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.



in the mountains said...

Great post, Carl. With all the doom and gloom that's out there, it's refreshing to read this kind of outlook!

Balsamo said...

Well Carl,

Point is each medication has side effects.

If i had trillions of dollars in debt and a growing deficit, i wouldn't be so happy to see rising yields.

Nice for the banks, i agree.

But what about the people. Rising rates will rise mortgage rates, inflation will hit hard...

printing money has never been a sustainable way to get out of problems...long term it will put even more presure on bonds, and yields will be out of control...

And there no easy way back once you go that way...

Love you optimism though

pursuitist said...

The worry is the timing of rising yields/mortgage rates, and the relationship between mortgage defaults and foreclosures and the not-yet-unwound mortgage-tied derivatives bubble. The default rate is not expected to peak until late in 2009, and the reset on variable rate mortgages is not expected to peak until sometime in 2010. With higher mortgage rates those estimated peaks get pushed forward.

The banks don't become "profitable" until the real estate market has bottomed because they are still holding trillions of $s of mortgage backed securities that become increasingly toxic as defaults and foreclosures increase.

These issues are being addressed by the "bad bank" solution, but I have not read anywhere that this is a sure path to the rosy recovery that your interpretation of rising yields spells.

Many respected economists believe that the bad bank solution is a bad solution.

And it's hard to imagine that RE has bottomed in the context of rising defaults and rising mortgage rates.

Chaya said...

thank you as always for your terrific blog and creative thought process. I have a question on your last paragraph: wouldn't rising yields ultimately bring certain asset prices down? As people demand higher rates of return, they will pay less for those very assets. Granted as you say that inflation brings with it economic growth and higher asset prices but could this be offset by a demand for higher yields?


Garrai Eoin said...

The overwhelming macroeconomic event of the last 20 years is the American consumer's affinity for debt-financed expenditures.

Rising yields = higher debt servicing costs for individuals. If we entered this phase with healthy personal savings rates and balance sheets, I would agree that rising yields portend risk appetite and optimism.

Is it possible that rising yields are actual evidence of risk AVERSION by debt purchasers--that they are now factoring in a here-to-fore unthought of risk of U.S. dollar dilution risk?

Throw this on top of an American consumer that is still trying to service last decade's debt, and I don't smile when I think of a steepening yield curve.

But that's why there's a market! Thank you for this excellent weblog.

Ken said...

Outstanding post on Bonds. You're best ever!!

Henry Bee said...

Completely and 100% correct.

Jorge said...

Inflation will destroy savers. Without (true) savings there can't be genuine credit nor genuine investment. Without (true) investment there can´t be real growth.

Savings can not be printed.

The interest rates go up because there are not savers that can finance deficits.

(I apologize for my horrid english)

PM said...

Hi Carl,

An excellent presentation, thanks for sharing your insights. I hope you're right about the outcome of our economy.

Well, every time the market gets close to my model's sell signal, the market rallies. Until then, the model is long and pointing higher. If we can clear the immediate overhead resistance, then we should have smooth sailing to much higher levels. On the other hand, if we get a sell signal before we clear the overhead resistance, then we're still looking at a dead cat bounce. This overhead hurdle is the 200 DMA for the major indices.

I'm also long China, Russia, and India, these three markets are all stronger than the SP's. I'm also heavily long the gold and lightly long the crude oil. I believe a healthy recovery will keep these markets moving higher along with stocks.


Kindest regards,