The Fear and Greed of Strangers

October 1, 2004

Dear Investor:

Some have said that the U.S. economy is a Blanche Dubois economy in that we depend on the “kindness of strangers.” This is a reference to the continued purchase of our Treasury bonds by foreign investors, the results of which are relatively low yields amidst deficit financing. The reality is that such strangers are less inspired by kindness than by fear and greed.

The implications of this distinction are very bearish for long-term bonds. The safe haven play that has continued to pour money into fixed income has kept yields artificially low for some time.

Foreigners have bought our bonds because they have made money there. But this cannot last forever, and the bubble in bonds is now of massive proportions. As deficits spiral out of control, the implication is for higher yields and higher inflation. Fiscal policy will remain expansionary whichever way the election turns. Once strangers see themselves losing money in our bonds, they will respond to fear and sell—and kindness will be the last thing on their mind.

The recent bump up in Treasury prices has given false solace to long-duration bondholders. This is probably the last opportunity for such holders to cut and run. It should be noted that in spite of the recent bond rally, the trend in yields is uphill (when yields rise, bonds lose value). When we wrote of the bubble in bonds in Barron’s on July 1, 2003, the 10-year Treasury was yielding 3.20%. Yields are now at 4.19%. Bonds have thus lost significant value over the past year. This will continue.

One call we’re less proud of was the price of oil. Writing recently about oil when NYMEX crude was at $37/barrel, we talked about Malthusian mistakes. In the short term, it has looked more like our mistake than anyone else’s, as oil has shot to a record $50/barrel.

There are many good arguments for continued high oil prices: low global reserves, low refinery capacity, low incentives for changing that status quo, and outsized demand. But eventually, any commodity that trades at a consistently inflated price inspires change, even if such changes take years. This change can come in the production of competing energy sources, or it can come in the form of another imbalance such as an oil-inspired recession that reduces demand. If a recession is the result, the irony is that bond yields would fall again before eventually rising. Oil is too difficult to predict in the near term. In the long term, Malthus will once again retreat as new technology improves supply, but waiting for it could take the patience of Methuselah.

The only sure bet is to never rely on the kindness of strangers. Nor to rely on their fear and greed.