Commentary Magazine


Bond Market Followup: Optimism Abounds

A week ago in this space, I alerted you to some unusual doings in the bond market. A very sharp decline got started in medium and long-dated U.S. Treasury debt on the same day that S&P made adverse comments about the sovereign debt of the UK. Some very knowledgeable people suggested the U.S. would be next. The decline gathered momentum and turned into a rout by last Wednesday afternoon. The yield on the 10-year T-note briefly went as high as 3.76%.

At that point, the stock market and the mainstream media got wind of the story. Stocks plunged 2% late in the afternoon on Wednesday, and a slew of news stories appeared about “bond market vigilantes beating up on Obama.” But as usual, the stock market and the press were late to the party, and bonds reversed almost immediately. On Thursday and Friday, we saw a rocket-propelled rally that took the 10-year yield all the way down to the mid 3.40s. The spate of bond market insanity stories has continued in the generalist media which doesn’t bother mentioning the rally. It must not fit the storyline, or something.

This morning, notes and bonds have reversed again and are declining, rather energetically, although not as in the middle of last week. However, this time the dollar has plunged and gold is soaring. The economic news background is full of optimistic signs, including indications that strong recoveries are underway in China, Australia, and, of course, in the U.S. The price of copper (which is heavily demanded in China for construction and power generation) just hit a multi-month high.

What the heck was going on in the bond markets? The best answer I can give you is that a highly technical readjustment took place among mortgage investors. These people appear to have decided en masse to hedge against extending durations in mortgage-backed securities and agency debt. This hedging is accomplished largely by selling or short-selling medium-range Treasury debt, particularly the 10-year note.

And what could cause such a realignment? It appears that mortgage investors have given up on the idea that retail mortgage rates will stay low for the foreseeable future. When mortgage rates rise, homeowners stop prepaying and refinancing, and mortgage assets extend out in time, necessitating an adjustment to investors’ hedges.

Why is any of this important? Because it’s been the stated policy of Congress, the Treasury, the FDIC, and the Federal Reserve to hold retail mortgage rates as low as possible. This is deemed essential for a robust economic recovery. The Fed has done the most to push this policy, committing to directly purchase well over a trillion dollars’ worth of mortgage-related debt in the open market.

The market appears to have decided that the Fed won’t be successful.

Meanwhile, what do the Fed and the Treasury have to say? Tim Geithner has been saying for days that bond prices will fall and the yield curve will steepen precisely because a recovery is underway. A data point in support of this view is that corporate yield spreads (the difference between corporate debt and Treasury debt of similar maturity) have been compressing, which may be a sign that investors are tolerating higher risk to get higher yield. For this to become a solid recovery signal, however, we would need to see a strong expansion in the market for newly-issued corporate debt. This is happening to some degree, but it’s not really healthy yet.

The perspective you’ll find in the news stories is that the bond market is selling down because of expectations for much higher inflation ahead, as the federal government fails to rein in its addiction to borrowed money. Vague rumblings about China are often part of this story. But China stopped buying the longer-dated U.S. debt more than a year ago, and there is no convincing evidence of inflation yet (although the stock market and some commodities are looking pricey).

Meanwhile, the Fed is stuck. If medium-term interest rates are tending higher because of economic optimism, then the Fed should stand pat and start thinking about keeping inflation from going out of control. On the other hand, the back-up in rates may choke off the recovery, which means they should be stimulating more now rather than less. They’re going to sit around and wait for better data, even as rumors fly of Obama (who evidently is as much of an expert in monetary policy as he is in the auto business) waxing dissatisfied with Bernanke’s reluctance to do more.

I think bond rates are running up due to a combination of technical factors inside the market, and growing optimism that economic recovery is just around the corner. That’s probably convincing more people than the inflation story. It happens, however, that I don’t share any of the optimism. I see a good possibility that government-driven spending will indeed have an impact on corporate earnings over the next few quarters. (Very important, it will also have a strong impact on China, as we start buying more of their exports again. Keeping China in good shape is a critical objective for American policymakers, whether anyone likes it or not.)

But the private sector in the U.S. is still deeply enmeshed in a cycle of de-leveraging and underinvestment. This means two opposing things at once: first, a recovery led by the private sector (going beyond the inventory rebuilds everyone is expecting) is a very questionable proposition; and second, with demand for credit from the private sector so low, the government has a lot of room to borrow and spend. Which they’re going to do. But if we get addicted to economic growth led by artificial stimulus rather than organic impetus, we’re not going to have a sustainable recovery. The green shoots may turn out to be weeds.

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