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Bond Yields

In Sept 1981, 10 Year Treasury bond yields reached a high of 15.32% as Paul Volker, then Federal Reserve Chairman, fought to tame record levels of inflation.

From their peak, bond yields have fallen relentlessly, reaching a low of 3.33% in June 2003.

In June, bond yields have moved up aggressively, with the 10 year Treasury bond breaking through 5% for the first time since August 2006. More importantly, the yield has broken through the 26 year long downward trend line, suggesting higher interest rates ahead!

In response, the 5 year Japanese government bond rose to an all-time high of 1.52% and the 2 year bond rose over 1% for the first time in a decade.

This could hurt a major component of global liquidity in recent years: the Yen carry trade. A rise in Japanese interest rates, coupled with the potential for a rise in the value of the Yen, makes the carry trade less lucrative. An unwinding of this is likely to result in an increase demand for Yen (which are needed to settle outstanding loans in Japan) and a decrease in asset prices where the funds were invested, including US debt. This could affect negatively demand for the US dollar as well.

In May 2005, Alan Greenspan (then Fed Reserve Chairman) was puzzled. As the Fed raised short-term interest rates, long term rates unexpectedly declined. He called it a 'conundrum'.

The reason was simple: China, Japan, South Korea and the oil rich GCC countries all wanted to keep their currencies pegged to the US $. To do so, they bought increasing amounts of US debt as their trade surpluses grew at a staggering pace.

This year the game is changing. Kuwait and Syria broke their US $ currency peg this month. China will now allow the renminbi to revalue upwards over a larger trading band, affirming the call made by the Australian Treasurer who has said that buying US debt is no longer a strategy that Asian Central banks will pursue and who has called for an orderly withdrawal from the US $.

With the EU, China and Canada having raised interest rates recently, there is a worldwide trend to higher interest rates to control climbing inflation. Inflation is rising because Central Banks have been printing money at double digit rates (inflation is always caused by an excessive supply of money).

With a GDP growth rate of 0.6% in the last quarter, the US is holding firm on rates as it cannot afford to hurt the wobbly housing market. But there will be further pressure on the US$ in the months ahead.

So, what asset classes will benefit and what will suffer from rising global interest rates?

• Long term bonds will fall in value, and Bill Gross, who runs the largest global bond company PIMCO, has turned bearish on bonds, predicting a rise in the 10 year note to 6.5%.
• Higher interest rates slow down the real economy as they raise the cost of borrowing. This should affect stock prices as corporate earnings slow.
• The global mania in real estate was the result of record low interest rates. As these climb, and as the downturns in real estate in the US and Spain suggest, real estate investments will not be as lucrative as in the past.
• The art market has seen record prices paid in recent years, as massive global liquidity found its way into exotic investments. Here is a New York Times extract from May 17, 2007: "Buyers from all over the world spent millions of dollars at Christie's last night as if it were play money. Together they made auction history: the most successful sale of postwar and contemporary art ever."

How does gold do in times of rising interest rates? This chart provides a long term perspective. The blue rise represents the yield on a 10 year Treasury Bond, the yellow line is the price of gold in US$ and the red line is the price of gold discounted by inflation.

Gold climbed from under $ 100 to over $ 800 as inflation and interest rates climbed substantively in the 1970s. The decline in the US $ re-ignited the bull market in gold and rising bonds yields will only help its growth, as money moves away from asset classes that are hurt by rising interest rates and declining liquidity.

It also tells you that while gold prices have risen to a 25 year high, they are nowhere near their earlier highs when accounting for inflation. This suggests that the bull market in gold has a long way still to run.

China's Record Exports

In May, China's exports grew to a record US$ 22.5 billion, up 28.7% from a year earlier!

In the first half of 2007, China now expects greater exports than all of 2005.

This is creating both a massive liquidity glut in China (fueling the Shanghai stock exchange to mania levels) and forcing it to buy substantial foreign exchange reserves to keep the renminbi from climbing.

China, alongwith Japan and the Middle East oil producers, has bought substantial amounts of US debt in its foreign exchange reserves. It keeps having to add US $ and debt into its foreign exchange reserves to keep its currency cheap compared to the US $. However, the US$ continues a decline that has seen it lose 30% of its value since 2001.

China is now seeking to put its reserves to better use. It has bought a 9.9% stake in the premier private equity firm, the Blackstone Group, for $ 3 billion (Blackstone's CEO, Steve Schwarzman was George Bush's roommate at Yale University). China has allocated $ 300 billion of its $ 1.2 trillion reserves for strategic investments overseas.

By doing so, China may hope to appease former Goldman Sachs CEO and now US Treasury Secretary, Hank Paulson, and Congress, which is considering tariffs on Chinese exports. It is also putting its surplus dollar reserves to far better use than just holding US debt.

Bees and Inflation

Despite the enormous amount of money supply created globally, the rise in consumer prices has been relatively tame. This is mostly explained by globalisation as cheap Chinese labour has allowed the cost of manufactured goods to fall dramatically in absolute terms, keeping the Consumer Price Index under control.

This is now changing. The renminbi is slowly climbing, which will make goods exported by China more expensive. The US is threatening tariffs on Chinese goods as the trade deficit widens. Wage rates in China are climbing. Commodity prices have climbed dramatically in the last five years, raising input costs which will increasingly be passed onto the consumer as corporate earnings slow down.

But rising pressures on consumer prices are also going to come from unexpected directions. For example, ethanol is rising in popularity as an energy substitute for oil (yet another case where politics trumps science).

As it is a product of corn, the rise in the demand for corn has raised prices dramatically. This led to food riots in Mexico last year, as corn is a basic requirement in the making for tortillas, a staple of the Mexican diet!

But an even unlikelier cause of future food price increases comes from the strange case of bees: they're vanishing or dying in huge numbers in the US, Canada and recently Europe and no-one knows why.

A significant number of crops depend on bee pollination, according to Bank of Montreal's Don Coxe. He estimates that up to $ 14.4 billion of American crops are at risk if bees fail to pollinate as they have done in the paste.

Bees are 90% responsible for the pollination of apples, onions, carrots, broccoli and sunflower and 80% for cotton. They are between 10-90% responsible for the pollination of citrus, soybeans, and various fruits, nuts and other vegetables.

Most importantly, they are 60% responsible for the pollination of alfalfa, hay and seed, which are used as feed for dairy animals. A shortage of hay and alfalfa could directly cause dairy and meat prices to rise.

Coxe says that when food inflation coincides with a rise in energy prices, it makes overall inflation very hard to control.

Expect rising inflation in coming years. Lots of it...

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