Saturday, July 7, 2007

Bonds? Stay Away Long-term


Once in a while, I like to give my extreme long-term view of the markets.
Instead of gazing in my crystal investment ball and saying what's coming for next month, or next quarter, I like to offer my thoughts on where I see the markets heading in the long haul - over the next several years. With Wall Street's finest admitting confusion in the markets at the moment, it helps to keep an eye on the long-term.
So without further ado, here's my extreme long-term market outlook...
First of all, I see interest rates heading higher and bonds of all maturities and types will suffer a major decline in value.
That's the big picture for the United States and many international government bond markets over the next several years. Massive entitlement spending will force the U.S. government to significantly boost borrowing and raise the ceiling on the budget deficit to new highs.
What's Coming After 2010?
By 2010, if not sooner, U.S. interest rates will rise in order to finance the bulging budget deficit caused by a new generation of retirees - the baby boomers. And despite years of political wrangling over the issue and how to finance the eventual strain on Social Security, politicians have been unable to resolve the impending crisis.
Markets, however, will find a way to deal with a new series of massive deficit financing in the United States and the resultant boom in borrowing. Over the last 25 years, governments, particularly in Asia, have been keen to finance America's daily trade imbalance of roughly US$2 billion dollars. But at some point, another heavy dose of spending caused by entitlement obligations will cause a financial rupture in bond markets.
Eventually, higher interest rates will be required to finance bloated deficits, a weakening currency and a bear market in Treasury bonds - a dangerous tonic that will undoubtedly make the entire crises worse.
It's Only Called a "Crisis" After It's Too Late
Historically, governments don't address imminent financial crises beforehand. Instead, politicians wait until the crisis unfolds, forcing them to legislate immediate changes to the financial system.
That's what occurred most recently during the Asian financial crisis in the late 1990s, the demise of Long Term Capital Management in 1998, the 1987 stock-market crash and the 1990-1991 Savings & Loans Crisis. Following each of these crises, governments introduced new laws to stem financial speculation and curtail exuberant lending.
In the 1930s, the United States passed a series of financial regulations following the Great Crash of 1929. These included tightening lending curbs and implementing the country's first securities laws that are still the foundation of U.S. markets today. That decade also spawned the creation of the United States Securities and Exchange Commission (SEC).
But these important developments occurred after a financial crisis, not before.
Bond, T-Bond
Since 1992, U.S. Treasury bonds and mortgage securities have ranked among the worst-performing segments of the entire fixed-income market. After inflation and taxes, government-backed securities like T-bonds have even posted flat-to-negative returns.
Compared to T-bonds, riskier assets like junk bonds and emerging market debt have posted double-digit returns this decade. Unfortunately, riskier bonds continue to offer the lowest spreads in history compared to risk-free T-bonds, indicating poor value and high risk for new investors in these securities. And by 2010, if not sooner, higher lending rates in the United States will kill off the ongoing rally for high-yield debt and emerging market bonds too.
Municipal bonds, tax-free instruments, are hugely popular among investors but will also be subjected to losses as U.S. rates rise over the next few years.
As the next financial time-bomb unravels, caused by rising interest rates to fund America's current account and budget deficits, bonds will sharply decline in value.
Higher short-term and long-term interest rates will be the absolute worst prescription to alleviate economic stress in the United States. Unfortunately, the Fed will desperately need higher rates to fund America's spending requirements as the dollar is victimized by a possible foreign lenders' strike, unless politicians address deficits.
At that point, the government, backed into a corner, will have no choice but to introduce a consumption tax or some other levy to finance deficit-spending and arrest the economy's freefall.
So, do you want to be a long-term buyer of bonds? No thanks.

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