Nothing to Treasure in Treasuries. By Mike Foster

Bonds will bomb

Thirty years ago, former Federal Reserve chairman Paul Volcker decided it was time to lower interest rates following a period of tight money which successfully squeezed inflation out of the US economy.

Drinks all round. Falling interest rates and low inflation presented the US with the biggest bull market in bonds it has ever seen. Exporters to the US, led by the Chinese, saw Treasury bond purchases as the ideal way to make their currencies competitive.

Following the onset of the credit crisis, Treasuries became seen as a safer and safer haven. More recently regulations designed to make institutions "safe" have encouraged yet more purchases at a yield which has become virtually invisible.

The impact of the buying spree can be seen in the attached chart drawn up by strategist Charles Nenner, who is convinced that thirty years of fat for US bonds will be followed by thirty years of lean. The sell-off should start soon, he thinks. All it needs is a trigger.

Nenner once worked at Goldman Sachs. He now advises a range of hedge funds, banks and private clients. By all accounts, Russian president Vladimir Putin is a bit of a fan. Perhaps he likes the thought of all those US bonds falling out of bed.

Nenner's view is derived from the late Soviet economist Nikolai Kondratiev who argued that economies moved through regular 40- to 50-year cycles. His ideas were not supported by the Soviet government because he took capitalism too seriously. He was sent to the Gulag and executed in 1938.

Kondratiev believed that innovation comes in waves. Discoveries during a down period do not get put to work when everyone is depressed, but they do contribute to the upswing.

Unlike Kondratiev, Nenner can plot his cycles with the help of computers. He reckons each cycle is reinforced by the comings and goings of life. Their movement dictates the way markets travel over the long term, and there is nothing any of us can do about it.

Nenner regularly compares market price levels to his underlying cycles, with a view to working out whether events will be amplified by them, or damped down. Whatever you may think of his techniques, the latest set back in Apple's share price did coincide with a fall in its cycle.

Nenner is deeply concerned about the challenges faced by the bond market. And he takes a long view – the cycles in his graph stretch way back to US independence. He argues we have travelled through four cycles since 1776. Often, the price movements experienced during up and down periods have not been extreme – the war years of the early 20th century were particularly restrained.

But the direction in which markets have travelled do correlate with his cycles. And there are reasons to believe the extraordinary bond buying spree over the last 30 years will be mirrored equally decisively on the way down.

Early on, the downshift will be glacial because the levels of belief vested in the US bond markets are so extreme. But it will pick up speed if and when investors, particularly the Chinese, come to question the virility of the US economy. And maybe the dwindling, but still powerful, band of hedgies will help the process along with a few shorts.

Whisper it gently, but if Charles Nenner is right, the state of the US bond market might yet turn out to be President Obama's biggest challenge in his second term.

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