Ad Hoc Commentary – America’s large budget surplus, capital smiles on America

In our last post, we said that capital will give America two good years. Overnight, America posted the largest budget surplus since the depth of the crisis in 2009. Capital will smile upon America for the next two years. This will mainly be driven by the rise in American long term interest rates. Higher rates will lead to unwinding of large US borrowings around the world that would then drive the US dollar higher. The higher rates will also lead to homebuyers jumping into the mortgage bandwagon to preempt the rise in borrowing costs. The recovering home prices and stronger US dollar will likely bring in even more capital, thus reinforcing the virtuous cycle.

Smart money and big money will find the American equity markets the new safe haven. Forget gold (we need Paulson to throw in the towel there), forget US treasuries (the boat is turning), and forget real estate (it might work for the small money but too illiquid for big money).

Who would then believe in Bernanke who effectively said on Wednesday that he will continue to print? In all likelihood, Uncle Ben is reacting to the rise in interest rates. uncle Ben might have affected the tactical shorts, but the market is still structurally long bonds.

We are calling for the end to the 31 year rally in bonds. The end will not be a walk in the park because traders who sold bonds have long lost their jobs and homes and even spouses. Bond traders that kept their jobs all these years are those who would likely feel a strong affinity to the song Hotel California by Eagles: ‘We are programmed to receive.’

The majority of bond traders only know how to buy bonds (i.e. receive rates) on every sell-off. The majority will be wrong, and will fight the rise in rates to the end.

Good luck in the markets.