Thursday, February 16, 2006

Is Pension Money the Smart Money?

Irwin Stelzer has delivered an interesting assessment of the current economic climate.

According to Stelzer, the U.S. is flooding the market with debt. Simple supply-and-demand theory would suggest that the price of that debt should go down. And if prices of debt go down, yields go up. Another way of looking at the suppy-and-demand argument is that the more we need loans, the more we should have to pay for the money.

So why haven't long-term yields gone up? One possible explanation for low long-term yields is if the economy is in bad shape and a recession is right around the corner, causing investors to load up on longer-term debt.

Another explanation is that foreign countries, especially China, are buying up gobs of U.S. debt for its stability, and in China's case, to support our currency (with which we pay for their goods).

Clearly demand is just sopping up all the supply of U.S debt. Another possible reason for this that Stelzer doesn't mention is that pension funds are overdosing on debt now to match their obligations. This is the opposite of what companies did in the '90s, when they overloaded their pensions with equities and thought that 20% returns per annum would allow them to not fund the pensions so aggressively. Companies don't want to suffer pension shortfalls as a result of the stock market going down again, so they're forcing the pension fund managers to load up on debt. It's difficult to come upon hard evidence of this, but from anecdotal evidence and from recent pieces in the WSJ, it seems very likely to me. We've gone from extreme greed to extreme fear in the pension world, and the result is abnormally low long-term interest rates.

It's difficult to know how all this will shake out. Certainly an abrupt rise in long-term rates will send the housing market reeling, wounding the consumer and likely sending the economy into recession. On the other hand, persistently low long-term rates would seem to encourage inflation. However, as Stelzer notes, cheap foreign labor has prevented the wage inflation that we would normally expect with such low rates and high employment.

According to Stelzer, either the bond market is correct, meaning that we are entering a period of slow growth or even recession, or other economic indicators signalling are more robust 2006 are correct. I'm putting my money on the second explanation, especially when I think that pension funds are simply eager to match their liabilities with longer-term debt, almost regardless of what that debt is yielding, in their reaction to their aggressivness in the 1990s.


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