Bond Outlook June 13th

Various reasons have been put forward to explain the sharp rise in yields at longer maturities. One is the fear of inflation, which echoes the worries of Bernanke. Another is a reduction in liquidity, blamed on growth of the world economy sucking up funds for working capital at an increasing rate. This is an argument we have some difficulty absorbing; it is largely based on the observation that TIPS are not suggesting much future inflation. Our own explanation is the shift in the focus of investment of the surplus countries’ reserves from T-Bonds to a range of other investment instruments. In the first instance this move affects yields, but not the USD rate of exchange. In all probability the Chinese and other central banks are too wise to play diversification from USD at the same time as diversification from T-bonds. Many national reserves have already been re-shuffled in terms of currency balance. That may suffice for a few months, while “sovereign investment corporations” play their hand. We were frankly surprised by the improvement in the USD exchange rate, but long-term adjustment is bound to be accompanied by recoveries in an overall downward secular trend.