Bonds, Bubbles and Busts

A Bubble in Treasuries?

Is there a bubble in Treasuries? This question has recently been discussed by nearly every financial commentator on the web and in the press, with both sides having amassed convincing but conflicting arguments. Value investor James Montier of GMO had something interesting to say about this question in his blog recently.  You would expect a value type like Montier to warn that Treasuries are overvalued compared to historical norms, and you would be right. The only trouble is that I'm not sure that I agree, and I'm not sure that his argument is even a valid value judgment is today's situation.

In his blog Behavioural Investing Montier published an article on August 31 titled "Bond Bubble - a sterile debate on semantics," which asked : "The issue shouldn’t be whether bond are a bubble or not, but rather are bonds a good investment or not?" Using Ben Graham's definition of an investment as an operation that promises "safety of principal and a satisfactory return," Montier proceeded to estimate the return from Treasuries over the next ten years, so as to see if that return would be in some sense "satisfactory."

Are Bonds a Good Investment or Not?

To do this, Montier estimated the three components of return -- the real yield, expected inflation and an inflation risk premium -- for 10-year Treasuries over the next ten years. He estimated the real yield as 1%, based on the yield of 10-year TIPS. For expected inflation, the inflation swap market implies 2% over the next ten years; alternatively, the nominal bond yield minus the TIPS yield implies 1.5%. For the inflation risk premium, which is a way of accounting for uncertainty in future inflation, he used 0.5%, which is the upper range of current estimates. This implies a return of 4% annually under "normal" inflation conditions. Montier upped the estimate of longer term average 10-year Treasury yields to the 4%-5% range because he questioned whether the current market real yield of 1% is really a "fair price," and because the longer UK experience with inflation linked bonds suggests a somewhat higher number.

Montier's conclusion is "In the ‘Normal’ state of the world bonds sit at close to equilibrium, say 4.5%." The implication is "The current 2.5% yield on the US 10 year bond is clearly a long way short of this." In contrast, a Japanese outcome for the US over the next ten years would have rates around 0%-1%, and an inflationary outcome would have yields around 7.5% (with inflation at 5%).

Montier interpreted these numbers as saying that "In essence, the market is implying a 70% probability that the US turns Japanese."  Maybe 2.5% Treasuries are attractive if you are certain that the US is becoming Japanese, but that is a lot to assume. A rise in yields even to the long-term average level implies some losses.

A Satisfactory Return?

I think that we knew this already, at least in a qualitative way, before Montier published his calculations. We already knew that T-bonds are overpriced according to historical metrics. We understand that an all-out bet on Treasuries at this point is risky, but we also know that all-out bets on other asset classes are also risky. Montier did not address the right question.

The problem is that Montier is arguing on the basis of the range of Treasury bond prices over the limited history of those securities. That history is limited in time extent and in the range of conditions that were sampled. It is not an average over an infinite sequence of all possible financial histories going through all possible states of the world. In other words, it is a sample average, not a known parameter. The values and frequencies seen over the recent past were dependent on the unique and contingent conditions pertaining during exactly that period of time. Why should we assume that the future will be like the past?

Today's financial state is highly peculiar in the US. It is a state of high indebtedness occurring at the end of a period of easy credit and overconsumption. If we look over longer periods of time than Montier examined, we see that periods of excess are regularly followed by periods of sub-par growth and financial crisis. We have examined the work of Reinhart and Rogoff in this blog before. We place much more weight on several centuries of world financial history than we do on the limited history of the past few decades of a peculiar and distinctly American era.

Bubbles are followed by busts, and long term averages can be violated for a considerable period of time. Excessive debt weighs down with an inexorable burden that has to be worked off over time. As a result, the "long term" average may not re-emerge for a long time. I don't think that any Roman descendants are waiting on their British estates for the legions to return from over the channel.

The Only Things That Really Matter in Investing Are Bubbles and Busts

Montier's colleague Jeremy Grantham suggested how to frame problems of this sort in the GMO Quarterly Letter of April 2010. In an article titled "Friends and Romans, I come to tease Graham and Dodd, not to praise them" he wrote on some potential disadvantages of Graham and Dodd-type investing. Grantham attacked the "preposterous belief" that all information is embedded in securities prices and that bubbles and busts can be ignored. Grantham said, in fact, that "I am at the other end of the spectrum: I believe that the only things that really matter in investing are the bubbles and the busts."

In support of this belief, Grantham presented a variety of statistics illustrating that even such "standard" stock valuation criteria as the price-to-book ratio come in and out of fashion, and can over-perform or under-perform over extended periods of time. To extrapolate a little from Grantham's examples, we are already familiar with the work of Reinhart and Rogoff and other historical studies showing how financial crises spawn more crises and are regularly followed by extended periods of sub-par economic growth.

Grantham quotes from Securities Analysis: "Undervaluations caused by neglect or prejudice may persist for an inconveniently long time … and the same applies to inflated prices caused by over enthusiasm or artificial stimulants.” Graham adds: "If ever we were living in a world of artificial stimulus, it is now."

When there is no bubble or bust around, "if you keep your nose clean, you will probably keep your job," by which he probably means that prudent value principles are usually the best investing guide. During bubbles and busts, however, the usual value principles may not be the best way to go. He exhorts: "But when there is a great event, that’s the time to cash in some of your career risk units and be a hero." The end of the age of credit excess certainly qualifies as a great event in my book.

A Margin of Safety

Should we base investment decisions on recent historical distributions or on the dynamics of bubbles and busts? Where does the margin of safety lie? If we take Grantham's advice, "the only things that really matter in investing are the bubbles and the busts." If you are living in a bust, maybe the future consists of something other than a statistical sample of the recent past. Maybe you should think seriously about the life cycles of bubbles and busts.

Treasuries look dangerously over-valued to our eyes, but our eyes have been trained by lifetimes spent in a credit-crazed culture worried about inflation. It is not surprising that, since Montier's article, the yield has fluctuated from 2.50% to 2.70%.  Howewever, if we are in a debt deflation, supported by extraordinary government intervention, maybe there is a better than average chance that Treasury yields will stay low for longer than Montier suggested. It also helps that a contraction in private debt issuance has made room for expanded government issuance without a backup in yields. Or maybe the economy will come back and tank bonds. There is no sure thing here.

Whatever the eventual outcome, there is much more to the Treasury bond situation than a simple comparison to historical average yields. Past returns are no guarantee of future results.

A Stochastic Stopping Problem

Police stand guard outside the entrance to New York's closed World Exchange Bank, March 20, 1931

How safe are Treasuries? Won't Treasuries fall when enough people start worrying about the ability of the US to finance its national debt? I recently read an article in Capital Gains and Games saying "the bond market today is exhibiting no worries about the deficit or federal borrowing at all" and "there is little or no concern on Wall Street about the government’s borrowing, either short- or long-term." In other words, the article says that we should have confidence in the markets to price risk.

Such confidence in the markets is totally wrong, I believe. Market prices fluctuate over time, and attitudes toward risk change over time. Today's markets prices only tell us what participants believe today. Sure, from today's perspective, with the Fed buying Treasuries and the economy heading lower, it looks profitable to hold Treasuries. But today's market conditions won't last forever, and we need to ask "When will these conditions end?"

The condition of the fixed income markets is hardly normal today. The Fed has bought nearly a trillion dollars of mortgage-backed and other securities in order to keep interest rates down and to encourage markets to operate. Other governments buy Treasuries to meet their currency and interest rate goals. Governments buy for policy reasons, and they will sell for policy reasons.

Other market participants buy Treasuries for their own reasons. Sovereign risk troubles in Europe have pushed huge amounts into the dollar for safety, and US bankers also need safety and park their funds in Treasuries. When the Fed guarantees easy monetary conditions and the economy is weakening, it is only logical that money managers shift their money into Treasuries. But these are all short-term perspectives. When the risk-safety equation changes, money managers will shift out of Treasuries and into whatever offers safety or return at that time.

This is a familiar situation: Three years ago commodities were high and climbing. Five years ago housing prices were high and climbing. Fifteen years ago, internet stocks were starting their climb. Eighty-one years ago, stocks had reached a "permanently high plateau". People lost fortunes believing that the prevailing conditions would continue indefinitely.

Many people feel that Treasuries are a good buy today, and it sure looks profitable, but this is short-term thinking. No serious investor plans to hold long or intermediate Treasuries to maturity. They hold for today and they have plans that define when they will sell. It hasn't been long since we heard the slogan "Now is the best time to buy a house." It hasn't been long since people bought "good" stocks and planned to hold them forever. These were mere slogans serving the purposes of narrow interests.

John Singer Sargent, Orestes Pursued by the Furies (mural, 1921), Boston Museum of Fine Arts

Economic indicators look weak, and the Fed is telegraphing the intent to keep monetary conditions extremely accommodative. How long will these conditions continue, and how will Treasury investors know when they should sell? How can they avoid getting caught in the last-second stampede for the exit?

All of you operations research types will recognize this as a stochastic stopping problem -- we get a reward for investing in Treasuries as long as the environment is disinflationary and accommodative, but we lose a whole lot if we still hold Treasuries when the Final Trump sounds. Although there is a world of contingent risks, the predominant controlling factors are in fact very few. The stopping problem is a bet on what politicians and the Fed will do.

Formulate a payoff function and a risk curve, and then answer me this: How much should we bet on Treasuries, and when should we sell?

NOTE: In classical times Greeks and Romans did not speak the name of the Furies out loud, lest they attract the Furies' attention. It was considered more prudent to refer to "the Friendly Ones" or a similar euphemism. Perhaps the Fed is now in the position that saying anything at odds with an accommodative monetary policy is like shouting out the true name of the Friendly Ones.

What's in Store for QE II?

There has been much talk in recent days of policy changes that the Fed might make at its meeting next week. Such talk has heightened in the wake of last week's statements by St Louis Fed President James Bullard that there is a need for more quantitative easing, and Chairman Bernanke's warnings not to tighten policy too soon. The Fed's balance sheet has been contracting as its portfolio of securities gradually matures, taking badly needed money out of the struggling economy. Another round of QE might reverse or compensate for this trend.

Given the likelihood that QE will impact my portfolio in one way or another, I decided to check out recent news stories for a small sample of what other market watchers anticipate.

Option: Stop the MBS Roll-Off

An article in the WSJ "Fed Mulls Symbolic Shift" predicts that the latest plan is for the Fed to use proceeds from maturing mortgages on its books to buy Treasuries. Paul Sheard, chief global economist of Nomura Securities, also published a note guessing that this would be the Fed's move (as reported in The Telegraph).

The Fed has a lot of mortgage-backed securities on its books from its previous QE program, and as these securities mature the proceeds remain at the Fed and the amount of easing achieved through the mortgage purchase program gradually falls. This amounts to a gradual tightening process that the economy hardly needs right now. "Buying new bonds with this stream of cash from maturing bonds—projected at about $200 billion by 2011—would show the public and markets that the Fed is seeking ways to support economic growth."

Giving some support to the option is that Charles Plosser, president of the Federal Reserve Bank of Philadelphia, said in an interview last week that he was open to reinvesting proceeds from maturing mortgage bonds into Treasury securities.

Option: Roll Off the SFP Program

A different guess was put forth by Barclay's Joseph Abate, who believes that the Fed will allow the Supplemental Financing Program to roll off, which would free up the $200 billion that the Treasury holds on its books for that program. According to Zero Hedge, Abate thinks that this would have a bigger impact than merely letting $10 billion a month of MBS roll off the Fed's books, which he thinks would be too gradual to have little impact on rates.

Recall that the SFP consists of a series of special Treasury bill auctions, the proceeds of which are maintained in a Fed account in order to drain reserves from the banking system, so as to offset the reserve impact of other Fed lending and liquidity initiatives. Abate's suggestion was that the Treasury will roll off the SFP by ending the 56-day Bill auctions, thus pushing almost 200 billion dollars into the banking system in only 56 days.

As for impact, Abate thinks that the disappearance of SFB would likely push bill and repo rates well into the single digits, without needing to buy additional securities, and it would then allow the natural attrition of the Fed's portfolio to slowly proceed, as had been the intention when the economy was expected to do better. Some commentators have referred to this option as QE Lite.

QE Is Just a Way to Inflate Asset Prices

The prospect of renewed QE has not been entirely popular. One of the critics has been PIMCO's Bill Gross who said on Bloomberg that QE cannot be very effective since it is just a shuffling of financial assets, and that it would inflate asset prices more than consumer prices. These are valid criticisms, but of course, maybe rising asset prices are what the Fed wants. Chairman Bernanke has said that a rising stock market would be a big help to the economy -- even thought that is kind of like getting the cart in front of the horse.

Gross also repeated his criticism of whether the US can get out of debt by issuing more debt. As much as I poke fun at Gross on occasion, he is right on target there.

Who Benefits?

Any extension of the Fed's earlier asset purchase program will just stimulate the markets to buy up more of the riskier assets. None of this gets into the real economy. Because banks need to control risk , they aren't lending. New money stays with the banks, who will continue to speculate in ways that will merely levitate asset prices -- bonds, stocks, commodities, etc.

This is good for the financial elite who profit from this speculation. Of course, we taxpayers are the ones stuck with paying the interest on those Treasury securities and making good on losses from all the other asset purchases that have propped up asset prices and forced interest rates so low that leveraged speculation is nearly free.

According to a comment to a related Zero Hedge article: "Our government and the federal reserve run a massive Ponzi scheme. Take from the bottom and transfer to the top. Been going on for 30 years. ... the only people who keep ahead of inflation are those that benefit from cheap credit and leverage. The great majority loose."

The financial elite don't even have to wait for the Fed to act. By telegraphing its intentions, the Fed has given the highly leveraged speculators another chance to score "as the market attempts to front run the Fed in buying up Treasuries."

The Fallout

The Fed is betting that the US can grow its way out of its debt mess, and it sees QE II as a way to move the economy forward again. In other words, they think that more debt can get us out of debt. Does anyone else believe this idiotic idea? Worthless debts must be written off and the losses recognized before the US can start on the road to healthy growth again.

Those in power can become blind to the truth. In his book Collapsed, Jared Diamond gives good examples of societies that have adapted to crisis and societies that have failed to adapt to crisis. The failures that Diamond uses as his examples either misunderstood the nature of the crisis, recognized it too late, or chose to ignore it. It is fair to say that the last group were arrogantly wedded to the status quo -- sort of like the US financial oligarchy. Maybe the Fed should read Collapsed.

The Bottom Line

As much as I enjoy Marc Faber's commentary, I don't take seriously his warning that investors avoid bonds, and that the US is at the edge of "the final crisis." Not yet anyway, because the US still has an economy, is still viewed as credit-worthy, and because in the developed world, the US is still the best of a bad lot of heavily indebted nations. But the day of crisis could come eventually.  But maybe later.

We need to consider about what the Fed does next, after QE II fails to stop the US from falling deeper into recession. This may happen sooner than some anticipate. Private forecasters generally expect real GDP to grow by an annual rate of about 2¾% in the second half of 2010. If the picture deteriorates and they forecast growth falling below 2%, which seems increasingly likely, the Fed would be more likely to act in a way that could alarm some holders of US securities.

To get an idea of what might follow in the future, we will need to pay attention to what the Fed does this time, and to the markets' reactions to this coming round of QE.

Shared Sacrifice

Edward Hopper, Railroad Sunset, 1929.

A Prolonged Economic Slump

With the recently renewed concern that the economy is faltering, a number of writers have been hazarding guesses at how the debt crisis may eventually resolve itself in the context of an economic downturn. Especially interesting are the recent writings of David Rosenberg, Bill Gross, Niall Ferguson, and Edward Chancellor, which contain a number of common threads on this topic.

These threads combine to make a scenario that differs from some of the more extreme forecasts, in that it does not necessarily sound like a complete disaster for the US -- no deflationary spiral, out-of-control inflation, or currency crash. Just a prolonged economic slump driven by austerity and the rebuilding of balance sheets.

Fiscal Prudence Means Shared Sacrifice

David Rosenberg, Chief Economist at Gluskin Sheff, makes the argument for a prolonged economic slump in a recent Globe and Mail opinion piece.  According to Rosenberg, fiscal prudence is taking over at the individual and government levels. Without credit or spending to fire the economy, it will limp along with some degree until balance sheets are sufficiently repaired to bring growth again. This will take time. He bases this scenario on the assumption that the US population is sufficiently shocked from the debt crisis to change its economic behavior permanently:

"It is reasonable to assume that the economic behavior of the population in general, and the baby boom cohort in particular, is on the precipice of a dramatic change, as Main Street has enough understanding of the situation to start to take action to get its balance sheet in order."

He assumes that the economy does not fall apart in a deflationary collapse, allowing debts eventually to be paid off enough that economic growth can begin again -- although it may take some time:

"Most likely, what happens next is that the credit collapse proceeds on the back of a severe form of the “savings paradox,” resulting in a prolonged economic slump. The good news is that it will ultimately lead to a balance sheet rebuilding process, both at the household and government level, that can sustain the next secular economic expansion."

That doesn't sound too bad, because he says that the US will avoid total catastrophe, like debt default, currency collapse, or hyperinflation. However, working down debt will require fiscal austerity by everyone in society, which will not be a pleasant experience for the participants:

"In the meantime, an enormous amount of shared sacrifice will be required." (My emphasis.)

Individuals can rebuild their balance sheets by sacrificing consumption if they have incomes.  A problem is that employment will continue to suffer as government will be unable to substitute for private spending:

"Initially, we can expect to see less government, fewer entitlements and higher taxes. ... Less government will require balanced budgets and this will contribute to continued stress in the job market, at least for a while."

Not only consumption, but entitlements will be cut back:

"Currently, the seeds are being sown for a radical restructuring of entitlements. ... Across the nation, sweeping changes are taking place as pension trustees and legislatures push for higher monthly contributions to pension plans, a later retirement age and lower annual cost-of-living adjustments for current and retired workers."

Cutting back entitlements will force much of the population to cut back spending and save:

"Out of necessity, the boomer population will be pursuing a strategy of working longer, saving more and reducing their debt obligations in order to secure a comfortable retirement lifestyle, while at the same time the public sector moves in the very same direction toward fiscal probity."

This of course guarantees the the downturn is prolonged.  One has to wonder how boomers can work longer and save for retirement if there are no jobs for them. One also has to wonder how the unemployed, the disabled, and the elderly are going to survive if entitlements are cut to the bone. The payoff for all that suffering could well be that it buys enough economic and financial stability for the US to dig itself out of the hole:

"... what we could well be in for is a prolonged period of price stability or modest deflation. It is reasonable to assume that a resumption of strong GDP and earnings growth in the future and a resumption of inflation and appropriate inflation investment strategies will have to await the end of the rebuilding phase as it pertains to the household and government balance sheets."

Harry Sternberg, Builders, 1935-36.

The Lenders of Last Resort Are Out of Money

The latest monthly commentary latest monthly commentary by PIMCO's Bill Gross supports important parts of Rosenberg's scenario. Part of PIMCO's New Normal is the notion that the advanced world has run out of funding sources with which to restart economic growth. If not even sovereigns can lend, economies will remain subdued and there will be "low total returns on investment portfolios" until debts are paid down.

"Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort – the sovereigns, the central banks, the supranational agencies – approach limits beyond which private enterprise’s productivity itself is threatened."

Shared Sacrifice Includes Default on Unfunded Liabilities

Harvard history professor Niall Ferguson also sees the US as avoiding an inflationary outcome, but he foresees problems with the deleveraging process. In fact, he does not see how the US can work off its debt without some kind of default.

The problem, he says, is that extreme debtors have rarely been able to grow their way out of debt in the past, and the conditions that allowed the rare historical case (like Britain after the Napoleonic wars) just don't pertain now. (We aren't the beneficiaries of a new industrial revolution.) This leaves inflation or default.

"Right now there is no sign of inflation. We have monetary contraction at an alarming rate, and zero inflation in terms of core CPI, so the option of inflating this debt away doesn't seem to be there right now. What you are left with is therefore default."

This could but doesn't necessarily have to include outright default to bondholders. Ferguson doesn't mention it, but we will later discuss a point of view saying that US outright default on its debt is very unlikely, given the past situations where this has occurred. Ferguson suggests this kind of default:

"And I think it is a fair bet that US will default at least on the unfunded liabilities of Social Security and Medicare at some point in the foreseeable future."

So we have another voice suggesting that the solution will include the dismantling of social programs. This would be part of the American people's if there is a prolonged slump.

No Default, but Bond Yields Are at Risk

GMO analyst Edward Chancellor has written a very interesting paper on the dynamics of extreme sovereign debt loads, which also contains a very interesting comparison to the current debt cycle. Given the historical preconditions for default, Chancellor concludes that the "US is not on the verge of a default." The US has carried high debt loads in the past and not defaulted outright, and it has the advantage that its debts are denominated in its own currency (although a lot of debt is foreign-owned). He agrees with the other forecasts in this respect, although not in others.

Chancellor thinks that "inflation is more likely than default in the US" because "public finance is a ponzi scheme." This makes the current environment of low government bond yields a very risky one for the bonds of the advanced economies:

"Under only one condition - that the world follows Japan's experience of prolonged deflation - do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside. As investors, such asymmetric pay-off profiles don't appeal to us."

Despite this admirable risk aversion, Chancellor is self-contradicting in one respect. First, he says that US debt can be paid off only if interest rates remain low. Then he says that inflation is the likely outcome, and that bond prices will suffer then. He glosses over the implications for servicing the interest and rolling over maturing US sovereign debt (and private debt) if rates rise. Perhaps this contradiction is an honest reflection of the impossibility of forecasting, but the contradiction also masks the ugliness and unpredictable instability of debt servicing under rising yields.

Such uncertainties reflect real risks in future outcomes. Even if we end up in a deflationary economic slump, there is no guarantee that it will provide a smooth ride with price stability or mild deflation all the way to recovery.

Thomas Hart Benton, Mine Strike.

How the Sacrifice Will Be "Shared"

The "shared sacrifice" is really a "soft default" on entitlements, which are seen by the financial elite as mere promises of hippie liberal governments. However, so-called entitlements are in fact the foundation of life planning for a good part of the US citizenry. Such promises include essential components of a retirement plan, including program like Social Security and Medicare, which many people have already paid for during their working lives.  If people have paid for Social Security and Medicare during their entire working lives, and planned their retirements based on these payments, they don't look at those programs as "soft" entitlements. In fact, they deferred consumption in order to pay for these insurance programs, and they planned the course of their lives around them.

Rosenberg says that boomers will work longer, in order to save for retirement. How are they to do this when there are no jobs? They are hardly likely to work longer when they have no jobs in the first place. They will just languish in poverty and illness until sinking away to an early death. That is the "shared burden" that Rosenberg is really writing about.

Not everything will be sacrificed. You can be sure that zero-interest money will continue to flow to banks, who will use that money to engage in more speculation and provide bonuses to their most "productive" parasites.

Sacrificeing to Pay Down the Debt

There are many ways of achieving "soft default" on the programs that the common people have worked so long for. In the case of Medicare and Social Security, the government can raise age limits, reduce inflation indexing, phase in benefits over longer periods, index to individual net worth, or other tricks.

At the local level, education, public safety, and other basic services are already being sacrificed in order to avoid raising taxes. State governments have already started cutting back on essential social and health services such as meals for shut-ins, family crisis centers, and higher education. There are many more elements of civilized life that the elites will find a way to cut.

Don't forget tax policy. The elites will be sure that unearned income (economic rent) is taxed at lower rates than earned income. If taxes on earned income are raised, what do they care? If you complain, you are just opposing the wonderful capitalist system that rewards risk taking. Never mind if you invest your life and effort in training and labor, and then end up supporting the rich with your taxes.

This is only one, alternative scenario, but perhaps it is what the elites of the developed nations are hoping for. It is easy to believe that their cries for "austerity" are really calls for "soft default" in the form of fewer entitlements. After all, the financial elites managed to default on the losses that the banks suffered in the wake of the mortgage crisis due to their greed and incompetence. The taxpayers shouldered that burden. Why stop there?

The "prolonged deflationary slump" has a lot going for it as a plausible scenario for the future of the US, but it assumes that the US taxpayer can pay down much of the private and public debt loads.  Unless the US frees itself of the financially-driven bubble economy grows and restores a foundation for real, organic growth with employment and income growth, the slump may turn into something worse.

Changing Treasuries for CDS

Natori Shunsen:  Nakamura Utaemon as Hanako in Musume Dojoji.  In this kabuki dance-drama Hanako changes costumes several times, including instantaneous onstage costume changes matching the character's movements.  Just before the change, an onstage assistant removes basting strings holding together layers of costume.

As you probably know, PIMCO's Bill Gross has in recent months given changing and contradictory views on the attractiveness of US Treasury securities. Late last year, he wrote that US debt was to be avoided because of rising debt levels and declining ability to service the debt load. In contrast, in the past few weeks news stories indicated that PIMCO had changed course and increased holdings of US Treasuries as being more credit-worthy and offering less interest rate risk than the sovereign bonds of the more developed European nations.

These stories did not explain the time horizon of this shift in PIMCO's allocations -- whether it reflected some fundamental shift in the attractiveness of US debt, or rather a reflection of the relative attractiveness of the US in reaction to the sovereign debt crises on the periphery of the European Union. PIMCO clarified an important part of this issue in a recent commentary published on its website.

It turns out that PIMCO is insuring the sovereign debt of G-7 nations rather than buying their bonds outright. PIMCO does this by writing credit default swaps on the sovereign debt of these nations, by which PIMCO collects premium payments from the counterparties and promises to indemnify them should they suffer default by the issuers.

This means that PIMCO is not exposed to the interest rate risk on G-7 bonds, but it is betting that the G-7 nations will not default on their sovereign debt.

This seems a neat way of separating interest rate risk from default risk.

This also implies that PIMCO is serious when it predicts that increasing debt loads will lead to higher interest rates on the bonds of the developed nations. This also implies that PIMCO is serious in believing that the risk of default is very low among the G-7 nations.

This still leaves room for a lot of market upsetting conditions to come, including ballooning debt and falling bond prices, and for personally unpleasant conditions, such as higher taxes and reductions in government services due to fiscal austerity.

Recent Comments from Ray Dalio

                       El Greco, The Vision of Saint John

There is an interesting interview with Ray Dalio of Bridgewater Associates in this week's Barrons. As you probably know already from earlier Barrons interviews of Dalio, Bridgewater is a very large hedge fund that specializes in global credit.  Here are some of the highlights that I found particularly interesting:

The Recovery and the Next Recession

"But it is a fragile recovery ... and it goes back to the fact we still have too much debt ... between now and 2012, the economy will probably go down again."

Contagion from Europe

“The European situation is a particularly risky one for a number of reasons. ... the size of the debt dwarfs that of any other debt crisis."

The Deflationary Environment

"My point is, in developed countries there is too much of most things at the moment, and that’s creating a deflationary environment.  There is too much manufacturing capacity. There is too much labor. There is too much housing stock."

Currencies of Developed Countries

"I want to minimize my exposure to the major developed countries’ currencies — the U.S. dollar, the euro, the British pound and the yen — because those countries have a lot of debt, and they are going to need to print more and more money and will have more sluggish growth rates. I prefer the yen to the others.”

Bonds of Developed Countries

Apparently Dalio intends to hedge the currency risk:  "As Europe’s economy weakens and its debt crisis worsens, the printing of money does not mean that it will produce an accelerating inflation because simultaneously there is also less being purchased, and the surpluses are already causing deflationary pressures. That is why, contrary to almost everybody’s belief, I believe the bonds in countries that can print money will be good investments.”

No Inflation Anytime Soon

“The depreciation of the major currencies and the printing of money will not cause a significant general level of inflation anytime soon. The printing of money will offset the deflation that is coming from the weak demand for goods and services due to weak credit growth."

As I read this, he does not expect aggregate inflation "anytime soon" but leaves open the question of the timeline by which inflation may enter the equation later.

Bridgewater's Portfolio

“Our portfolio is mostly skewed to Treasury bonds, gold and emerging-market currencies, especially Asian currencies. We also hold commodity assets that are limited in supply and that high-growth emerging countries need."

This looks like a response to the present deflationary environment and anticipation of future currency deflations. Hard to say, but perhaps it also reflects an anticipation of inflation beyond the time horizon of "anytime soon".