning ------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com Yeah, Thanks A Lot! This week, Americans sit down in their sturdy chairs to enjoy a national feast. Businesses are shut down. Congress is adjourned. For one day at least, citizens can enjoy their peace. In every hamlet, urban ghetto and rank suburb they gather, sacrificing turkeys to their deities, whoever they might be. Before they tuck in, they bow their heads and give thanks. But for what? Myriad Responses to the Global Financial Crisis On the Destructive Part of Capitalism Why the Government Hates Deflation Being the naturally cynical type of guy that you would expect from someone so angry, so depressed, so outraged, so paranoid and so “Howard Beale” (“I’m as mad as hell, and I’m not going to take this anymore!”) as I am, people want to know “what is with” all of this “deflation” stuff that the Fed is worried about. Buy Gold: It’s the Only Way to Combat Government Spending Economics Professor Ignores Fiat Money Failures Putin Suggests Russia Could Join Euro Zone, Make Euro World’s Reserve Currency At a recent conference on economic cooperation in Germany, Russian prime minister Vladimir Putin explained it was “quite possible” that in the future Russia would join the eurozone. He also expressed that the move would probably bring about the replacement of the US dollar with the euro as the world’s reserve currency. There is No Food Inflation; the BLS Made Sure of That McMoran Exploration Co. (NYSE:MMR) — Still Bullish on Drilling in Shallow Waters The Daily Reckoning: Now in its 11th year, The Daily Reckoning is the flagship e-letter of Baltimore-based financial research firm and publishing group Agora Financial, a subsidiary of Agora Inc. The Daily Reckoning provides over half a million subscribers with literary economic perspective, global market analysis, and contrarian investment ideas. Published daily in six countries and three languages, each issue delivers a feature-length article by a senior member of our team and a guest essay from one of many leading thinkers and nationally acclaimed columnists. Cast of Characters: Bill Bonner Founder Addison Wiggin Publisher Eric Fry Editorial Director Joel Bowman Managing Editor The Mogambo Guru Editor Rocky Vega Editor