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LOW rates will ULTIMATELY hurt the WORLD ECONOMY... Just not NOW

Conventional wisdom suggests that financial markets should be acting in a particular way. Interest rates should be rising based on fears that high oil prices will lead to higher inflation. Stock prices should be suffering from fears that terrorists will disrupt the global economy. Yet none of these things have happened. The fact that markets are not reacting to news as they have in the past suggests that the structural changes that have taken place over the past two decades are having important effects that must now be factored into investors' thinking. Almost a year ago, HCM wrote about how conventional thinking comes to change.
Investors should never forget that lower quality credits are really equities-in-disguise and as such should not be valued or priced based on spread. Because they are priced based on spread, however, they are mispriced (i.e. overpriced) and will eventually succumb to the risks inherent in equity instruments offering bond returns. Today, the average price of a high yield bond (based on the Merrill Lynch High Yield Index) is a mere 343 basis points above Treasuries, which is a paltry return for a security that over time is likely to experience a significant number of defaults (which will vary from 40% for single-Bs to 80% for triple-Cs). We happen to be in a very low default environment today, but this too shall change as these bonds mature. After all, weaker credits are competing in a globalized economy with few barriers to entry and strong deflationary forces suppressing their revenues but not reducing the value of their debts. The market - for some inexplicable reason - is still willing to fund dividend deals to financial sponsors of weak credits. At some point, these inconsistent trends will collide.
The more important point made by Hoisington and Hunt is that global economic forces are overwhelming what occurs in the United States economy. "The lesson here seems to be that first, our $12 trillion GDP economy can be significantly influenced by the $44 trillion world economy, and second, long term forces - or secular trends - can, in fact, overwhelm the normal U.S. cyclical economic developments." This is one reason why inflation in the U.S. has remained so muted in an era of record low interest rates; global deflationary forces have counterbalanced the effects of low U.S. interest rates to keep prices low. Where low U.S. interest rates have had an obvious impact is in local U.S. housing markets. As HCM has argued before, there are good reasons for the Federal Reserve to continue to raise the overnight rate to 4.0%. Inflation, however, is not one of those reasons. As stated in the 75th Annual Report of the Bank of International Settlements (p. 4) (published on June 27, 2005): "a wide body of empirical evidence indicates that inflation upticks have recently become much less persistent, that exchange rate pass-through to domestic prices has fallen considerably, and that inflation expectations are now much better anchored at low levels than in the past." As this is being written, Federal Reserve Chairman Greenspan is telling Congress that the Federal Reserve must continue to raise interest rates. HCM hopes that the Chairman is a man of his word. If the central bank insists on waiting for inflation to return to continue to raise rates, it may be waiting a long time, and in the meantime it would allow serious imbalances to continue to grow.
One of those dumb things may be to pile back into the bonds of the dying automobile industry. One of the reasons that overall bond spreads have tightened dramatically over the last month is that the sell-off in auto sector bonds has reversed. The bonds of General Motors Corp., which had led to significant losses in April and May in the aftermath of rating agency downgrades of both GM and Ford Motor Company, have rallied back on good June U.S. sales (resulting from the extension of employee discounts to customers - if you can't sell cars profitably, at least you can try to make it up on volume, right?). GM's 8.375% bonds due in 2033, which reached a record low of 72 in June, rallied back to as high as 88.25 in mid-July to yield 9.6% (a spread of 610 basis points over Treasuries, more than 200 basis points narrower than its widest level).5 To place this in context, these bonds traded as high as 102 in early February of this year. Mind you, this is still a very high yield for a corporate bond in today's environment and 267 basis points wider than the average spread of the Merrill Lynch High Yield Index, which was trading at a stingy 343 basis points above Treasuries in mid-July.
The global search for yield has become an exercise in what Thoreau would have called "circle-sailing," and what others would correctly describe as investors chasing their own tails. The problem is that like the dog who finally catches his own tail, bites down on it and yelps in pain, investors who are able to invest in strategies offering higher returns often end up regretting the risks in which they have sunk their teeth. Because the cruel logic of investing in today's financial markets means that there is more money chasing the same prize but only a limited amount of prize money to be awarded. The global economy is really a zero sum game. The central banks can go on creating money from nothing, but they can't do so forever (despite what they tell you on CNBC). In HCM's opinion, we are nowhere near the kind of comeuppance that will lead to catastrophic market losses. But we are also nowhere near the kind of economic equilibrium that would bode well for sustained, healthy economic growth. The game can continue for awhile but it can't continue indefinitely.

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