The Pin Prick
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 7 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, 2 points. What? Sorry Al, there is mass confusion here. We have the 5 year down 2 points and the 30 year down the limit of 3. 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 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, your creditors, get nervous as to the size of your country's debt, we will demand a higher risk premium. This will affect interest rates in your country and therefore the serviceability. Since the Federal Reserve of the U.S. 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 .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.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter