Taming the bear: despite the recent rally in the bond market the long-term trend is down down down

National Review, May 20, 1996 by John Dizard

Despite the recent rally in the bond market, the long-term trend is down down down.

THE front page of the New York Times of October 16, 1993, headlined a collection of what are now half-forgotten stories. The U.S. military mission to Somalia was in trouble. Mike Milken, out of the slammer, had turned to teaching. Three Navy admirals were censured in the Tailhook scandal.

But the most important event of the previous day went unnoticed by the Times, or, to be fair, anyone else. On October 15, 1993, the long decline in interest rates that had fueled the U.S. economy since 1982 had ended. Bonds, whose valuation represents the summation of investors' faith in the stability of a society, have been in a choppy bear market ever since.

When I first started reporting on the financial markets in 1971, bond men (there weren't a lot of women in the business at the time) were for the most part ignorant, clubby drinkers who had their jobs because they'd been congenial frat rats in school. The smart types were in equities or corporate finance.

Now the bond market is run by the smartest people on the Street. They drink Gatorade, Orangina, or Perrier, and they've forgotten more about stochastics and the history of G-7 monetary series than most people hear in a lifetime. Corporate-finance people are patronized as superficial parasites. And the bond people have made a lot of money for themselves.

But as the market has gained an impressive collection of analysts and thinkers, it has lost another group that existed back in 1971: investors -- people who actually buy bonds and keep them rather than use them as a speculative vehicle.

In the words of the ancient joke, these fish aren't for eating, they're for buying and selling. Let's take last year's numbers to illustrate the point. There were about $137 billion of Treasury securities issued last year (excluding what was sold by the agencies and guaranteed debt). Of that, $168 billion was bought by foreigners. That's right, more than 100 per cent of what was issued, meaning that Americans were, on balance, dumping their own paper. Most of the foreign buying -- 58 per cent of the notes and bonds -- was by foreign central banks and speculators in tax havens such as the Netherlands Antilles and the British West Indies.

When I was taking my first college economics course in 1967, I was assured by my professor that even though the Federal Government was running a deficit, "we owed it to ourselves." Not any more, at the margin anyway. As foreign central banks were buying $40 billion of Treasury securities, private domestic investors were selling $42 billion worth. There are some Americans who are buying Treasury bonds, though. Broker dealers, the most febrile of market participants, bought $58 billion last year.

Jim Bianco is a partner with Arbor Trading in Barrington, Illinois. He is known to his associates and counterparts as the Rain Man of the bond market, thanks to his nearly monomaniacal collecting of statistics. As Jim says, "The rational investor is putting his money in the stock market, because in recent experience that has been the way to make money. The bond market has been left to the politically motivated central banks and to the very short-term-oriented buyers such as leveraged hedge funds."

On my desk are two piles of reports. One I would call the Scientific Pile. That includes all the detailed, documented econometric analyses of the major trading countries, which make a good case that bonds are a buy based on the prospects for growth and inflation. The other stack is what I would call the Astrology Pile. That includes the financial version of witchcraft: technical analysis. Technical analysis comes down to drawing lines on charts of price histories, and attempting to predict the future by seeing which way the lines point.

It will probably not surprise you that the Astrology Pile has proved to be far more useful as a guide to how to speculate in the bond markets this year. If, at the beginning of the year, you had bought the 30-year T-bond based on the benign inflation prospects projected in the Scientific Pile, you would have lost 8.4 per cent of your money by the end of the first quarter. On the other hand, if you believed the bond chart was tracing out a "double top" and you shorted T-bond futures, you'd be sleeping on silk and laughing at the wretched academics behind the curtain in Economy Class.

As I write in the third week of April, the technical analysts have decided to join the bond bulls, briefly. The economists, or at least the ones with whom I agree, believe that the U.S. economy is at best in a holding pattern, with an annual growth rate between 1 and 2 per cent. Those estimates have gradually been lowered since the end of last year. Then the standard corporate forecast was for 2.5 per cent growth; now even the International Monetary Fund is looking for no better than 1.8 to 1.9 per cent.

As the technical analysts see it, the long-term trend for the bond market is down down down, as interest rates rise over the next couple of years to at least 9.5 per cent on the 30-year T-bond from today's 6.8 per cent. But the bear market will be interrupted by rallies. The current one, some think, could go on for a couple of months, or long enough for the 30-year yield to drift down to 6.5 per cent or a little lower. That will help the aging bull market in stocks to eke out some more gains.