Friday, May 22, 2009

Treasury yields will continue to rise

The Fed is trying to fight a force of nature—the bond market—and they are bound to lose. Purchasing long-maturity Treasuries, mortgage-backed securities or corporate bonds in an atttempt to keep their yields low is a self-defeating strategy, since it at some point it will supply unwanted dollars to the world that will fuel inflation. Ultimately, inflation and inflation expectations are what drive bond yields. If the Fed buys too many bonds, rising inflation expectations will kill the world's demand to own bonds, and yields will rise. It's that simple.

So far this year, the yield on 10-year Treasuries has risen from 2.05% to 3.4%, and that is just a down payment on the eventual rise. Yields fell at the end of last year because the market came to believe that deflation and depression were highly likely to engulf the U.S. and global economies. Now we know that those dangers were vastly over-estimated. So yields couldn't remain at 2% or even 3%. If the U.S. economy is in the process of recovery, even tepid growth of 1-2% is not low enough to justify Treasury yields of 3% or lower. And if inflation manages to rise just a little above where it has been in the past several years—which shouldn't be too hard, given the Fed's massive monetary stimulus—that only adds fuel to the rising interest rate fire.

As politicians should know (though they refuse to believe), the economy is not something that can be easily manipulated according to their whims or preferences. As the Fed should know (but amazingly they seem to ignore this), long-term interest rates are set by market forces, not by the Fed's Open Market Committee, whose only job is to attempt to control very short-term interest rates.

Rising 10-year yields will put a floor under conforming mortgage rates, which have most likely already hit bottom. Yields on jumbo mortgages still have room to fall, however, as suggested by the second chart.

Full disclosure: I am short Treasury bonds, via a fixed-rated mortgage and a long position in TBT.


Public Library said...

Very interesting read...

This highlights the departure from the gold standard, resulting unsustainable trade imbalances and boom/busts, and the eventual implosion of the dollar which will wreak havoc across the globe.

The trillion dollar question seems to be will it be death by hyperinflation or deflation.

I am certainly in the camp that eventually the US will pop. Nobody wants to believe the US will one day be unable to repay its debt but the logic is pointing the other way...

Anonymous said...

this whole 'i'm short inflation b/c i have a mortgage' is overstretched. it assumes either rents or your income, or both will increase with inflation. that might not be the case this time. remember, a bear market gets everyone in the end.

Scott Grannis said...

admin: If inflation rises, then by definition the whole price level, including incomes, will rise. And housing prices will rise. Having a mortgage and shorting a bond are equivalent.

And we may have seen the end of the bear market.

Scott Grannis said...

Bernard: even if U.S. inflation rises because the Fed stays too easy for too long, it is too early to assume that the dollar will implode or that we will end up with hyperinflation. Most other central banks have been following the Fed's lead. Gold is up against all currencies. This is likely to be a global inflation problem, with all currencies losing value relative to hard assets.

And while the U.S. appears on course for an unsustainable debt expansion, we can't assume that there will be no opposing reaction at some point. Perhaps the voters revolt and the Dems lose the Congress next year--that's only 18 months away. Big government can be rolled back if the political will is sufficiently strong.

Anonymous said...

um, no. don't think incomes can rise, because of the higher unemployment created by che guevara and low utilization. however, the dollar will bring import inflation. that's what lower standards of living mean.

Scott Grannis said...

admin: The definition of inflation is a rise in all prices (or most prices). Incomes will most likely be slow to rise as inflation picks up (that's why inflation is really nasty for the average guy), but incomes will definitely rise if the general price level rises.

Just look back a decade or two or three: we've had 3% inflation year in and year out, and incomes have actually risen more than that. If inflation goes to 5-6% incomes will eventually catch up.

A weaker dollar is a key factor in any rising inflation scenario. But it might not be so obvious this time, because all currencies are weakening at the same time against gold and commodities.