Axel Merk, August 4th 2005

The U.S. consumer and the U.S. government have a lot in common: ever more powerful drugs are required to keep them spending. The latest move by the Treasury Department to reintroduce the 30-year bond (the "long" bond) after a four year pause is the latest step in a pattern to micro-manage the economy.

The "return of the long bond" warrants some reflections of the environment we are in. In October 2001, the Treasury Department announced it would no longer issue 30-year bonds, and focus on the issuance of 10-year bonds. The official reason was that deficits had been brought under control and the long bond was no longer required. That was obvious nonsense: the tech bubble had burst, the economy was fragile, and record deficit spending was in the pipeline in the aftermath of the 9/11 attacks.

Instead, an important driver behind the abolishment of the 30-year bond was the desire to stimulate the economy. By abolishing the 30-year bond, investors in the bond market were forced to purchase shorter maturities. There is an inverse relationship between bond prices and yields: as supply for the long bond was artificially decreased, and demand for shorter maturities was artificially increased, bond prices rose and yields fell. This significantly contributed to lower medium and long-term interest rates. Short-term interest rates are controlled directly by the Federal Reserve, and these were also lowered.

As we have reported in the past, former Federal Reserve Board Member Ben Bernanke (currently the Administration's Chief Economic Adviser and candidate to succeed Federal Reserve Board Chairman Allan Greenspan) is an open advocate of managing the entire yield curve (see also our April 18, 2005, analysis, The Fed Embraces Public Perception in Place of Sound Monetary Judgment to Set Policy) to fine tune the economy.

In recent months, there has been a debate about "interest rate conundrum," the fact that the economy seems very strong, yet the yield curve is very flat, i.e. short-term rates are almost as high as long-term rates. Traditionally, a flat yield curve, is a warning flag that we are heading towards an inverted yield curve (short-term rates higher than long-term rates), which traditionally has been the precursor to a recession. Given that interest rates are historically low, a recession is not desirable by central bankers as little ammunition would be available to jump start the economy. Greenspan has said that he does not understand why long-term rates have remained that low, and would prefer to see them higher.

It is beyond the scope of this analysis to discuss the 'interest rate conundrum' in detail - it shall only be said that we believe that the market properly reflects that the economy is not as strong as suggested by some data; you only need to reflect on why the automotive industry has to provide its biggest incentives ever to lure consumers if the economy were truly as strong as suggested. Needless to say, the markets have not been swayed by Greenspan's words and long-term rates have not moved significantly. The Fed Chairman's wish is the Treasury's command (the Fed and the Treasury operate independently, but these days, they closely coordinate policy). By reintroducing the long-bond, supply is added to the market, and a steeper yield curve (longer-term interest rates higher than short-term rates) is fostered.

The shape of the yield curve affects many facets of the economy. Amongst others, financial institutions typically operate more profitably when the spread between long-term and short-term interest rates is higher. When short-term interest rates are as high as long-term rates or even higher, it tends to discourage investment activity.

We provocatively call the active management of the yield curve a symptom of a modern command economy. The micro-management of an economy, be it through the active management of the yield curve, extremely low interest rates, large tax breaks, or manipulation of exchange rates, all are aspects of a planned economy. It turns out all these factors have significant impact on consumer, corporate and government behavior in recent years. And whenever free market forces are distorted, dislocations in the markets appear. To name just a few, these distortions have included an overheated housing market, a consumer with a 0.0% savings rate (the latest number from June), high energy and other raw material prices, low consumer prices, accelerated outsourcing by corporations, a lower dollar, ...

After the technology bubble burst, corporate America worked hard to repair its financial statements. U.S. corporations have since lengthened the average maturity of their debt. Many corporations are cash flow positive these days, hoarding lots of cash. These are prudent reactions to low long-term interest rates and a fragile consumer. On the other hand, consumers and the government increased their debt loads to unprecedented levels and shortened the maturity of their debt. Part of the reason why debt service payments by the U.S. government has gone down is because it has done the equivalent of refinancing to an interest-only loan. The dangerous side effect of this policy is obviously an acute sensitivity to changes in interest rate.

One could argue that the Treasury is finally taking steps to return to a more prudent debt management. We would agree if it were in a different environment and the reintroduction of the 30-year bond had been done for different reasons. Instead, we are very concerned that the Treasury department has learned from irresponsible consumer behavior and may take it to a new level. Consumers have learned that they only need to worry about interest payment, not the absolute level of their debt; for consumers, this policy works as long as no shock is encountered (such as losing a job). The Treasury may feel that a government is immune to such shocks as it can simply print more money. In the absence of cuts in Social Security and Medicare/Medicaid programs, enormous payments will need to be due in the decades to come. One of the ways to address these obligations is to simply issue ever more debt. With careful management, interest payments can be staggered to keep the system going for many years. If the government were a consumer, we would say it took out ever larger negative amortization mortgages - mortgages where a below-market rate interest rate is paid in return for an increased debt burden. At some point, political pressure may force a change in policy, but we do not see such political pressure in the absence of a major crisis.

Needless to say, no matter how carefully managed an economy is, the market will seek and find a valve. The one potential valve we have been emphasizing as a likely candidate is the U.S. dollar. The U.S. dollar is a convenient scapegoat: the U.S. is in the fortunate situation that most of its debt is denominated in U.S. dollars, giving it the power to devalue its own debt, be it debt to other nations, or obligations to our retiring baby boomers. We have been suggesting that long-term investors seeking protection from this threat should evaluate whether investing in a basket of hard currencies, including a gold component, is a prudent diversification for their portfolios.

In the meantime, we see a further escalation of both fiscal and monetary actions to keep the U.S. consumer spending. As the housing markets and the consumer have shown ever greater strains, we will have to see how long this dance between market forces and intervention will play out before the consumer will throw in the towel and drive the economy into recession; a recession that is likely the more severe the longer the economy is kept afloat.