That being said, I do agree with you, youngmoney, that - over the very long-term - nominal
interest rates will (must??) rise.

The simple end of mass disenflation (which is what we've been experiencing the past 20
years or so) means that rates simply cannot move lower over the long-term. Indeed, at
best, they will stay the same.

3. Inflation (and fear over inflation) is really not related to the absolute (or current)
level of inflation, but rather the trend in inflation. Currently, it would appear that
this trend is downwards. There are several reasons for this:
- Not one CPI # does an inflation trend make. Thus, just because CPI increased a touch,
there's no reason to think it's actually accelerating. Indeed, the overall trend is
downwards.
- Growth last quarter was primarily fueld by government expenditures. If you look
elsewehre, growth wasn't really that high.
- It takes 12-18 months for a monetary policy decision to actually have an effect on
things. Thus, if you believe that somewehre around 5% is a good level (I do, personally),
then you'd figure that - sometime in the second half of the year - growth will slow enough
to make any inflation fear there is recede.
- It appears as though companies are beggining to trim jobs a bit, which would create
excess capacity (and thus do away with inflation). Spring selling season for homes - and
the inventory glut that will likely arise from it - will also lead to job cuts in the
housing market, again creating excess capacity, and helping to dampen the economy. These
affects, when combined, will help to cut-off the recent increase in the money supply.

1. With the economy appearing to shift down from third gear to second gear, and with the
housing market not doing too well, I would suspect commercial banks to be purchasing 1-5
year treasury's aggressively. Indeed, many of these banks have ample supplies of cash.
Without enough growth to truly support loans until some time after the Fed has cut, I
would guess that they put it into 1-5 year treasuries. The short-duration of these
holdings also decreases the amount of interest rate risk they are subject too - which is
important to consider, because that would make them less "turned off" by any sort of
possibility of rates increasing.
2. Foreign central banks (see China) will most certainly continue to purchase US
treasuries through the end of 2008, for "economic" purposes rather than "profit-driven"
reasons. However, in their desire to gain as high a yield as possible (as Mr. Bill Gross
pointed out some time ago), one would expect them to pretty much purchase whathever
maturity is highest at that point in time. Thus, this should help keep both short and
long-term rates down, and should support treasury prices (I feel pretty confident in
saying that I don't expect treasury yields to rise much - if at all - above 5%). This
makes treasuries attractive.

I was actually about to make several points about short-term treasury prices over on the
thread entitled "The Macro Situation". But I will post it here as well, I guess... (also,
in response to your question, two of us, this would make Europe an attractive place to
invest, especially for the next 3-5 years or so. Long-term gorwth prospects of Europe,
however, aren't too strong.... just as a side note)

the best way (and the way that emerging countries have grown so rapidly in the past 25
years) has been through "export-driven growth", whose focus is on "exporting" something
they have in excess (example: for China, this would be cheap labor). Thus, a
"return-oriented" movement away from treasuries is not on hte immediate horizon, and will
not come about until their countries are much, much further developed (where domestic
consumption and domestic wealth has reached a high level).

Thus, this should prove bullish for treasury prices through 2009-2010, at least. Beyond
that, I am not talented enough to forecast accurately...

Indeed, I agree that a rate hike is not on the horizon (for all the reasons I've explained
above, and on other threads). Several things, in response:
- A raise in market risk would only result in treasury prices falling (corporate bond
prices are a whole different story) IF it was directly related to fear over the future
solvency of the US (credit risk), or if the returns on assets in the US became so low that
it FORCED foreigner's to no longer desire to hold them.
As many studies have shown, it appears that the major force behind low treasury rates
(focus on long-term rates here) has been central bank and "petrodollar" purchases on U.S.
treasuries. Although "petrodollar" inflows are likely slowing (and have been for a while),
central bank purchases will not slow anytime soon. THe reaosn is because their purchasing
of treasuries is not "return-oriented". Rather, their purchasing of treasuries is
"economic-oriented", in that it is what allows them to keep "weak currencies", allowing
for higher growth, lower unemployment, and larger foreign currency reserves. As studies
(including a terrific one published in the WSJ not too long ago) show,

Current markets conditions are saying rate cut is needed or expected. Homebuilders, Banks,
etc. would not be rallying if interest rate hikes were on the horizon. What else is
rallying, precious metals. Ben Bernanke is softening on inflation a little bit too soon.
He obvious wants to cut rates soon and will talk his way to it. I see inflation emerging
while housing is screaming for a cut. Ben will have to move off this pause drunkenness.
The market, in my opinion is saying he will cut in a inflationary environment. I'm very
suspect because we seem nervous about foriegners having a majority of US assets. Now many
will say this is good and we are benefiting, of course, but that is one side of the real
situation. Should we have another recession during inflation I would expect confidence to
weaken in the dollar and bond prices will weaken instead of rally. Capital flight just as
the last recession cause asset deflation. We dont have consumer price inflation we import
deflation export inflation. So its the assets that are vurnerable. The 21st Century and
I'm loving it!

6. We must not forget the power of sovereignty, however. The benefits are real, as our use
of it has spurred growth.

Personally, I am pretty darn worried about a sustained increase in inflation expectations.
This is why I think the Fed has to hold here longer than they might otherwise...

3. I agree that it appears as if the appetite for risk seems too high. That being said,
financial innovation and continued trust in our "financial technology" have allowed for us
to make inroads that weren't plausible before. Thus, although I agree that things are too
calm right now (my major indicator of this would have to be spread yields), I do believe
that we can achieve higher market multiples than before (although the tech bubble was far
too high for any given amount of innovation; summarizing what I am saying, I think the
market can go a touch farther than before before it becomes "stretched")
4. "We have these pay as you go budgets": that we do. I agree, youngmoney.
5. In regards to the weak dollar, I think a fair amount has been priced in (in regards to
rate cuts weakening it). Long-term, higher output as well as higher inflation - when
compared with mature countries/regions like Europe - should mean long-term dollar
depreciation against the euro.

Last edited on: 02-25-2007 11:36 am

Couple things:
1. Great point, Omid (on the "central bank put"). May I also add plain-old financial
innovation in with why volatility is so low. In addition, I have also been positing that a
good portion of the rate cut is already baked in (although the effect of a rate cut will
still be the same on economic activity... it just won't have the same affect on the
markets)
2. Although there are dangers with the deficit, the wealth it has created is real, not
fake. As Bernanke seemed to hint at a couple weeks ago, it appears that the amount of
wealth it has created has far surpassed any future liability payment. Also, I think most
every country around the world is actually benefitting from the current situation in one
way or another. For many, it allows higher domestic growth, as well as opportunities to
invest in a country that is currently earning a high risk-adjusted rate of return. As
Bernanke points out in some of his research, every other mature country has - until very
recently - been dormant for some time now, other than the U.S. So, really, it is of little
surprise to me that the U.S. has a deficit. We have the money, the wealth, and offered the
highest returns of all the mature countries (until recently).