the bond market
June 10, 2005
Last month Standard and Poor’s downgraded General
Motors’ and General Motors Acceptance Corporation’s debt to
junk status. Later in the month Fitch Ratings followed suit. GM is the
largest corporate debt issuer in the United States, with about $300 billion
in outstanding debt -- all of it junk.
If you thought GM is in the business of selling cars, you
might find it interesting that GMAC, which is the financing arm of GM,
accounted for 80% of the group’s total profit last year. As the
recent downgrading of GM’s debt has significantly increased the
cost of capital for the group I wonder where their profits are going to
come from now.
To cope with rising costs and declining sales, General Motors
announced that it plans to eliminate 25,000 manufacturing jobs over the
next three years. Part of the problem, according to GM, is the rising
cost of health care in the US. Health care expenses add approximately
$1,500 to the cost of each GM vehicle. Not surprisingly, GM is trying
to convince the unions to allow it to cut its health care spending. Equally
unsurprising, the unions oppose that idea.
Meanwhile, Federal Reserve Chairman, Alan Greenspan, believes
that the US economy is on “reasonably firm footing” despite
the “uneven character of the expansion over the past year”,
and he has indicated that the US central bank is not done raising interest
rates just yet.
The Fed chairman said that it is “very difficult”
to know what level of interest rates is optimum for the economy although
“we probably will know it when we are there.”
Since June last year the Federal Reserve has raised its
short-term interest rate target from 1% to 3% while at the same time ten-year
Treasury rates have declined from 4.7% to less than 4%. This flattening
of the yield curve is what many are calling the “bond market conundrum”.
Whenever long-term interest rates fall below short-term
interest rates (referred to as an inverted yield curve) there is a good
chance that a recession is ahead. Greenspan, however, does not believe
falling long-term interest rates indicate economic troubles ahead. Federal
Reserve Officials are upbeat on the economic outlook and Mr. Greenspan
stated that even if the yield curve did invert they would “not automatically
assume it will mean what it meant in the past” -- meaning that he
does not think an inverted yield curve implies the economy will slow down.
The chief economist for Manufacturers Alliance/MAPI, a public
policy group in Arlington Virginia, recently stated that the rate of manufacturing
growth is decelerating virtually across the world. I look at the US auto
industry and note that US auto sales fell 8% in May compared to a year
ago. We know General Motors will eliminate 25,000 jobs; how many other
manufacturing jobs are at risk?
Back in the Nineties, several currency crises caused massive
international capital flows that distorted exchange rates and affected
various financial sectors including US bonds and stocks (see “The
Greater Depression” in the Commentary Section of my website: www.paulvaneeden.com,
dated January 30, 2004).
Those imbalances caused, and continue to cause, misallocations
of capital that must be reversed before real, sustainable economic growth
will be possible.
I believe we will experience a severe recession while these
imbalances are corrected, and until then the best we can hope for is to
muddle along as we have been doing lately.
Financial survival will require us to act rationally, not
emotionally, and to be careful. The way I am playing it is by looking
for leverage to a falling US dollar exchange rate. The dollar may look
strong right now, but it has severe structural problems. In the end I
think the dollar is going to suffer… a lot. It is just a matter
Paul van Eeden
Paul van Eeden works primarily to find investments for his
own portfolio and shares his investment ideas with subscribers to his weekly
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