Friday, October 17, 2008

What Will/Are Foreign Investors To Do?

The "Other" Consumer Confidence Survey

By | October 2008

The "Other" Consumer Confidence Report...What the heck are they thinking now? You know who we mean, the 'foreign' investment community. Who else? Hopefully without wildly belaboring the point, we remain convinced that the US is ultimately going to face a funding issue down the road. Maybe not a funding issue in terms of being able to borrow funds, but rather the issue is the cost at which funds will ultimately be made available to the US.

This is exactly what we addressed when we penned the Fun With Funding discussion last month. Put yourself in the shoes of the foreign investment community. Many moons ago, you started recycling trade related dollars back into US financial assets. In essence, you were able to facilitate a little mercantilist economics. By buying US financial assets (primarily bonds) you effectively helped keep US interest rates low and enabled the relatively blinded by asset inflation US consumer borrowing and spending (on your export products).

As commodity prices rose, the BRIC nations and OPEC got into the dollar recycling game in a big way. If you remember the Fun with Funding article, one of the tables in the discussion showed us that since May of 2006, 100% of foreign purchases of US Treasuries were undertaken by Brazil, Russia, India, China and OPEC. Japan was a net seller over the period. Quite the happy circumstance...while it lasted.

But over the past seven months, the foreign community has been treated to the visual of three of the five largest US investment banks disappearing. One literally disintegrating in the night. They also watched as the largest two US residential mortgage-financing intermediaries entered Club Fed, never to be seen again in public. Let's face it, the foreign community knows Lehman had been around for 158 years. The firm had lived through a domestic civil war and a financial/economic depression.

And what eventually took it down? Granite countertops, stainless steel appliances and travertine flooring. Quite the sorry commentary. You get the point. We suggest that one of the most important consumer confidence surveys of the moment is the monthly tally of foreign purchases of US financial assets. The foreign investment community has had a front row seat in the US credit cycle drama playing out amongst Wall Street and the Fed/Treasury/Administration.

They, along with almighty Bill Gross, expressed their extreme concern over Fannie and Freddie solvency, instigating relatively immediate action. They, along with almighty Bill Gross (to the tune of $750 million) would have been hurt badly had AIG gone nose first into the tarmac without even attempting to pull the nose up before crash landing. We know in part what the foreign community has been saying, but what are they thinking at this point? To us, one of the most important questions as we move forward.

Although we know we have covered this in the past, we believe it's critical to keep an eye on foreign capital flows into US financial markets. We ALL know how important foreign capital has become to the US economic and financial system continuing to function properly. And we all know that since early this year, foreign sovereign wealth funds have gone on a buyers strike in terms of providing US companies capital amidst the ever evolving US credit crisis.

No more Saudi princes riding to the rescue? C'mon, where's their sense of humor? Let's have a quick look at the longer-term rhythm of foreign flows of capital into US financial markets. Why? Because the character of that flow is changing meaningfully as we speak. You know these numbers unfortunately come to us with a lag. As of now, data is current through July. Since that time, Lehman has passed away and Fannie and Freddie senior and sub debt securities have been rescued.

AIG has been thrown a lifeline and Merrill has crawled under the skirt of BofA. We know the foreign community was indeed getting a bit skittish about the government agencies over the summer, and that skittishness is reflected in these numbers. But what's most important to us is the rhythm of longer-term trends in the twelve month moving averages you see in each chart. In short order, let's have a look.

Clearly into the credit crisis phase of the current cycle beginning last summer, Treasuries have been the asset class of choice for the foreign community. It’s a natural. Institutionally the world has been conditioned to run to the supposed safe haven security that is perceived to be UST's. As we’re sure you saw, 90-day T-bill yields kissed .2% in trading a few weeks back in what was clearly a panic run into the short end of the Treasury market.

The safe haven asset? In spades at that yield. We can understand foreign and domestic investor behavior here, but as we have said many a time in the past, we believe there will indeed come a day when this may no longer be the case. Although one day does not a trend make, gold’s one-day price fireworks show a few weeks ago was indeed the noticeable event. We heard rumors of a large AIG short in the metal being covered, but who really knows at this point.

Although we’re guessing, if gold zooms higher from here, we’d take it as a sign the markets have lost considerable faith in the Fed and Treasury. By extension, could marginal loss of faith in the credit that is US Treasuries be far behind if this line of thinking is even near correct? Nope. No wonder there is such establishment resistance to gold as a monetary symbol.

For now, foreign flows into Treasuries, as seen above, are not a major issue point of concern, but we watch intently as we move ahead. As a quick refresher, we believe the important data point in the chart above is the twelve month moving average of purchases. We're well below record highs seen years ago, but in no way are we looking at a supposed collapse for now. One note that we'll refer back to as we conclude this discussion is that into the last US recession, the foreign community was a seller of Treasuries in aggregate.

Although the credit crisis environment in the US has taken center stage attention for now, the fallout influence of the credit crisis on the real economy, and the real world recession it will ultimately engender, is the next act to anticipate in the current drama playing out before our eyes. Will we see a repeat performance of foreign liquidation of UST's in the US recession to come? If so, it could not come at a worse time. We watch and wait.

Before moving forward, one last view of life for perspective on the importance of the foreign community to the US Treasury market. Below is a look at the character make up of Treasury holders as of the conclusion of 2Q 2008.

As we suggested in the "Fun With Funding" discussion last month, the US government balance sheet will expand meaningfully ahead. Key question being, will the pie chart we see above change in character as this balance sheet expansion occurs? Will households become big UST buyers? How about domestic banks that currently own the smallest slice of the pie?

For now, although it's clearly loose commentary cast in the heat of the moment, the "reaction" of major sections of the foreign community (Asian, European and Middle Eastern) to the proposed bailout package in the US has been well south of a resounding thumbs up. But, as always, it's not what they say, but rather what they do ahead that will be important to US funding outcomes. Let's move on to the foreign influence in the government agency market.

The fact is that the sale by the foreign community of US government agencies in July was a record. The chart below is relatively dramatic in revealing this circumstance. Certainly some of the proceeds of these sales found their way back into Treasuries. We know the foreign community was indeed "asking questions" prior to the "conservatorship" of Fannie and Freddie, despite the implicit moral hazard guarantee that had been in place for literally years.

So it’s a one off in July, we believe. But despite the one month July sale-a-thon in agency paper by the foreign sector, the longer-term trend embodied in the 12 month MA has already been telling us for some time that the foreign community is growing weary of continuing to acquire agency paper. If the July activity in agency sales isn't a ding in the side of the greater confidence ship on the part of the foreign investment contingent, we just don't know what would be characterized as such.

Who knows, now that agency paper is essentially government paper with a yield premium, foreign community perceptions may change ahead. We've seen buying in recent anecdotal data. But we’re not holding our breath. As the chart clearly shows us, the foreign community indeed was a key provocateur in funding the macro US mortgage market from the mid-1990’s through to late 2006. Will they be so obliging to do so again given what has happened to supposed quality mortgage paper in the current cycle? We’ll see.

The real and very meaningful walking away, or confidence destruction, seen in actions by the foreign community in terms of purchasing US financial assets has occurred in the corporate bond market. Without question, what you see below speaks to academic risk reduction and a very much heightened sense of currently pricing in investment risk, if you will. The drop in foreign acquisition of US corporate bonds is striking, if nothing else.

As a quick tangent, we take what we see above very seriously. Corporate bond spreads have widened very meaningfully over the last year. Whether it’s corporate Aaa versus 10 year Treasury yields, Baa credits using the same spread, or high yield corporate spreads, it is clear that meaningful change has occurred in macro credit market perceptions and pricing. In our minds, there is no way the US economy is about to reaccelerate until corporate bond spreads contract. This is a distinct and definitive message of history.

And as is more than apparent in the chart, the foreign community has been nothing short of integral in keeping US corporate bond yield spreads tight throughout the entire prior economic cycle via their very meaningful purchasing activity. The twelve-month moving average of foreign purchases of US corporate bonds is just about back to the trough of the prior cycle seen early this decade as we speak. This strikes directly at the heart of the real economy being able to fund itself as we look ahead.

The last asset class under examination is equities. Foreign investment history has been that peak exposure usually occurs at major price peaks and trough exposure at major price troughs. You know, buying high and selling low. So what else is new in terms of human behavior? Not much. Since last summer, the foreign community has lost it’s taste for US equities, as has the US public.

Funny that way. Stick a 30% off sign in a retail store and it attracts buyers immediately. Stick a 30% off sign on Wall Street and everyone avoids the place like the plague. Human nature never changes, does it? We simply need to be aware of our own faults in terms of emotional human decision making and try to "rewire" our actions and reactions.

As you can see in looking at the absolute dollar numbers, foreign purchases of US equities in terms of dollars is very small. It’s the fixed income markets where the big foreign money is invested. And to us, this is very meaningful in that, as we have said, the big issue looking ahead is how the US government and greater economy funds itself. Who provides the funds and at what cost? Critical questions.

Final chart, we promise. Total foreign flows of capital into US financial markets over the last two-plus decades. There have been very few instances of monthly net selling by the foreign community of US financial assets. July just happened to be one of those months. Not good for a greater economy that we believe faces intermediate term funding "challenges", to be tactful.

But as we’ve said looking at individual asset classes, this is not a one-month one-off experience. The declining trend in foreign purchasing of US financial assets has been happening for a year now, completely coinciding with the deteriorating credit market fundamentals in the US. The chart is clear on this statement. Does this show us what the foreign community is thinking? How could it be otherwise?

As a quick comment on historical perspective, we know the nominal dollar decline in the twelve month moving average of foreign purchases total US financial assets is meaningful. As of July, the 12 month MA has declined close to $50 billion from June of 2007. In percentage terms it's a 46% decline. In the wake of the Asian currency crisis, we saw a 51% top to bottom drop in this 12 month MA. So is the world coming to an end here and are we in uncharted waters? Not yet.

What we believe is most meaningful right now is the powerful issue of change at the margin. At the exact time macro US funding needs are increasing, one of the largest buyers/holders of US financial assets is changing their behavior at the margin. This is what we need to stay on top of, monitor monthly, and anticipate financial market and real economic outcomes based on this change.

There you have it, a very important foreign financial consumer confidence survey if we’ve ever seen one. Maybe one of the most important confidence surveys we can think of at the moment for a US financial sector and general economy increasingly in need of capital. In summation, we believe the foreign community faces the following decision points over the near term. As has been the case for many a moon now, foreign investment in US financial assets must contend with interest rate risk and currency exchange rate risk. Nothing new to see here.

But what is changing is the very important need of the US government to expand its balance sheet very meaningfully. You already know our thoughts on this. The US and really the globe is heading into a major consumer led recession that at this point, as we see it, is unavoidable. Key questions for now being duration and depth.

Will the BRIC countries' and OPEC capital reserves (the key foreign buyers of UST's over the last two years) be needed on their respective home fronts to help shore up/stimulate their own economies? If so, that's competition for a US government in need of increased funding. Lastly, there is a new monkey wrench that has been recently thrown into the total equation.

The foreign community has been treated to the new wrinkle that US authorities are now willing to "change the rules" without any prior notice. Again, at the margin this creates investment uncertainty. How are foreign entities to feel comfort in providing capital to the US financial sector when equity and preferred asset values can be essentially wiped out on a Sunday afternoon? It's no wonder the global sovereign wealth funds have been on a buyers strike.

As a quick counterpoint to what we see as enhanced risk to foreign capital committing to US assets at the moment, be sure to keep your eye on many of the major European financial institutions. In terms of the raw numbers, leverage ratios for many of Europe's largest financial behemoths make former US investment bank outfits look like choirboys and choirgirls. IF the European financial sector encounters meaningful credit issues ahead, as have their financial sector brethren in the US, we could indeed see Treasuries continue to be the safety trade of choice. A confusing time with a lot of moving parts globally as really global credit cycle reconciliation plays out? You better believe it.

Point blank, the US cannot afford to lose the confidence of the foreign investment and central banking communities in US financial asset markets. Now more than at any other time in recent memory, the US financial sector and real economy need access to relatively inexpensive foreign capital. We would just remind you of one truism we have repeated in these pages for years.

Liquidity/Capital is a coward. There’s always too much around when it’s least needed and it’s never there when needed most. One has to look no further than the US residential mortgage markets to be reminded of the importance of this comment. But unfortunately and quite inconveniently for US financial and real asset markets is the fact that as humans, we’re "wired" incorrectly. In times of stress the fight or flight mechanism takes over. You can blame the cave men and women for that one. Hey, they don’t have any capital, do they? Just checking.

Fun With Funding

By | September 2008

Fun With Funding...You know that for some time now we have been preaching about what we believe to be one of the most important macro themes of the moment that is deleveraging. Important both for financial market and real world economic outcomes ahead. And, whether we like it or not, it's a theme that we believe will be with us for a good while to come.

The ultimate contraction of balance sheets in the financial, household and corporate sectors will be a process, not an event, with plenty of volatility along the way. For those attempting to call interim bottoms with respect to this phenomenon as we travel along this path, as we have already seen this year and will undoubtedly continue to see again, our only comment is good luck. In the much larger picture, it was this very multi-decade expansion of private sector balance sheets in aggregate that in large measure drove corporate profits over the longer cycle.

So now that deleveraging and balance sheet shrinkage is destined to play out ahead, all as part of the natural progression of a longer term credit market cycle, the trajectory or rate of change in corporate profit growth is in question. A major issue for the financial markets, especially equities. We believe the markets are just starting to wake up to this long cycle thematic realization.

But perhaps another major issue that is not being given enough attention is the fallout consequences due to the one balance sheet not destined to shrink during this process of deleveraging we have described, and that's the balance sheet of the Federal government. While the financial markets, the household sector and in good part the corporate sector engage in long overdue deleveraging, a natural offset to avoid either the reality or perception of collapse will be the continued expansion of the government's balance sheet.

And this process of expanding the Federal balance sheet, as you know full well, has already begun in full force. For now, the de facto bail out of the GSE's and the residential mortgage bail out bill are two poster child examples of this phenomenon at the exact point of acceleration. Even the auto manufacturers have their hands out. Will it be the airlines next? Unfortunately, we expect a lot more where this came from ahead. In one sense, the government really has no choice. This is the price all US taxpayers will bear for years of regulatory self induced blindness.

Could our current set of circumstances have been avoided? Of course, but regulatory oversight simply turned a blind eye in deference to the Wall Street and credit cycle driven profit motive. Let's face it, a lot of individuals became very wealthy during the prior credit cycle mania period, now clearly seen to be at the expense of the larger US taxpayer base. Privatizing profits and socializing risk. Sounds like Russia a decade ago, no? Welcome to the USSA. As Jim Grant recently opined, "where is the outrage?" We have no idea.

Enough of the ranting and raving. Let's get to the point. As this process plays out and the Federal government is continually forced to expand its balance sheet as an offset to the leverage contraction occurring largely throughout the remainder of the economy and domestic financial markets ahead, THE big question becomes, where will the funding for this balance sheet expansion come from and what will it ultimately cost?

A question near and dear to the hearts of US taxpayers everywhere, to say nothing of the investment community. This, we believe, is now and will continue to become one of the most important questions for our investment activities. We cannot take our eye off of this ball as we move ahead. Point blank, and we could not be more serious when we ask this, will the US face a funding problem at some point?

In at least starting to address this extremely important question, it's time to head east and turn back the clock a bit for a little exercise in compare and contrast. Although no two sets of circumstances are ever identical, the US today is facing a number of major cycle issues comparable to Japan a few decades back. Post the early 1990's Japanese equity bubble collapse came the beginning of a property bubble collapse a number years later that to this day is characterized by values well below what was experienced almost two decades ago.

An important comparative phenomenon throughout the 1990's was a Japanese banking system riddled with and literally overwhelmed by bad debt. A financial system immobilized. Sound familiar? In good measure, the official US banking system, and importantly the US shadow banking system, has begun traveling down a very similar path. We expect US financial system reconciliation character to ultimately differ from the historical circumstance of the Japanese banking system as the US system will indeed recognize these losses in a more timely manner, which hopefully will mean total cycle reconciliation will not be multi-decade in nature.

The US financial and broader corporate sectors will also act to cut costs (employees) mercilessly as reconciliation plays out. Another huge differentiation factor relative to the Japanese experience. Lastly, throughout the process of leverage reconciliation in the Japanese equity market, property markets and financial system in general over the last few decades, the Japanese government expanded their balance sheet as private and financial sector balance sheets contracted. In all sincerity, we believe the conceptual parallels are very importantly similar between the Japanese experience then and the current circumstance faced by the US at present.

But standing out like the proverbial sore thumb are differences related to our important issue in this discussion - the character and circumstances surrounding the forward funding of the expansion in the government balance sheet that necessarily needs to take place. It's here where this compare and contrast exercise diverges in a very meaningful manner. Getting right to the point, with the clear benefit and clarity of hindsight, Japan was able to fund government balance sheet expansion during its period of reconciliation from internal or domestic sources.

It was not beholden to and dependent upon outside funding sources. This is THE crucial difference between Japan then and the US now. As you can see in the chart below, Japan began its decent into systemic non-governmental balance sheet reconciliation with a national savings rate near 15% in 1990. As we've shown you many a time, for all intents and purposes the US savings rate is non-existent. Quite the contrast.

Once again, in the clarity of hindsight, the initial Japanese response to the equity and, several years later, property bubble peaks and subsequent busts was to lower interest rates. Classic monetary policy 101. As the decade of the 1990's wore on, the cost of what was accelerating government spending (expansion in the government balance sheet), was indeed in very good part supported and able to be accomplished by a lower interest rate structure.

As Japanese government funding needs expanded, the cost of that funding declined. Why? It was financed internally. Just what the doctor ordered. The following chart is a proxy for longer term interest rates in Japan over the identical period covered in the chart above.

The important point and true dissimilarity with the current funding need situation in the US is that back in the early part of the 1990's, Japan as a financial and economic system had the benefit of a very high internal savings rate. Savings that were able to be tapped even within the context of a declining interest rate environment to fund the needed counter cyclical expansion of the Japanese government balance sheet. Savers were able to purchase increased issuance of government bonds.

As is clear in looking at the two charts above, savings declined along with interest rates over the entire period of the 1990's. The last, again in hindsight, benefit to the Japanese at the time was that inflation was clearly not an issue. Deflation was the issue confronted by the Japanese economy. As such, Japanese investors/savers were accepting of an ever declining nominal interest rate structure as government spending accelerated as a necessary counterpoint to contraction in the remainder of the Japanese economy.

Fast forward to the present and circumstances faced by the US could not be more different. As mentioned, current domestic internal savings is lacking completely. Set against historical context, macro US interest rates are already low. It's hard to see how they could decline meaningfully from here as they already sit near half century lows. The ten year US Treasury yield today is literally identical to what was seen in 1959. The secular decline in interest rates in the US has already taken place. In 1990, the secular decline in interest rates was still to come for Japan.

In stark contrast to Japan in 1990, today the US is crucially dependent on foreign funding and will not be the forward beneficiary of a declining cost of funds. The only way in which the US could develop its own internal funding sources for the counter cyclical Federal balance sheet expansion that necessarily needs to take place ahead, and has essentially really already started to take place, is to have the domestic savings rate accelerate markedly. And the only possibility the US has of accomplishing something like this is if domestic consumption almost literally collapses.

Japan was able to fund both ongoing consumption AND government balance expansion throughout the 1990's specifically because it already had a very significant prior period build up in internal savings which could be tapped. The US has no such asset or flexibility in funding choice. In other words, the question now becomes who will be the incremental buyer at the margin of what is surely to be increased US government bond issuance ahead? Again, unless consumption literally collapses in the US in deference to increased savings, it will not be domestic buyers. This very circumstance leaves the US much more vulnerable than were the Japanese in addressing the process of credit cycle and asset value reconciliation.

I'll Gladly Pay You Tuesday For A Hamburger Today...Let's have a quick review look at US long term capital flows. Specifically, we want to look at net foreign purchases of US financial assets. This is where we are going to see the importance and magnitude of non-domestic funding sources to overall US capital/funding needs. In the following chart we are detailing by year net foreign buying of US financial assets.

As you can see, since the middle of the 1990's, the annual number has grown from a little over $200 billion to over $1 trillion as of the end of 2007. But we believe the more important line is the blue line that details annual net foreign purchases of US financial assets as a percentage of the year over year change in total US credit market debt outstanding. The annualized number as of the first quarter of this year is 31% of total US capital/credit market needs. Please remember that Japan's need for foreign capital in 1990 was essentially zero.

As you look at the above chart, we believe one very important additional characteristic needs to be kept in mind. Over the 1995 to 2007 period, the US experienced probably the apex of long term credit cycle mania in terms of nominal dollar credit creation. Both the US banking system and Wall Street driven shadow banking system were simply working overtime to provide "funding" to the greater US economy and financial system in general.

And yes, in part that "funding" was sold to the foreign community in terms of "investments" (debt securitizations). But the data you see above measures only foreign buying of Treasury debt, agency debt, corporate debt and equities. Plenty of foreign investors also provided investment funds for CDO's, CLO's, subprime debt packages, etc. But THE important point as we look forward is that "funding" provided by the US banking system and shadow banking system is now in serious question, if not an outright freeze. Just look at the uptick in the 1Q data in the prior chart for how meaningful foreign funding has become to the US.

Although foreign buying of US financial assets in nominal dollars is falling, there has been a big up tick in the magnitude of that funding as a percentage of total credit market growth. Bottom line being? Magnitude of foreign funding for total system US capital needs will become ever more important as the banking and shadow banking system continue on the path of balance sheet repair really over the years that lay in front of us. Again, a completely dichotomous circumstance relative to Japanese situation of a few decades back.

One last point of character that we believe deserves more than a bit attention and reflection as we look ahead and contemplate the very important need of foreign capital funding to the US during the process of balance sheet reconciliation the US system as a whole must live through. Given our major thematic contention that the US Federal government balance sheet must expand ahead as an offset to private sector balance sheet contraction, just who have been the key buyers of US Treasury debt at the margin recently? Let's have a quick peek.

Major Holders Of US Treasuries (billions)
Country Current Holdings As Of June 2008 Holdings As Of May 2006 Difference
Japan $583.8 $636.1 $(52.3)
China 503.8 324.5 179.3
UK 280.4 166.2 114.2
OPEC 170.4 99.7 70.7
Brazil 151.6 32.9 118.7
Caribbean 122.4 65.2 57.2
Russia 65.3 Not Even On The List 65.3(?)
Total Of Above $1,877.7 $1,324.6 $553.1
TOTAL Foreign Holders $2,646.5 $2,071.4 $575.1

As you can see, we're looking back across the last two years for a bit of perspective. Traditionally the largest holder of US Treasuries has not been buying over the last few years, quite the opposite. It seems that in terms of Japan, they own enough, thank you. It's no surprise at all that China has been the largest incremental nominal dollar buyer of UST's over the last few years. Clearly the Chinese are recycling trade related dollars as well as managing their currency cross rate with the buck (printing renminbi, selling it and buying US Treasuries to support the dollar against the yuan) as their accumulation of UST's has zoomed skyward.

Maybe a bit surprisingly, the second largest buyer has been Brazil. As we mention in the chart, Russia has simply come out of nowhere to become the eighth largest owner of UST's at the present time. And as we have mentioned to you in the past, we are convinced that the UK numbers are really petro money (floating through London) in disguise. Total purchases by these folks seen in the table, inclusive of the Japanese sales, accounts for very close to 100% of the total foreign buying of US Treasuries over this period in totality.

You can see the punch line coming after looking at this table, right? Of course you can. It's the BRIC countries and petro money that has been THE key support to Treasury prices and suppressor of Treasury yields over the last two years. These are the very folks who have been "funding" the US in terms of our increasing reliance on foreign capital. So as we look ahead, we need to ask ourselves, will these very folks be so willing to continue funding the expanding US Federal balance sheet (through purchasing Treasuries), perhaps at a greatly accelerated rate as we move forward? Yes or no?

You don't need us to tell you that foreign current account surpluses in these countries that has allowed this reinvestment in Treasuries has been driven largely by two phenomenon. First is the US trade deficit in terms of consumer goods, and secondly it's commodity prices, especially as this applies to the price of energy. As you know, we have witnessed commodity and energy prices come down as of late.

Although we have not discussed this recently, the non-energy component of the US trade deficit has been contracting in recent months. No surprise at all as the US consumer remains under increasing pressure. So as we look forward, if indeed the global economy, necessarily inclusive of the BRICs, slows AND commodity prices remain relatively subdued, will the very important incremental buyers of US Treasuries seen in the table above have the financial wherewithal to continue funding US government capital needs? And potentially fund those needs at an accelerating pace?

We hope that by now you can see why we believe the forward US funding issue is so important. We believe the question mark is huge as to who will be willing to meet these funding needs during a period of greater US non-government sector balance sheet contraction. Will the US continue to be able to procure low nominal cost funding as its already very large balance sheet (liability) expands ever further by necessity in the coming period? The US faces a series of obstacles that were absent in the similar cycle reconciliation experience of Japan.

And THE primary obstacle and question mark is cost of funds. We're not preaching end of the world here. In fact, we're really not even questioning the ability of the US to procure continued foreign funding. THE critical issue looking ahead is COST OF FUNDING. At the outset we asked the question, will the US face a funding problem at some point, given that the US is beholden to foreign financing? It's the cost of funding that will be key to forward outcomes both in the real US economy and financial markets.

In the past we have suggested that perhaps THE most important chart we can think of is the long term chart of the 30 year US Treasury bond. What we have described above simply puts an exclamation point behind this thought. The following is nothing but an update of the non-logarithmic 30 year UST. To suggest the red rising bottoms trend line is important is a multi-decade understatement. Will the whole forward funding question ultimately be the straw that breaks the proverbial camel's back for the US bond market? Or in this case the back of the rising bottoms trend line?

Very quickly, we can't help but also show you the log chart. As we've done a pretty bad job of penciling in, you can see the arc in the log chart showing that from a very long term perspective, prices are "leveling out" after having accelerated for many years. It's the leveling out that is suggesting important long term change is occurring in relatively glacial, but noticeable, fashion.

You already know we'll be following the magnitude and character of foreign capital flows intensely as we move forward. We believe it will be one of the most important analytical exercises to investment decision making in the years ahead. Fun with funding ahead? Naw, it's probably not going to be much fun at all. In fact, quite the opposite.



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