Editor's Note: The following article was originally written on December 3, 2003. Given the higher rates, we felt Minyans would benefit from the vibe.


(I wrote this article a little early, but it seems appropriate to review these thoughts today in front of one of the most important 10-year auctions in a while. Higher yields in a leveraged economy could be devastating.)

Rea Shur (floor bond commentator for financial news): We’re waiting here for the results from the $25 billion 5-year treasury auction. There is a little more nervousness than usual as the size of these auctions continues to grow: the last auction was $16 billion, up from a previous $10 billion; this current one is the largest auction in memory.

Al Doublespeak (economist and commentator for financial news): Rea, it's Al here. I don’t think size matters much. It seems that there is still high demand for U.S. financial assets as the stock market is climbing and rates, although a little more volatile as of late, are still relatively stable given the Fed’s assurance that they will keep rates “low for as long as necessary.”

Rea: Right, Al. Prices are off seven ticks, but that is normal posturing ahead… wait, here are the results. What? Uh, hey Al, we seem to have a little confusion here. The news must not be right, we are checking now (pause). Prices are dropping rapidly: the 5-year is now down, uh, two points. What? Sorry Al, there is mass confusion here. We have the 5-year down two points and the 30-year down the limit of three. Nothing is really trading and things are moving very fast.

It seems the results of the auction, which we are double checking right now, were horrific. Foreign demand seems to be somewhat non-existent when normally they participate fairly heavily. We are still trying to sort this out; perhaps we'd better go back to you Al.

Al: Uh, thanks Rea. Be careful down there, it looks pretty rough from up here. Well, folks, I don’t know quite what to say. Phil, do you have any idea what is happening?

Phil Ovit (head commentator and former government economist): I am sure this is an error of some type. We have quickly arranged to talk to the head economist of Tokyo Savings and Loan, one of the traditionally largest buyers of auction debt, Mr. Ito Yuso.

Good morning, Mr. Yuso. Tell us, this confusion, in your opinion, what exactly is going on?

Ito Yuso: Good morning Mr. Ovit. Unfortunately, from our perspective, there is no real confusion. We simply declined to participate in this auction.

Phil: Uh, and why would that be?

Yuso: Well, very simply, we have come to the conclusion that the dollar’s prospects are not very good for the near future. Based on the amount of new debt being issued by the U.S., the level of the current account deficit, and the Federal Reserve’s untenable position on low rates, we believe that the dollar will fall at least another 20% from current levels. This being the case, it makes little economic sense, other than for artificial reasons, to purchase U.S. notes at these prices.

Phil: But given a slow steady decline of the dollar, the current situation is certainly manageable, no? Isn’t it only the serviceability of the debt and not the actual level of debt that is important?

Yuso: Well, from our perspective, which should consequently affect yours, the level of debt is inextricably tied to its serviceability. When we, the creditors, get nervous as to the size of US debt, we will demand a higher risk premium. This will affect interest rates in the US and therefore the serviceability. Since the Federal Reserve of the US is attempting to keep domestic rates low in the face of mounting debts, we see this relationship manifest in a lower level of the dollar.

It is the expectation of the level of the dollar that really matters to us, not how quickly it gets there, as long as the change occurs over the anticipated investment horizon.

The central banks of the world have been buying U.S. securities, in place of private sources, for quite some time in an effort to allow the U.S. to continue to grow out of its problems. Time, however, has shown that this is at the expense of too much debt with rates held artificially too low. As businessmen, it makes no sense for us to continue to buy U.S. financial assets at these prices.

Phil: How do you mean sir?

Yuso: If we expect the dollar to decline by 20% during the life of our investment, we need higher rates or a lower investment price to compensate us for this loss. For example, the five year last night was yielding 3.4%. Over five years we will earn approximately ((1.034)^5 -1) = 18.2% gross income on our investment. If we expect to lose 20% on this dollar investment, you can see that it is an expected return of negative 1.8%. The 5-year rate in Japan at 0.65% is very low, but at least it is positive from our perspective.

If we were to participate in this auction we would therefore need to bid below par in order to earn a higher implicit yield on the investment. Given that we are not sure how far the dollar will fall and given the volatility of the situation, we have decided not to participate in order to evaluate the market’s reaction.

It seems that others have decided to do the same.