Thursday, February 9, 2012

Upward pressure on bond yields is becoming intense


As this chart suggests, long-term bond yields have a strong tendency to track the strength of the economy (as reflected in equity prices). Except for the past four months, that is, as equity prices have surged 23% but long bond yields have barely budged. You can almost feel the tension in the bond market building. Something is going to have to give—either equity prices and budding economic optimism have to collapse, or bond yields have to surge. It just doesn't make sense for the economy to be doing better while bond yields languish near all-time lows. My money is on higher yields, since the evidence of continued economic improvement is pervasive.

The Fed may hold a significant amount of long-term Treasury bonds, but they can't control long bond prices, and there are gobs of them that are held by investors all over the world. Those investors face the prospect of massive losses should bond yields once again sync up with equity prices. With the duration of the current 30-yr bond now 19, the price of the long bond could fall by 25% or so if 30-yr yields return to the levels of early last year. And that would still leave 30-yr yields very close to the low end of their range over the past three decades. Bond buyers beware.

29 comments:

Donny Baseball said...

Thus Warren Buffett comes out today to say that bonds are "among the most dangerous of assets."

And Blackrock's Larry Fink thinks investors should be 100% in stocks, which really means 0% in bonds.

I suspect that the "bond market vigilantes" have just about finished licking their recent wounds - they have been wounded by the likes of Operation Twist, European squabbling, and pervasive doom and gloom - and will regroup for another assault on US debt. US credit worthiness is deteriorating rapidly and inflation is set to finally emerge full blown.

It won't take much, a bad inflation print, a less than stellar auction (the Germans had one in November)...and bang, yields could go to 4.25% in a heartbeat.

Unknown said...

30-year bond auction today resulted in a yield of 3.24%, up about 10 basis point.

What was interesting was watching the price of gold. At the same time treasuries went down in response to the auction, gold erased a notable amount of today's rise. Seems like gold is acting as an alternate long bond, at least sometimes.

William said...

Unknown, said:
"Seems like gold is acting as an alternate long bond, at least sometimes."

Or perhaps more likely the respective changes represent a lessening of PANIC.

William said...

Scott Grannis, How much effect to you believe the general rise in bond interest rates will have on High Yield Corporate Bonds?

Specifically, how will you know when to sell your investment in Hi Yield Corporate Bonds?

Scott Grannis said...

Higher Treasury yields aren't necessarily bad for high yield bonds, and in fact the two are often negatively correlated. Higher Treasury yields would be symptomatic of an improving economy and possibly higher inflation as well. This in turn implies stronger cash flows for borrowers, and thus lower default rates and tighter spreads for high yield debt.

Benjamin said...

Yeah, and just wait for those yields on Japanese bonds. They are going to the moon, and have been for 20 years. Any day now. They will take off. Soon. Okay maybe next year. Or the year after that.

Or mayhem we have global gluts of capital, as we have created huge and growing middle and upper classes with the ability to save money. A good thing.

But capita is cheap due to supply and demand. A huge amount of supply is out there and grows every year.

You want pansy-safe investment like US Treasures, get used to zero.

Dr William J McKibbin said...

Increases in bond rates will devastate gold and silver positions, which is why no one should be banking on gold or silver for their future -- hopefully everyone bought into dividend-paying stocks when the DOW was at less than 11,000 -- I expect the DOW to hit 36,000 by the end of decade -- however, the Federal budget problems will continue to get worse regardless -- the coming decoupling between the public and private sectors is the story historians will be writing about after 2020 -- in the mean time, smart investors will stick with income and rent-earning equities, and world-class skills will continue to earn premium wages -- everyone else is in for dark times...

Benjamin said...

Dr McKibben:

I enjoy your posts, but evidently there are two men using the same name and photo. A sort of Jekyl and Hyde tag team.

William said...

Benjamin wrote:
"I enjoy your posts, but evidently there are two men using the same name and photo."

I have noticed that also Benjamin - kind of like coin, two faces.

Hans said...

Thank you for the most excellent thread, Mr Grannis!

Benjamin said...

I invite Scott Grannis to pursue this thought:

The Fed chose precisely the wrong time in 2007-8 to "fight inflation" that was emerging in commodities.

They sunk a torpedo into the US economy, and dented commodities prices for a while. The US economy never fully recovered, but commodities prices have.

So much for fighting global commodities prices with US monetary policy.

William said...

Warren Buffet: Why Stocks Beat Gold and Bonds

http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/

Squire said...

I will go long 100% into stocks all at once when my technicals call out a prospective rally. It will probably look like 11/28/11 or 12/20/11 again. Hopefully it won't look like the last week of Jan '12. Hopefully the market goes down to 1300. How lucky I will feel if it even goes to 1325. If it goes below 1300 I will be thrilled.

Investors might start buying their chosen stocks on an averaging-in method every week as the market goes down from here. Maybe 10% of your funds per week. 5 weeks down and a bottom and 5 weeks as it rallies. Then the 1350 break upwards finally. One of many scenarios.

There is too much aeronautical drag in society for the country as a whole to flourish, but the market should swing enough or dividends will be enough for one to be successful.

The bail out of irresponsible home owners will create the worst moral hazard ever. It is one thing to bail out institutions but to bail out individuals is going to be really bad. “Where is my bail out?” will become stuck in peoples mind as cynicism takes hold. This is all by plan; get everybody demanding the government give them money. The American moral character will finally become European. I actually knew depression era people, now deceased from old age, that wouldn’t “take hand outs” due to their pride. Today, such people would be considered fools and deserve disrespect. This is the hope and change and it is the way of the future. Flow with it and get your bail out if you can.

Benjamin said...

Squire---

I afraid the tone for bailouts was set at the top.

If Wall Street bankers can get bailout, really we should't help the family guy with a mortgage? If farmers get perennial bailouts, the guy moonlighting doesn't also deserve a break?

If military contractors can just raise their prices and get the money, the small business guy shouldn't get some taxpayer loot also?

Hans said...

http://online.barrons.com/article/SB50001424052748703518604577213671775601052.html?mod=BOL_da_udwsd

William said...
This comment has been removed by the author.
William said...

Squire said...
"I will go long 100% into stocks all at once when my technicals call out a prospective rally...If it goes below 1300 I will be thrilled."

Oh, Wow! A retracement to 1300 on the S&P.

I guess you didn't believe Scott Grannis' excellent bottom call last September when his VIX/ 10 year US Bond ratio peaked and the S&P neared 1100. Too bad.

One can learn a lot on his website - and profit from it.

Squire said...

Benjamin, you prove my point.

Squire said...

William, I am a trader. I started pyramiding long 8/9/11, 9/26/11, and added longs intraday 10/4/11 below 1100. Sold it all and went short 10/31/11 and started pyramiding long again 11/28/11 and 12/20/11. I may achieve 100% long on the next pull back and I will consider standing pat instead of trading.

Calafia Beach Pundit has been the single most education website I visit. I am grateful beyond words for the positive influence it has had on my outlook.

Scott Grannis said...

Hans: Re "stocks aren't cheap just because bond yields are suppressed." Of course not. But when Treasury yields are extremely low, the Fed has the pedal to the metal, the Vix is elevated, credit spreads are relatively high, and PE ratios are well below historical norms at a time when corporate profits are at record-high levels, then I think it is pretty non-controversial to conclude that stocks are cheap. They are cheap because the market is priced to very pessimistic assumptions about the future.

Tim Dubost said...

I certainly hope we see yields move higher instead of the equity market moving to the downside. I assume a lot of institutional investors are getting itchy trading fingers after such a strong start for risk assets ytd. As always thanks for your terrific insight.

Bob said...

Benjamin said "I afraid the tone for bailouts was set at the top.

If Wall Street bankers can get bailout, really we should't help the family guy with a mortgage? If farmers get perennial bailouts, the guy moonlighting doesn't also deserve a break?

If military contractors can just raise their prices and get the money, the small business guy shouldn't get some taxpayer loot also?"

No on all counts. Two wrongs don't make a right.

Benjamin said...

Bob--
I agree. But we have established the fact that some groups--such as rural America and farmers--are entitled to permanent subsidies. Now the banking industry gets bailouts. GM and Chrysler got bailouts. Military contractors are on a perma-bailout system.

Once we have created a weakling, knock-kneed economy as we have, there is no moral ground to stand on for refusing bailouts to other people or industries.

I resent all bailouts.

Side note to Scott: The Fed does not have the pedal to the metal. Many contend the Fed is following a contractionary policy. The evidence of that (as stated by Milton Friedman) is low intreats rates and zero inflation for the let three months.

Low interest rates alone are not an expansionary policy. Japan proved that and has for 20 years running. QE is expansionary, but only if done with a growth target in mind, and sustained to hit that target. The Fed has not shown that worthy approach.

The Fed has been suffocating the USA economy, that is why we see lenders willing to buy T-bills for nothing and inflation dead.

Tom Gates said...

Bond yields could be low for some time because the variety of "credit risk free" bonds is diminished. By that I mean that prior to the demise of Fannie and Freddie and the current pressure on municipal entities and the credit pressure on foreign sovereigns, US treasury bonds are the only game in town.

Rob said...

Dear Scott,
How can one capitalise on a rising bond yield, eg would this likely be accompanied by a stronger US dollar ?
Thank you.

Rob said...

Dear Scott,
It's all very well to be relentlessly optimistic but what do you have to say about this:

http://news.bbc.co.uk/panorama/hi/front_page/newsid_9694000/9694094.stm

?!

Tom Gates said...

Rob,
Buy some TBT, a double inverse short ETF on the 20 year TBond price.

Scott Grannis said...

Rob: being optimistic is not the same as saying the economy is in great shape. Indeed, it's clear that the economy is doing miserably compared to other recoveries. I'm optimistic about the future because I think it will be better than the market expects. The market expects things to remain terrible, and I think things can continue to improve on the margin, albeit slowly. The economy is going to be operating below potential for a long time (which is why we have so much unemployment and even some tent cities), but nevertheless I think it is likely to improve.

Rob said...

Thank you very much Scott for your thoughts.