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Bond Prices … Up or Down … Which Is It?

Posted By John Schroy On 3rd April 2005 @ 23:25 In Corporate Bonds | No Comments

In March 2004, news tickers reported a larger trade deficit. The Fed announced its decision to raise short term interest. Bond traders, crowded elbow to elbow on their communal desks, alerted by blaring bull horns, were quick to react. Intermediate and long bond prices fell sharply.

Operating with a time horizon of a few days or months and under pressure to show a profit today, traders can’t pause to wonder if market opinion is true or even logical. What’s important is that everybody is saying the same thing. Consensus, not truth, drives short-term prices.

Logically, the more money flowing to bonds, the higher bond prices should be. We know that a larger trade deficit means that more foreigners will buy bonds.

(See “[1] Trade Deficits Have Depressed Bond Yields For 20 Years“).

We also know that Mr. Greenspan has tenuous control over long bond rates.

(See “[2] Limits to Federal Reserve Power“)

Furthermore, news about the trade deficit is old. By the time the government publishes the numbers, investors have acted long ago, influencing prices to whatever extent they will.

So, consistent with the [3] Irrationality Axiom, traders dump bonds and then report their reasons to TV reporters who transmute these explanations into fact, relayed to them by professionals at important institutions. This is why the media said in March that “bad news” about the trade deficit drove bond prices down, We are supposed to believe that more foreign investors chasing after bonds somehow depresses prices. It might be logical, if you don’t think about it much.

Why Financial Reporting is Often Wrong

Unless you are a short term trader, the chattering of financial reporters can be bad for your wealth. You could be panicked into buying or selling at the wrong time. Throughout most of 2004, the press and Wall Street predicted a fall in bond prices, because Mr. Greenspan was going to move short-term interest rates upwards. However, the crash in bond prices didn’t occur.

Reporters got it wrong because the trade deficit is generally presented as a negative force on bond prices, while the opposite is true. Just google the Internet for “trade deficit” and you’ll find hundreds of negative opinions. Furthermore, you’ll discover that in most of these articles, the long term is often three to five years, certainly not the ten or twenty years it takes to see the bigger picture.

Nor will you find much reporting of flow of funds and the logical connection between the accumulation of dollars in the hands of foreigners and the fall in bond prices. The ability to gain a different perspective based on real capital movements is what makes capital flow analysis useful.

A capital flow analyst, noting the fall of bond prices in March 2004, might interpret this as an irrational, short-term reaction to the “bad” news of the trade deficit, in other words, trading jitters rather than an indication of a longer-term trend based on well-founded money flows. Having a logical interpretation of events might just keep the analyst’s finger off the sell button, providing the restraint needed to hold a position a bit longer to avoid selling at a bottom.

Urban Legends and Bond Prices

So many people have said that the trade deficit is bad, we’re almost tempted to believe it must be so. But this is not the only unconvincing tale making the rounds. Another curious story is that the dollar is about to plunge because the Bank of Japan and the Bank of Korea will “rebalance” their portfolios of dollar bonds. They are going to do this by selling dollar bonds and buying euro bonds. Their massive sell off of U.S. bonds will depress both U.S. bond prices and the dollar … right?

It seems logical, if you believe that (1) the trade deficit is bad for the U.S.; (2) the euro will replace the dollar as the leading international currency; and (3) portfolio balancing on this scale makes economic sense for central banks.

Let’s think this through. When the Bank of Japan sells dollar bonds, who is going to buy them? Probably not “spendthrift” Americans. What currency will the Bank of Japan be happy to receive in exchange: the Brazilian Real? the Thai Baht? The Honduran Quetzal?

The likely buyers will be some other foreign holders of U.S. assets, who won’t be eager to give up euros to buy dollar bonds. Even if the Japanese and Koreans manage to sell dollar bonds at a discount and buy euros at a premium, achieving “currency diversification”, some other foreign institutions will be doing just the opposite; the net volume of foreign holdings of U.S. bonds shouldn’t change.

If fact, once dollar assets get in the hands of the Rest of the World, its remarkably difficult for foreigners, as a group, to get rid of them. Of course, foreigners could always buy goods or services from Americans, who will be happy to receive dollars, but the growing trade deficit suggests that Americans have already sold just about everything foreigners want to buy, at least in the short run.

The Rest of the World could also, as [4] Mr. Buffett fears, sell bonds to buy up real estate in the U.S., which really would drive down bond prices.

The “Bank of Japan story” is a typical legend passed on by TV commentators. It seems logical until you think it through, step by step.

However, so many believe these stories that it is easy to think that our own logic is somehow flawed. In fact, it may be that although common opinion is wrong, we are also mistaken because of some unconsidered factor. So which is it? — will bonds trend up or down?

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Article printed from Capital Flow Watch: http://capital-flow-analysis.com/capital-flow-watch

URL to article: http://capital-flow-analysis.com/capital-flow-watch/bond-prices-up-or-down-which-is-it.html

URLs in this post:
[1] Trade Deficits Have Depressed Bond Yields For 20 Years: http://capital-flow-analysis.info/capital-flow-watch/archives/46
[2] Limits to Federal Reserve Power: http://capital-flow-analysis.info/capital-flow-watch/archives/33
[3] Irrationality Axiom: http://capital-flow-analysis.info/investment-tutorial/lesson_6.html
[4] Mr. Buffett fears: http://capital-flow-analysis.info/capital-flow-watch/archives/44
[5] bank of japan: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=bank-of-japan
[6] bond market: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=bond-market
[7] central banks: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=central-banks
[8] foreign investors: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=foreign-investors
[9] statistics: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=statistics
[10] trade deficit: http://capital-flow-analysis.com/capital-flow-watch/index.php?tag=trade-deficit
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