Common sense is the knack of seeing things as they are, and doing things as they ought to be done – C.E. Stowe
I commented back on August 31st about the fact that we see bubbles everywhere, and that the US Bond market was the next victim. My opinion was, that although I would not buy bonds myself at those levels, I could certainly understand the logic that yields could go lower. I believe we are in somewhat of a war where one opponent is the deflationary forces and the other inflationary. There is no doubt to me that we are living through a massive de-leveraging in the U.S., and on the other hand the massive government injections of money has inflation drooling in the background, hungry to pounce.
Markets have a tendency to continue their trend even after the fundamentals fail to support the continued advance. This is the definition of a bubble- a market running solely on speculation of higher prices. On the other hand you will see times where the market does not react to fresh fundamentals and in fact can begin heading the other way.
I think there is a very good possibility that the bond market is in camp number two here, ignoring good fundamental news for a continued advance. The inability to make new highs on the announcement of QE2 and the fact that the 10-year Treasury bond auction had the strongest demand in at least 16 years, is disturbing for the bull case.
In addition another warning sign is that the public feels more comfortable owning corporate paper as opposed to AAA U.S. Government paper. Mike Larson of Money and Markets pointed out months ago that “The relative behavior of different types of bonds — and the credit default swaps that reference them — tells you everything you need to know about who is really in good shape, and who isn’t. And right now, the trading action proves the U.S. is guilty of running a profligate, debt-ridden operation, one that’s in worse shape than some American corporations”
He noted where Berkshire Hathaway notes due in February 2012 dropped to 0.89 percent, 3.5 basis points below comparable-maturity Treasuries, in mid-March. Berkshire is officially rated AA+ by Standard & Poor’s, one notch below AAA. He also shows where Proctor and Gamble paper, rated AA-, due August 2012 notes, slipped to 1.12 percent, beating Treasuries by 6 basis points. Finally Johnson and Johnson’s August 2012 notes yielded only 3 basis points less than Treasuries. Unlike the other companies, it is rated AAA.
Also bothersome was when the “U.S. Comptroller of the Currency (OCC) reported that America’s largest banks now hold $172.5 TRILLION in derivatives that are directly linked to interest rates, the most of all time. That’s over THIRTEEN times the amount they hold in credit derivatives — a primary cause of the 2008-2009 debt crisis.” said Martin Weiss of Weiss Management.
Another extreme development was seen recently when on Oct. 25, the U.S. Treasury auctioned $10 billion in treasury inflation protected securities, or TIPS, at a negative yield. In other words, it seemed that bidders were prepared to pay the U.S. government to own its debt.
Finally we have seen where the Thomson Reuters/Jefferies CRB index — a closely watched barometer of commodity prices — which has climbed to two-year highs recently, with some commodities exploding in price. See Related Post
So here we are, close to 60 years after the 1950 bottom in rates (around current levels) and 30 years after the 1980 peak at 15%. We have retraced the entire cycle from 1950. I’m not sure exactly what that means, but I do know that 30 years puts us in a rather mature trend, and more importantly we don’t have much further to ease rates where it makes any sense to take on the risk.
That’s what I think the bond market is saying. You don’t have to have a bubble to have a market go down. Bubbles imply ownership is irrational and I don’t think owning bonds is irrational. I just think it is a terrible risk reward investment at these rates of return.
Here is the old “a picture is worth a thousand words”-The interest rate cycle from 1950 to the present, compliments of Money and Markets.
Claus Vogt of Money and Markets points out that, “the huge money inflow has bond mutual fund managers so excited. Bond fund monthly inflows are rivaling those of stock mutual funds during their record year of 2000. Unfortunately financial history is telling us that whenever a market is being discovered by the masses it’s in the final stages of a secular bull market. Second, the chart pattern for Treasury yields may very well turn out to be a major bottom formation — a huge double-bottom. The first was a panic low associated with the banking crisis of 2008. The second low is currently in the process of being formed. Speculating on a new round of what the Fed has named “quantitative easing,” that is buying Treasury bonds with newly created money, seems to be behind the strong down move in yields during the past months. This move looks like front running of the Fed. Buy the rumor sell the fact” may well be the credo of many astute buyers.
“Knowing that another buyer with very deep pockets and no loss aversion is coming in later, recent buyers have driven prices up, determined to dump their holdings to market participants like the Bernankes of the world. Therefore, I believe there is a real possibility the planned effects of QE2 have already taken place in anticipation of the Fed’s next policy step. And the monetary bureaucrats may be in for a nasty surprise. Third, there are obvious divergences in the behavior of different maturities. Up to five-year yields have declined below the December 2008 low, as shown in the following chart …
But longer maturities haven’t…. look at 10-year yields in the chart below …
Divergences between maturities like divergences in different stock indices are a warning of a possible trend change. The inability of all maturities to confirm is characteristic of the last stages of a bull or bear market. This is important because interest rates are probably the most important market. They affect every other important market we must deal with, and have a major impact on our everyday life. So I would prepare for higher rates, possibly sooner than we think, and definitely for much longer than we would care to see.
Traders and more speculative investors may want to stalk a short position on the current rally. Look at the yields up to the five year maturities and compare them to the 10 year and the thirty year to see if they can all make yield lows on this rally. Also look at the 10 year and the thirty year to see if they confirm each other by both going to new yield lows. A failure to do so and a turn up in rates would signal that a rate bottom is already in place.