Inflection Point in U.S. Treasury Bond Interest Rates Near?
Interest-Rates / US Interest Rates Mar 07, 2009 - 12:41 PM GMTBy: Michael_Pollaro
Pity the tortured Treasury bond buyer; what to do, what to do. These headlines from Bloomberg news chronicle the struggle. On March 4th :
Treasuries Fall on Looming Auctions, Deficit Funding Concern
By Susanne Walker
March 4 (Bloomberg) – Treasuries fell as stocks rose and traders speculated the U.S. will sell $60 billion of notes and bonds next week after the worst two months of losses in government debt in five years
And this one on March 5th :
Treasuries Rise on Bets Central Banks Will Buy More Assets
By Susanne Walker and Dakin Campbell
March 5 (Bloomberg) – Treasuries rose, led by 30-year bonds, on speculation the Federal Reserve may buy longer-maturity government securities after the Bank of England said it would buy sovereign and corporate debt.
Why the flip flop? Walker and Campbell's article attempts to explain:
“It seems to be that the Fed is running out of options,” said Charles Comiskey , head of U.S. Treasury trading in New York at HSBC Securities USA Inc., one of 16 primary dealers required to bid at Treasury auctions. “The market is making the analogy that because the Bank of England spoke about it, conditions continue to worsen and stocks are down today, then that's another step in the direction to buy Treasuries.”
Translation: deficits, even huge ones, ain't no problem if we got a printing press and we can monetize those deficits, especially when deflation is the primary concern. Really? Does everyone think that way?
From this Bloomberg news headline we find that maybe they don't, at least not in the gold pits:
Gold Rises for First Day in Nine as Lower Equities Spur Demand
By Nicholas Larkin
March 5 (Bloomberg) -- Gold rose for the first time in nine days in London, rebounding from its longest losing streak since June 2006, as falling stock markets boosted demand for the metal.
The headline says gold rose on “Lower Equities”. Buried in the article I think is a more credible answer, with highlights mine:
“ A surge in inflation expectations in interest-rate markets, a rapid increase in credit risk, falling stock markets, and a wave of monetary and fiscal policies are fueling a gold- price rally,” Merrill Lynch wrote in a report. “Things don't get much better than this for gold.”
The Treasury market says inflation is tomorrow's concern. The gold market says no it's not, its right around the corner. No market is hurt more from the ravages of inflation than fixed income. No market benefits more from inflation than gold. They both can't be right. Some might say that both bids, the bid for Treasuries and the bid for gold are simply safe haven bids? I have sympathy for this view, but that is purely short term; because, by definition, inflation is a long term negative for fixed income and a long term positive for gold.
On March 2nd, I penned an essay entitled, Obama Says Short US Treasuries ( http://www.marketoracle.co.uk/Article9171.html) , making the case that ballooning US Federal Deficits, combined with the fact that the primary funding source for the US Treasury will eventually be the Federal Reserve, will cause Treasury rates to rise, and rise in earnest. Simply stated, if the US Government's debt borrowing binge doesn't overwhelm investor demand and blow up the Treasury market, then its monetization by the Federal Reserve will, by putting a larger and larger inflation premium into Treasury rates. Bill Bonner sums it up beautifully:
"If the government funds its deficits honestly - by borrowing from willing lenders - this huge extra demand for credit will force up yields... thereby lowering bond prices. Or, if the government resorts to "monetizing the debt" - that is, funding its debt with printing press money - investors will flee bonds, in fear of higher inflation”. Either way, it will be bad news for bond prices"
Treasuries lose either way
Yet today, they didn't. Today, the Treasury bulls won, even as gold surged, as the mere possibility of Federal Reserve monetization drove Treasury rates down. And as long as deflation concerns prevail in the fixed income market, the Treasury bulls may continue to win. But they can't win longer term. The inflation premium may take time to evolve in the fixed income market, but it will evolve, just as it has in the gold market, made all the more certain by the Federal Reserve's wholesale purchases of Treasuries. Divergence will come, because gold is a safe haven in inflationary environments too. Treasuries are not.
I can hear you now: don't tell me what to do, tell me when to do it! Just when can we expect this tug of war in the Treasury market to end and for Treasury buyers to begin discounting inflation. The answer: when Treasury buyers realize that the only thing monetization of all this debt will do is create inflation. And what you say will tell them that? My guess is a series of unexpected outcomes, going something like this:
• First, when the Federal Reserve finally gets around to actually buying Treasuries, in mass, the fixed income market finds that the downward pull on rates is not as great as expected. My bet is that at least some of this monetization is already priced into Treasuries. So it will be a bit like buy the rumor, sell the news. For those Treasury buyers who haven't yet factored inflation into their buying decisions, it will give them cause for concern;
• Second, gold, that monetary metal that can not be printed out of thin air, breaks out to new highs, in all currencies, especially the mighty US dollar, signaling inflation is here to stay;
• Third, measurable evidence of rising inflation expectations in the Treasury market itself; namely, a widening positive spread between Treasuries and TIPs of the same maturity;
• And finally, the prices of commodities and of “things you need” to live find a bottom and begin to rise once more, DESPITE the fact that the economy continues to weaken. In essence, confirming that inflation is back
What's a missive without at least one graph, so here goes:
To start, take a look at recent market trends, within the oval. First, after a nice run, note the plunge in TIP spreads to near zero, along with the plunge in Treasury rates. No concern about inflation in the Treasury market right now. Second, note the surge in gold, albeit interrupted by a correction, over the same period. Both responding to a safe haven bid? Yes, but safety from what?
Ask yourself, who's right about inflation? Observe that since the gold bull began, the gold and Treasury markets seemed to be on the same page, with both gold and TIP spreads moving up together. Then, deflation scares took over. The gold market didn't buy it. The Treasury market did. With what we know about the Government's fiscal position, and the coming wave of monetization, do you think the Treasury market might have it wrong? Do you think gold might have it right?
Turn your attention back to the oval and the most recent month. Note the rally in gold ALONG WITH a turn in Treasuries rates and TIP spreads. A head fake? Possibly. Or possibly, Treasury buyers, at least some, are beginning to see what the gold market has seen since 2001. More to come? As I opined in my previous essay, perhaps only one more deflation scare away.
I'll leave you potential Treasury Shorts with this thought. Take a look at the latter half of the inflationary 1970's. Treasury rates and gold prices exploded up, together. That's what the inflation premium is all about.
By Michael Pollaro
Email: jmpollaro@optonline.net
I am a retired Investment Banking professional, must recently Chief Operating Officer for the Bank's Equity Trading Division. I am also a passionate free market economist in the Austrian School tradition and private investor
Copyright © 2009 Michael Pollaro - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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