Thursday, May 28, 2009
The bond market
Here is a daily and a monthly bar chart of the yield on the U.S. 10 year treasury note. For nearly 27 years I had been a long term bull on treasury note prices and told everyone willing to listen that yields on treasury securities were headed much lower. But about six months ago, on December 1, I decided that this trend toward lower yields and higher prices was nearly complete. I announced this change from bull to bear on treasury note prices in this post (red arrow).
Where do we stand now? I think we shall see yields on treasury notes and bonds trend generally upward for the next 20 years. The current bull market in yields (bear market in bond prices) should last 18-24 months and carry yields up to one of the midpoint resistance lines shown on the monthly chart (purple dotted lines). The lower line stands at 5.45% and the upper one at 6.65%.
I have noticed a lot of commentary on blogs and the financial press which asserts that this ongoing move upward in bond yields somehow spells disaster for the U.S. economy.This is such a completely wrong- headed view that I barely know where to begin in criticizing it.
Bond yields are determined by two things: expected inflation and the expected real (adjusted for inflation) rate of return on capital investments made to keep the economy growing. A rise in yields means that both of these expectations are headed higher. The fact that people are now expecting more inflation than they were six months ago IS EXTREMELY BULLISH for the U.S. and the world economy. It means that there is a growing belief that the expansionary monetary and fiscal policies undertaken by the Federal Reserve and the congress will be effective.
Yes, these policies WILL increase the rate of inflation from current levels. BUT this will not have nearly the adverse economic effects rising inflation had during the 1960's and 1970's. Back then income tax rates were not indexed for inflation. Consequently inflation increased marginal tax rates in the economy and had a contractionary fiscal effect on real economic activity. But tax rates are now indexed for inflation, so a rising price level will not in itself have adverse consequences for the level of real economic activity.
There is another reason why increasing bond yields will be economically beneficial in current circumstances. They will enable banks to become very profitable again. The Fed is keeping short term rates very, very low and will continue this policy for a long time to come. Meanwhile longer term treasury bond yields are rising. A bank can therefore borrow short term money, invest it in the bond market and hedge the risk of falling bond prices. The result is an almost risk free return of about 4% currently. This will do wonders for bank balance sheets and profitability!
People - remember this. The Fed WANTS longer term bond yields to rise. A rise in yields indicates that monetary and fiscal policies are being SUCCESSFUL in achieving their goals of stopping the drop in the economy and setting on a course toward growth.
How does the Fed arrange for a rise in yields? By "printing money" of course. By financing a good part of the Federal deficit of course. By doing these things it engineers an upward move in the prices of existing assets, in commodities, and in inflationary expectations. This medicine is exactly what the doctor ordered as a remedy for the deflationary "fear" shock that hit the economy last fall.