Most of this space is usually reserved for writing about the stock market. Of late some rumblings in the bond market have made for much nervousness among our financial policymakers. Long term interest rates have been rising and there is evidence that the thirty year bull market in bonds may be coming to an end? This could bring some new challenges for fixed income investors and those that sell the securities that finance our country’s debt.
In 1981 then Fed head Paul Volcker had been asked by President Ronald Reagan to stop inflation, which had hit 18% at one point in the late seventies. Volcker complied by raising the Fed Funds rate to twenty percent. That drove the country into the deepest recession to that point in the post World War II period. We remember mortgage rates reaching 15% and Certificate of Deposits paying 13-14%, quite a distinction from today’s interest rate landscape. The other side of that recession actually was the start of one of the biggest booms in our country's history as falling tax and interest rates fueled extended economic growth and a Secular Bull Market in stocks.
It also led to a generational bull market in Treasury Bonds that is now showing signs of coming to an end nearly thirty years later. The last few weeks the technical pattern on the chart of the US 30 Year Treasury Bond yield has been showing signs of rising and breaking above 5%. Outside of a momentary morning spike last June, the thirty year has not been above 5% since August of ’07. What is more important is any strong move above the nickel level could break a down trend line that stretches back to the early eighties. As you can see from the chart this trend has capped yields for a number of years.
Currently inflation does not appear to be a threat to the interest rate landscape as the core CPI was reported at an annual rate of 1.3%. With a fragile economic recovery, rising wages, a key component of inflation, have been unable to gain much traction. We had a decent employment number last week, the best in three years, but many of the jobs that have been created were in the government sector. If you factor in the census workers and the new entrants to the job market the number was essentially flat. It appears we have stopped the bleeding and a continued reversal of job losses will be something the economy could use. Still runaway inflation does not appear on the horizon.
Yield of the 30 Year Treasury Bond 1993- Present
What is also somewhat curious is that the flow of monies into mutual funds has been mostly into bond funds. Bond mutual funds in the U.S. attracted $409.4 billion over the past 14 months, according to Morningstar. Stock funds gathered $11.7 billion during the same period. Generally an influx of that nature would push bond prices up and rates down. Many of these bond investors will not be happy if rates do break that down trend mentioned earlier.
So if it is not wages and it is not money chasing bond funds, what is the culprit driving rates higher? Our burgeoning deficit is certainly a factor. The appetite for our Treasury securities may be waning and in order to attract investors the Treasury has to raise the rates on the securities they offer. One of the talking heads on CNBC recently mentioned that China is not going out any further than five years on US Treasuries. He also mentioned they may be backing us into a tight negotiating corner when it comes to finance and economic trade. As maturing securities need to be refinanced higher carrying costs to fund our deficits does seem inevitable. It reminds me of the credit card company playing hard ball with their clients who have fallen on challenging times.
This is one of the many fine lines policymakers need to navigate as higher rates would not be good for the economic recovery.
The Treasury has been the buyer of all mortgage securities of late ($1.25 billion according to a Sunday morning news pundit) as the securitization market has disappeared due to the sub-prime fallout. They have ended this bailout process and now turn to the private sector to take on that risk. It is hard to imagine that the hand-off can happen without a bump in mortgage rates as the private sector does not possess a currency printing press.
One of the periodic events that will probably garner more headlines outside of just financial professionals in the coming weeks will be the weekly Treasury auctions. The recent weak demand might continue and drift into main stream media reporting. According to newsletter writer Bert Dohmen the recent auctions have shown signs of a large stealth buyer and he thinks it is the Fed attempting to keep that market stable and keeping rates from moving even higher. Maybe they are moving from the mortgage market to the Treasury market? So much for transparency, but we guess you cannot show your hand when you are playing poker. We hope they are playing well.
The rising stock market could get an added boost as bond investor’s shift some assets to equities, especially in the mutual fund complex. As I mentioned last time the technical structures for the stock market are still positive and round numbers 11,000 on the Dow Industrials and 1200 on the S&P 500 seem a forgone conclusion at this point. The key season of “sell in May and go away” is approaching and it will be interesting to see if this dynamic has its typical affect. The area that might get a significant boost is the Certificate of Deposit market. With current one year rates topping around 1.5%, a move above 3% especially among teaser rates could be showing up soon and I see the advertisements coming.
There are two takeaways from this apparent and possibly imminent rise in Treasury rates: first is the fine line the policymakers have to walk to keep the recovery going, but also keep those who lend money to us engaged. Another dynamic they battle with is high budget deficits as they do not appeal to lenders. The second is that fixed income investors may have to rethink their portfolios. The long term government bond funds which have provided income and capital gains for so many years may soon experience chronic principal deterioration if rates do begin a multi-year rise. Those who own tax-free municipal funds might experience a double whammy as the weakening credit quality of municipalities and the rise in rates challenges their principal.
It does appear to me that the ills that stalk the bond market initially are more wind at the back of stocks, as if this historic rise needs more wind. I have to admit I am in awe of the relentlessness (yes it is a word) of its mission. Many say the stock market is a prognosticator of the economy six to nine months out. If so it appears there are some very good economic times ahead…We hope?
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