One of the more puzzling aspects of market trends these days has been the obvious indifference of the bond market to budgetary indiscipline and rising risk associated with the increasing debt burden of the government. Bond markets did not fail to signal the approaching recession of 2008, since the yield curve had been inverted in the U.S. for a while before the Federal Reserve's rate cutting phase began. After the crisis set, bond markets were alert to any event that could have led the Federal Reserve to lower borrowing costs, and appreciate bond prices. But the enormous rise in the debt stock, the increase in Federal deficit, the downside risk in other words, has been completely ignored by bond market players, even if we discount the added attractiveness of government paper at a time when the financial world has been undergoing fundamental changes. Neither the rally in stock markets, falling Libor rates, nor the commencement of the recovery phase have had a significant impact on bond prices commensurate with what would be expected in light of the deterioration of the health U.S. public sector finances. Although to a lesser extent, bond markets have been similarly unresponsive to the multiple bailouts organized by Germany in the E.U. (in spite of their selective behavior in the region).

What is the cause of this situation? The most frequent answer is that bond market players have been seduced, so to speak, by the very large yield gap that exists at the moment between the costs of long and short term maturities as a result of the Federal Reserve's lack of ability to influence rates much beyond a few months. The lack of government interference on the right side of the yield curve leads to greater steepness, and increase the yield of carry trades entered into via a short on short term maturities, with an accompanying long on longer term. It is understood that in fact the most important actor in this activity are banks themselves, which recycle the short-term funds they borrow from the government into longer term assets,such as loans to corporate and consumer sector, including mortgage lending, and of course government paper with longer-term maturity. This is thought to constitute an important portion of the recent improvement in profitability.

Various regulatory bodies have recently drawn attention to the dangers created by this development, stating that a sudden reappraisal of interest rate risk could result in a rapid deterioration of bank balance sheets, and a general unwinding the capital market carry trade positions with unpredictable results. This is a valid concern, but, we believe that it is not enough in itself to explain the unresponsiveness of the bond market.

The shift in investment strategies of major market players over the past two decades, with the emergence of super-dealers active in all kinds of asset markets with similar objectives and methods, has lead to a blurring of differences between asset classe. Managers of hedge funds like Renaissance Technologies, who depend on technical methods and possess access to a huge range of investment opportunities thanks to advances in communication technologies, have caused correlations between different asset classes to rise so much that, at least in our opinion, the old distinctions between asset classes are no longer as valid as they were. In consequence, it will be proper to classify investors and traders into two major categories for the next few years, on the basis of their approach to risk in general: those who seek speculative gain, and those who seek to maintain, and protect their wealth. We suspect that investors who seek protection will tend to view, most, if not all asset classes as dangerous and risky, given the significant correlations that exist between them. In consequence they may well prefer to take their funds out of the market entirely, shunning all kinds of speculative instruments, be they bonds, currencies, stocks, or their derivatives.

An investor seeking that kind of retrenchment will have a few alternatives open to himself. If he seeks basic protection, CDs, and goverment bonds are acceptable choices due to the inherent guarantees supporting them that cannot fail in any foreseeable scenario, supplemented by diversification into traditional assets like gold, or cash. Even if they anticipate inflation, it is unlikely that they will be willing to dump Treasury Bonds en masse due to a lack of alternative. Taking risks on the basis of a hypothetical future hyperinflation scenario is a lot more complicated than seeking protection against an already well-understood and analyzed economic landscape dominated by volatility. The problem is not that investors (as opposed to traders, and speculators) do not recognize inflation as a risk, but risks involved in hedging against that are, perhaps surprisingly, higher than living with the risk, at least as long as the fringe scenario of a general collapse of confidence and the financial infrastructure built on it does not become a reality. As a consequence, the so-called bond vigilantes have reallocated to gold, or are too cowed to short anything after the massive losses suffered by shortening government paper during the crisis of 2008. Even the well-respected PIMCO was not immune to this type of development, and is in fact favoring U.S. Treasuries, in spite of all the odds.

The failure of markets to adjust to warning signs was particularly well-illustrated by the events of Summer-Autumn 2008, where markets suddenly shifted into collapse mode in spite of clear signs that the U.S. investment banks were unviable in their then current form. There was no preparation phase, and indeed, oil had reached almost $150 just a few months before the Lehman collapse indicating confidence that the world as we knew it would go on. We believe that the current situation of the bond market, where risks related to U.S. public finances are not being properly priced, can be explained in similar terms. The Federal Reserve has contributed its share to derailing the healthy functioning of financial markets as assessors of risk by its multiple bailouts, bond vigilantes are gone since they are all beholden to the trendsetters. When the shepherd is astray, it is only natural that the sheep follow to the edge of the cliff, if not a few steps beyond.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.