We haven’t targeted housing stocks specifically. What I think people don’t understand is the way the housing bubble is linked to the rest of the economy and the way in which it’s linked to consumption. The fact that we have a 0 percent savings rate is driven by the housing boom, because people don’t feel they need to save when their house prices go up every year. And so there are a whole set of repercussions from a macro view.

The way to see the housing slowdown is as a deflationary shock. When the bubble ends, it’s like the ATM machine in everybody’s house gets turned off. Money will be scarcer, prices will fall. From late 2000 to late 2002, the inflation rate fell off by about 3 percentage points, and we’d expect something like that to happen, maybe even more, with respect to the end of the housing bubble.

If you think about which financial investments will do very well in that world, the most straightforward are 30-year U.S. government bonds. Now, the 30-year bonds are probably the least favored investment in the world today. You have all these different ideological camps with different views on the fixed-income markets, but they all come out with the same answer: 30-year bonds are awful.

One really big question is what would happen if the price of oil fell sharply. All of a sudden there would be no petrodollars supporting the financial markets.

You have a flat yield curve today.  The “Goldilocks” people, who think that the economy is perfect, say it’s going to go back to a normally shaped yield curve and probably move up by maybe 100 basis points—so you don’t want to hold 30-year bonds; you should have your money in stocks. You also have people who say there’s inflation in the pipeline, the Fed’s way behind the curve and it’s going to have to tighten more, and the bonds are going to sell off. And a lot of the inflation people also think there is going to be a dollar collapse because the current account deficit will cause Japan and China to sell bonds, so you really don’t want to hold bonds. And then you have the deflation people, like Pimco’s Bill Gross, who believe the Fed will cut the short rate very quickly if housing crashes, and then the yield curve will steepen. Economically, you might get deflation, but politically, we will get inflation because Bernanke’s going to print money—the helicopter money scenario.

Now under what scenario do 30-year bonds actually do well? I think they do very well when the economy slows, housing slows, but oil prices stay high—and therefore the Fed can’t cut rates. You then get a massively inverted yield curve and a relentless rally at the long end. It’s the deflation scenario without the helicopter money.

So Bernanke will have to keep short rates high to defend
the dollar?

That’s exactly what happens. You don’t want to ease, because the risk is that if you ease, the dollar weakens and the oil price goes up tremendously. Therefore you’ll see a housing collapse and a recession with no monetary easing.

What about political pressure on the Fed to cut rates—
the man in the street probably doesn’t understand the link between short rates, the dollar and the price of oil.

Most people think politics will force the government to print money. But I think the politics are actually very unclear. The Fed’s fairly independent. Remember, Volcker raised rates in ’79 to ’82 to deal with the last big oil crisis; we ended up with 10.8 percent unemployment by early ’82 and the worst recession since the 1930s. And arguably the oil situation is more out of kilter this time around than it was then, because in the ’70s there was no real shortage.