Bond Markets Rout; Signs of Rising Inflation? Bullish on Philippine Agriculture

``Whether through asceticism, ideology, religion, advertising or other means, whether consciously or not, the elites in all societies manage desire-the starting point of wealth creation. Obviously, just pumping up the desire level-or for that matter, extolling greed, which is different from either wealth or desire-won’t necessarily make anyone rich. Cultures that promote desire and pursue wealth do not necessarily attain it. On the other hand, cultures that preach the virtues of poverty usually get precisely what they pray for.”-Alvin and Heidi Toffler, Revolutionary Wealth

Now going back to the world markets, the world bond market tells us of some risks to be concerned of.

US coupon rates jumped across the yield curve as global bonds got crushed. This has been occurring as global Central Banks has been on an interest rate hiking mode; where New Zealand and the Euro zone were the latest to raise rates this week.

Figure 2: US Treasuries and emerging market yield spikes!

The inflationary policies adopted by global central banks have now started to permeate into consumer price indices. In the same sphere, we see government intervention (in forms of subsidies) in the energy markets have likewise contributed heavily to the law of unintended consequences; raising steeply corn prices that triggered the tortilla crisis in Mexico and the spiraling pork prices in China!

Legal mandate and subsidies on corn as feedstock to the biofuel programs have led to a sizable shift in demand for corn (in competition to its traditional uses; food, animal feed, sweeteners), aside from the reallocation of acreage into corn plantation at the expense of crops. This has likewise prompted price increases in other products, such as soybeans, cotton etc.

According to McKinsey Quarterly’s article Betting on BioFuel, ``From 2003 to 2006, the percentage of the total US corn harvest used to produce biofuels rose to 16 percent, from 12 percent. But now that the federal government has adopted a goal of 35 billion gallons of alternative fuels a year by 2017, the use of domestic corn-based bioethanol to meet even half of this target would require 40 percent (emphasis mine) of that year’s expected harvest. Not surprisingly, the cost of corn has soared: average wholesale prices rose from $1.90 a bushel in 2005 to $2.41 in 2006, and corn has regularly surpassed $4 a bushel on the spot market since late 2006.”

``Other unintended consequences of greater demand could bring a consumer backlash like the one that broke out in Mexico when tortilla prices skyrocketed because of bioethanol-related corn shortages. Environmental concerns were also raised after last autumn’s burning of Indonesian forestland to make space for palm oil crops that were linked to increasing demand for biodiesel. The environmental impact of other aspects of biofuel production, including the widespread cultivation of fast-growing jatropha (a plant that produces a toxic vegetable oil), are unknown.”

Again as we have long forecasted, we remain bullish on the domestic agriculture industry in spite of its downtrodden state, primarily because of its prolonged era of underinvestment in the light of the dramatic wealth induced demand growth in emerging countries equally matched by the multifaceted supply constraints from rapidly developing emerging market economies (such as demographic and urbanization trends, rising incidences of desertification, industrialization, chronic water supply shortages), the weakening US dollar and now, the effectual distortions emanating from government interventions in the marketplace due to energy and climate change requirements.

As shown in Figure 2, bond prices have accelerated their descent in the US (upper window), as well as in emerging markets (lower window), as 10-year treasuries yields nearly topped its 2006 high (center window).

In the US, Chief Economist Paul Kasriel of Northern Trust believes that rising consumer price inflation, or New Zealand’s policy actions or inflation expectations have NOT been responsible for the present activities in the bond market.

Instead he argues that perhaps the recent bond market rout could have been an outcome from a spate of market activities which included hedging out of growing mortgage prepayment risks, Mr. Kasriel says (emphasis mine),

``When bond yields started creeping up a few weeks ago, mortgage portfolio prepayment risk started creeping down. This meant that the massive amount of mortgages in portfolios needed fewer non-callable Treasuries as duration maintainers. I am not saying that something perceived to be fundamental by bond investors has not changed. But what Lahart is saying is that the massive duration hedging required by mortgage portfolios acts as a supercharger to fundamentally-induced changes in yields. Remember 1994?”

This means that that rising rates has prompted for higher mortgage rates, which likewise increased the risks of fewer prepayments. And with high inventories of mortgages, mortgage investors could have either sold mortgages or hedged their portfolio by selling US treasuries, as expectations for rate cuts have diminished.

And another possible unseen reason could have emanated from declining interests with US treasury purchases by foreign investors, adds Mr. Kasriel (emphasis/highlight mine)…

Figure 3: Northern Trust: Less Purchases from the Foreign Official Holdings

``I will, however, add one fundamental factor that may have played a smaller role in this week’s bond market selloff – foreign official holdings of U.S. Treasury and Agency securities. As the chart (Figure 3) shows, in the week ended Wednesday, June 6, there was a relatively large $12.5 billion reduction in these custody holdings.”

Our take is that if this is an emerging trend where foreign central banks have shown lesser appetite to prop up US assets then the likelihood that the rally seen in the US dollar recently could merely serve as a blip.