Thursday, May 7, 2009

Rising T-bond yields are very bullish

Treasury bond yields have surged since their December lows. Today's auction of 30-year bonds resulted in a higher-than-expected yield, even though Treasury was only selling a relatively paltry amount, $14 billion, compared to the trillion-dollar deficits that will be the norm for the next several years at least. Due to sharply higher yields, 30-year Treasury bond prices have fallen 25% so far this year.

The equity market has rallied, and the Treasury bond market has sunk, because the market has realized that instead of collapsing in a deflationary depression, the economy appears to have stopped declining and deflation is nowhere to be seen.

All those investors and speculators who were desperate to pile into cash at the end of last year have apparently been asking themselves this year whether they want to hold onto an asset that yields almost nothing. On the margin, investors have concluded that they want less cash. As the world attempted to reduce its cash holdings, the prices of other things have risen: equities have surged, commodity prices are up across the board, junk bond prices have rallied, and emerging market debt and equities are on fire.

As I said in a post last December, if the economy doesn't continue to deteriorate significantly, then cash will prove to be a major embarrassment. Today I would modify that statement as follows: If the economy doesn't deteriorate significantly, then cash will continue to be a major embarrassment.

So, in the absence of any sign that the economy is deteriorating, and in the face of mounting evidence that the economy may actually be recovering, I think the trends we have seen so far this year will continue. T-bond prices will continue to fall, while the prices of just about all other asset classes will rise. TIPS prices may not rise, but TIPS will benefit from the rising inflation that is likely to follow the rise in commodity prices. Selloffs such as what we see in the equity market today are to be expected of course, but they just create buying opportunities for those who are embarrassed by their cash holdings. The attractiveness of cash is not likely to improve any time soon, since the Fed has all but pledged to keep short-term rates near zero for a long time, and all major central banks are toeing the same line.

Full disclosure: I am long equities, long emerging market debt (EMD), long emerging market equities (SLAFX), long TIPS (TIP) and short T-bonds (via TBT) at the time of this writing.

4 comments:

Bernard said...

If treasury yields keep heading north, how is the Fed going to keep mortgage rates down to prop up the housing market?

Can the Fed fight the entire global market and if so, for how long?

Scott Grannis said...

MBS spreads are way down, and they can't go much further, so I think it's clear we've seen the bottom in rates for conforming loans (see earlier post on this subject). But even if mortgage rates rise, they are still incredibly low. I don't see any threat to housing for quite some time. Besides, if rates are rising because the economy is stronger, that is the best possible news for housing. Rising confidence and rising incomes will trump rising rates.

The Fed definitely cannot fight the entire global bond market. They are rapidly losing that fight already as treasury yields rise.

prophets said...

time to sell calls against long equity positions. volatility is diminishing and we will have a mildly up, aimless market for years now.

Scott Grannis said...

Lots of people are thinking like you. The Vix is down because on the margin people are more willing to sell options than to buy them. Everyone is calling for this to be a bear market rally. Everyone (even me) is saying the recovery will be tepid. I wonder...