The Real Cost of Borrowing and Asian Economies
by Jes Black
December 06/04
Friday’s payroll disappointment took quite a swing at our bond forecast, sending yields careening lower. But the key 4.25% level on the 10-year yield held, keeping hopes alive for our bearish bond outlook. This week we present yet another case for why we remain so adamant that yields must rise and what this means for investors seeking opportunities in Asia.
To begin with, the inflation adjusted 10-year yield is hovering around
2%, half of the nominal rate just above 4%. Yet both are butting up against
long-term downtrend lines. In our view these resistance barriers will
eventually be overcome resulting in higher nominal and real interest rates.
Considering the US debt burden, this should slow economic growth.
Short Note on Asian Economies:
As real interest rates in the US appreciate Asian economies will have to allow their currencies to rise to pick up the slack. In doing so they will likely cut interest rates to offset the blow to industry. South Korea already tried and failed last month to supress the Won. When presented with a rising currency they decided to then cut interest rates. As a result, US investors looking for opportunities in Asia may be well advised to take a diversified approach and not just concentrate on China.
When the South Korean central bank intervened in the markets and cut
interest rates last month we immediately advised subscribers that when
this happens that stock market represented in the US by an ETF stands
to really take off. Each week in our research service ETF Global
Weekly we highlight five Asian bourses and their exchange rates relative
to the dollar. As such we look to position ourselves in markets where
there is a breakout in both the currency and stock market. In South Korea
that is now happening. Shown below is the Korean Stock Exchange, the Won,
and EWY.
In Marc Faber's excellent book "Tomorrow's Gold," he actually uses South
Korea as an example of an unloved market ready to take off again. In our
view, a sustained move above 1,000 in the KOSPI would likely be similar
to the Dow finally rallying above 1,000 in 1983 after a decade long consolidation
pattern. The only difference here is that the KOSPI in real inflation
adjusted terms has not fallen 80% as the inflation adjusted Dow did during
that time. But the P/E ratio on EWY is a mere 7.5. Recall that in September
we highlighted a similar opportunity in Taiwan where both the stock market
and currency were poised to breakout while the P/E was below 10 at that
time. So far the Taiwan dollar and stock market have lived up to their
promise, delivering a total gain of 22% via EWT.
Bond Market Update:
Now back to bonds. One chart that we continue to update for subscribers is the Gold/Bond ratio plotted over yields. This is a method presented in John Murphy’s “Technical Analysis of the Financial Markets” to identify inflationary conditions in the marketplace. The Gold/Bond ratio had a correlation of over 90% with yields between 1990 and 2001. That is primarily because bond yields move inversely with price and because rising inflationary pressures also help drive yields higher. Or at least they used to.
To us, the greatest anomaly in modern finance is how low US interest
rates are given the crashing dollar and rising global equity markets.
We are incredibly bearish on the bond market but our view is not dogmatic,
just perhaps out of touch with the main stream.
As you can see yields are seriously lagging the uptrend in the Gold/Bond
ratio. Said another way, the rapid rise in gold (decline in the dollar)
has caused both the relative value of a bond and the interest rate paid
to fall together at the same time. This is a stealthy type of inflation
and in our view this liquidity spike explains the sharp rally in commodities,
stocks, foreign currencies and the perseverance of bonds over the past
two years since most of these markets are ebbing and flowing together
in real time.
So while no one can blame an investor for seeking inflation protection
from the stock market, if we had to pin the tail on a donkey we’d call
the bond market investor the biggest donkey there is. What very few investors
we meet understand is that whatever you buy you buy priced in a certain
currency. Foreign investors have this concept down. But the vast majority
of Americans do not. So while a falling dollar may offer some upside to
asset prices by default, only by looking at these same assets priced in
a constant currency like gold can we ascertain the overall trend. With
this in mind consider that both the bond and yield priced in gold are
falling together since 2001 due to the surge in gold prices (decline in
the dollar and thus decline in purchasing power).
Since we feel the dollar’s decline is near an end and the first chapter
on the gold rally is coming to a close, “real” interest rates should begin
to rise and thus take some of the excess liquidity out of the market.
If we are right, this will lead to a sizeable decline in the global stock
markets in Q1 2005. But obviously, unless there is a bond market revolt
stock markets can come roaring back after a correction if nominal and
“real” yields remain near historic lows, thus providing a huge incentive
to borrow.
Jes Black
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Jes Black, hedge fund manager at Black Flag Capital Partners, specializes in foreign exchange and global macro trends. Prior to organizing the fund he helped MG Financial Group launch Forexnews.com. Afterwards he went on to found FX Money Trends, a research firm catering to professional traders.
Mr. Black holds a degree in economics from the University of Kansas and
an MBA from the ESC in France. His market commentary is often featured
in the Wall Street Journal, Financial Times and Reuters. He has also written
numerous strategy pieces for Futures magazine. To find out more about
the fund’s research letter visit www.fxmoneytrends.com. Qualified
prospective investors can find out more about Black Flag Capital Partners
by e-mailing info@blackflagfund.com
Jes Black
FX Money Trends, LLC
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