23 JUNE

As far as we can tell there are three main reasons why US bond prices have been so strong over the past several months. First, the Japanese Government Bonds (JGBs) have moved relentlessly higher, pulling other government bonds along in their wake. Second, foreign central banks have been large and persistent buyers of US Treasuries, primarily in an effort to weaken their currencies against the US$. Third, the Fed has threatened to cap long-term interest rates at an artificially low level if such action is deemed necessary to stimulate growth and prevent deflation.

Therefore, with the support that has been provided by the Japanese bond market perhaps in the process of disintegrating and with the US bond market acutely vulnerable to any growth in inflation expectations (or growth in the belief that there is not really a deflation problem), a perception that the Fed might have gone too far would likely result in a bond market sell-off. The Fed is no doubt aware of this risk, so the most likely outcome from this week's FOMC Meeting is that the Fed Funds Rate will be cut by 0.25%.

From a cyclical perspective this year is a likely year for a major low in the T-Bond yield, although the strong tendency for yields to bottom during the final quarter of the year and the fact that the last 2 major bottoms occurred in October suggest that we might still be about 4 months away from such a bottom. However, regardless of whether the bottom has just occurred or will occur later this year, it is likely that bond yields will be substantially higher in 12 months time than they are now.

By the way, although betting against the bond market should work very well for anyone with at least a 12-month investment time-frame, we think there are better ways to profit from a reversal in the bond market than by short-selling bonds or bond proxies such as TLT (an exchange-traded fund). Specifically, we prefer to be 'long' those investments that will benefit from rising inflation expectations (e.g., gold and gold stocks) than to be 'short' those investments that will suffer.

Below is a long-term chart of the Dollar Index. The Dollar Index has strong support from 91 down to 88 and is unlikely to break below this area without first experiencing a multi-month rebound.



posted by Dil at 7:19 AM