US 10-year Treasury yields looked set to close below 4 per cent this week even as investors prepared for the Federal Reserve to raise short-term interest rates again next week.
(…)
Typically, as short-term interest rates rise in response to inflation pressures, longer-dated bond yields rise to price in greater uncertainty.
The divergence this time has been described as a “conundrum” and observers have been at pains to construct coherent theories for why it has happened.
“When technology stocks get to levels we don’t understand, we call it a bubble,” [president of Bianco Research Jim] Bianco said. “When real estate gets to levels we don’t understand, we call it a bubble. But when bond prices get to levels we don’t understand, we call it a conundrum.”
We all know – now that it’s burst – about the dotcom stock bubble. We’ve discussed in previous diaries the strong likelihood that there is a real estate bubble. I’ve also tried to mention in other diaries the bubbly phenomenons in the financial markets, and I am glad to have seen the two articles quoted above, who are asking the right question: do we have a bond bubble?
Not so with the question du jour of why long-term interest rates have defied the Federal Reserve(which has raised the funds rate to 3 percent from 1 percent), the economy (which has grown at an average rate of 4.3 percent the last two years), and record budget and current-account deficits.
“Ask people why long-term rates are currently so low and you’ll get a lot of reasons,” Bianco says. “This is throw-it-on- the-wall-and-see-what-sticks analysis.”
(…)
The Fed offered its own explanation for the conundrum: a glut of global savings. This view gained wide acceptance because investors regard the Fed as omniscient when it’s merely omnipotent.
Other candidates to explain the conundrum include a slowdown in global growth, part real, part forecast; Asian central bank buying; pension fund buying in order to better match long-term liabilities with long-term assets; the aging population, with its demand for fixed-income assets; and a predominance of short positions on the part of bond investors, who have been forced to cover as the conundrum failed to resolve itself in their favor.
The fact that there are so many possibilities, offered up at convenient times and with little conviction, suggests everyone is shooting in the dark.
But that fails to answer the initial question. Why are we searching for something to explain low long-term rates and stating definitively that housing is a bubble? For all the talk of a housing bubble, why so little discussion of whether bond prices represent a bubble?
The fact is, both the housing bubble and the bond “conundrum” are caused by the same thing: the era of cheap money unleashed by ‘Bubbles’ Greenspan’s policies of incredibly low interest rates. Cheap money has made it possible to inflate the prices of assets, whether housing or financial, by making the debt to pay for them more affordable. Now this era is slowly coming to an end with the steady rise in the Fed rates (which still remain pretty low by historical standards), but the money slushing around is still there and has had time to give birth to more (with asset price increases giving everybody more “wealth” to leverage once again on another deal).
In addition to the reasons listed above, i have the following suggestions as for why long term bond prices have remained so high (and yields/interest rates correspondingly low):
- it is a bubble, and people are getting sick and tired of losing money by betting against it, so they are finally joining the party: “if it’s not going to go down, let’s go up along” (a number of investors in recent years have lost money by betting that interest rates could only go up and bond prices down);
- it is a bubble, and people are protecting themselves. US Treasuries are the safest haven around. They don’t pay much, but al least they won’t default. To get better returns in today’s frothy markets, you need to take incredible risks, and more and more people are aware of it, and deciding to give it up for safety. As a fond manager, it’s really hard to take decisions that will make it certain that you fund’s return will be lower than the others (who are investing in bubbly assets), because that’s how you are assessed. So the fact that many of them are deciding to do it nevertheless would speak volumes about the perceived riskiness of other investments. Simply put, the risk to lose a lot of money is becoming bigger than the risk of being a few points behind the others by “not joining the fun”.
Without individual investors, who have never been a force in the Treasury market, reporters lack the anecdotal ammo to elevate the conundrum to bubble status. (“Soccer Mom Bets Life Savings on Bonds Before Employment Report.”)
Probably the single best explanation for why bonds are a conundrum, not a bubble, is that Greenspan said they are. The Fed chief framed the debate by assigning a quotable, pithy, Latin- sounding noun — conundrum — to the persistence of low long-term rates. What if he had said, “We at the Federal Reserve continue to be stupefied by low long-term rates in the face of our efforts to normalize short-term rates?” Maybe we wouldn’t be talking conundrum today.
So Greenspan has created the bubble, made everybody happy by inflating away the value of their assets, gained God-like credibility in the process, which he uses to deny that what he’s done is just one big runaway bubble, and most people are simply happy to go along. After all, it’s worked wonders until now, hasn’t it?
Remember, <u>all he cares about is that it does not crash before the 2008 elections.</u>
Now, just a few words for individual investors:
- if you have bonds in your portfolio, don’t worry, their interest rate will not change. Simply, when such bonds are traded, their price reflects not their face value, but the value that reflects the interest rate then prevalent in the market. If you keep them, you will get your capital back, and the initial interest rate of the paper;
- if you are invested in bond funds, there is a bigger risk that these will lose their value – if the bubble bursts, which may happen, soon, not so soon, or not at all if I’m totally deluded. But again, US Treasuries are at least safe instruments, whereas bonds from corporates or other issuers may end up being less safe. So check what you have, how it is managed, and decide where you want to have your money invested. As usual, caveat emptor.
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Its amazing that long term rates are low everywhere, not just the US. Ten year rates are near 3% in Germany, and even less in Japan. Long term rates are actually lower than short term rates in the UK and Australia. This phenomenon (called “yield curve inversion”) is usually a good predictor of recession.
Saturday’s New York Times has a column by Conrad Aenlle, “Shifting Gears, And Funds, Into Equities”, that opens with a reference to Greenspan’s lack of understanding regarding government bond rates. It then immediately turns to the issue at hand: the investment strategy of tactical allocators:
While there’s no guaranty that the professional money managers will get this right, the fact that there’s not really any dissent among them, combined with their willingness to place so much (other people’s) money all in one direction — away from bonds — is telling.
Mr. Loeb, who also manages the Vanguard Asset Allocation fund, has been moving money in one direction, then back again, since 1973. He said he found this to be one of only seven occasions in which the stock market has been so cheap, relative to bonds. Several of the others were near the ends of bear markets – December 1974, May 1980, December 2002 – and all produced double-digit gains over the next 12 months, with an average return of 24.9 percent.
Mr. Loeb is confident of a similar result this time. “We expect quite a gain in equities,” he said. “When pricing gets out of whack, as it is now, you get a windfall gain – if you’re positioned correctly – when things snap back.”
— — —
Mellon’s method is a conceptual cousin of the so-called Fed model, which compares the yield on 10-year Treasury bonds with the earnings yield – the inverse of the price-earnings ratio – of the Standard & Poor’s 500-stock index. Using the Fed model, stocks are deemed undervalued when the earnings yield, calculated using analysts’ estimates of operating earnings over the next 12 months, is above the bond yield. The reasoning is that it costs less to buy the same chunk of returns.
Where does the Fed model – which, incidentally, has only a tenuous relationship with the Federal Reserve – say we stand now? With an estimated forward price-earnings ratio of about 15, the S.& P. 500’s earnings yield is 6.7 percent, far greater than the 4.1 percent yield on the 10-year bond. By the reckoning of Thomson Financial, the stock market has been undervalued by 20 percent or more since late 2001 and is about 35 percent undervalued now. Contrast that with the spring of 2000, when the model showed stocks more than 70 percent overvalued – just about right, as it turned out.
Yet with equity markets seeming to tread water at best, due in large part to the effect of oil at nearly $60 per barrel and climbing, “conundrum” doesn’t even begin to describe what most individual investors are feeling these days.
Interesting point. But I don’t see the stock market go up when the bond market crashes or slides down.
Profits have been squeezed out of the beast to the utmost. anything that squeezes consumers now will have a direct effect on consumption and thus profits. I certainly would not buy stocks now – except maybe for energy stocks…
“…but at least they won’t default.”
I think I read somewhere that dubya has all his money in Treasuries. If that’s true, there’s a clue…
Who else is Treasuries heavy?
I think they’re expecting a massive crash before November 2, 2006 and everything is being pushed through ahead of that date.
Halliburton et al. aren’t getting bonus payments now, for nothing. Get as much money, as fast as possible…
Why the need for speed?
eh?
Loved your diary. I am a dim feeb when it comes to economics, and it is always good to read these things to try to keep abreast.
One assumption that everyone seems to make always makes me philosophical though. When I hear economists talk about safe harbors in investing, I always hear comments like U.S. Treasuries or Bonds are the best place to be. Things like, you’ll always get your principle back with those. And, they can’t default like junk corporate bonds.
And it always makes me wonder what the money men said in other dominant empires in the world. There must have been a safest investment in Rome at some point. Or in Persia, or Britain at the time those regions dominated the world. Governments collapse. By buying T-bills now I am supporting this bloated military expansion, and the current administration won’t even raise taxes a dime to pay for what it is doing. Leaving a humongous debt. Someday, the T-bill is going to default. Right?
Maybe it won’t matter where your money is then. What’s a dollar without the U.S. to back it?
My point is that there is an assumption built in to an economists point of view, it seems. And that is that the current way things are will continue forever, unchanged. Current government. Current religions. Current system of dividing the spoils. But, we all know that change is life. We’re just hoping the change holds off until a time we can’t imagine. Kind of like Greenspan waiting for 2008. What’s it to him (poor man is too short sighted to care about his own grandchildren — or ours I guess).
My gut tells me bad things about America. All of it. I hope that day holds off, but I swear I can smell it out there somewhere in the distance.
Blah, blah, blah. Sorry to run on. Thanks again for info.