Thursday, March 20, 2008

Bond Yeilds Bottoming??

As the flight to safety continues I have been watching bond yeilds closely.
This chart highlights a potential bottom that is forming in Treasuries and as they say at my favourite trading blog

"bottoms arent a point so much as they are a process"

lets take a look at my case for the process unfolding:

Next week is a critical pivot point for these technical developments.

Mish Shedlock sums it up in his recent post regarding the case for deflation:

Recap Of Fed Sponsored Facilities:

The TAF (Term Auction Facility) failed to
restore liquidity.

The TSLF (Term Securities Lending Facility) failed to
restore liquidity.

(Primary Dealer Credit Facility) will be the next "facility" to fail.

Clearly the bond market does not believe the TAF, the TSLF, or the PDCF are going to solve the liquidity problem. I don't either because the problem is not liquidity and can't be solved by liquidity. Treasuries Are Safer Than CashI had an email exchange with a reader yesterday who said "Deflationists don't generally believe in buying gold, because they believe cash is king".

The same person was also questioning a statement I made about cash losing value in deflation. Let's take a look at these ideas starting with cash.While cash may be king, and I have made that statement many times myself, it is only king if it cannot be defaulted on. Cash in the bank, above the FDIC limit, can indeed be defaulted on.

Also note that money markets are at risk if they are invested in mortgage backed securities instead of treasuries.The only guaranteed safe way to hold cash is in amounts below the FDIC limit. Above the FDIC limit, cash is not king and cannot safely be held as cash but must instead be parked in US Treasuries. Realization of this simple fact is likely behind the huge rally on the short end of the curve.

How Cash Can Lose In Deflation?

Cash may be worth less in term of other currencies.
Cash may be worth less in terms of gold.
Cash (above the FDIC limit) can be defaulted on.

The first two points above are in relative terms of course. As for gold, there are many deflationists who believe gold is money and money will do well in deflation. I am one of them.

However, I have also said that gold would likely correct because leverage in hedge funds would have to be unwound and some of that leverage is in gold. Also there are many who have piled into gold for the “wrong” reason. The wrong reason is inflation.

Unlike cash in the bank or US Treasuries, gold is the only currency
that is no one’s liability. Government decree alone cannot stop gold from being money. Gold’s role as money has held throughout history.Long term the US dollar is headed to zero, so is the Yen, and so is the Euro. All fiat currencies eventually go to zero. Gold will never go to zero.However, the long term is a long time. The dollar is not headed to zero tomorrow, nor is the Yen, nor is the Euro. Right now, a flight to the safety of treasuries is underway as leverage elsewhere is forced out of the system. This is just what one would expect to see happen as deflation picks up steam.

Mike "Mish" Shedlock

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