By Jared Dillian, Mauldin Economics:
You know what’s as steep as a double black diamond ski trail? The yield curve. At least, it’s getting steeper at an alarming rate.
That’s not supposed to happen. Supposedly, the Fed is tightening monetary policy, or soon will. They are threatening to. And they have been threatening to for a while.
So if the Fed raises rates, short-term rates will go higher and long-term rates will go lower, or stay put. In the chart above, you see the spread between the yield on the 2-year note and the 10-year note.
The 2-year note yield is basically just a function of fed funds expectations, but the 10-year note yield is a function of many things—three things in particular I’d like to highlight:
- Inflation expectations
- Supply and demand for loanable funds
- Supply and demand for securities at that maturity
If you own a 10- or 30-year piece of paper, you really care about inflation. Even a small amount of inflation, over time, will erode the value of that security. Think about it. If you own a 30-year bond at a 2.5% yield, there isn’t a lot of margin for error. If inflation rises even a little, your real yield could be negative.
So when the back end sells off and the curve starts steepening, it’s usually because people start to worry about inflation. There is evidence for this. First of all, copper, steel, and iron ore are coming back—
—and the yield spread most sensitive to inflation expectations, the spread between 10- and 30-year yields, is ripping higher.
Gold isn’t doing anything yet, but hope springs eternal.
What the market is telling us is that the Fed waited too long to hike rates. Now inflation expectations are becoming unmoored. The consequences could be dire. If mortgage rates go up to 5%, people are going to notice. It would be bad for me because I’m trying to sell my old house (in an area where pretty much everyone depends on financing).
There is another way to look at this. I actually talk about the forces that determine interest rates in the class I teach. You can draw a supply/demand diagram for interest rates, just like anything else. Interest rates are a function of the supply and demand for loanable funds.
If you think about it, we are literally choking on loanable funds. The banks are sitting on tons of cash and not lending it out, which you can see in this chart of excess reserves—
Little wonder that interest rates have been so low for so long! But now, perhaps, we’ll be seeing the first sign of demand for loanable funds. People borrow for 10 years or 30 years to fund long-term capital projects, like to build a house or maybe a factory. If after six years of what we’ve called a recovery, we are really having a recovery—maybe companies will rely a little less on buybacks and financial engineering and more on capital projects.
And finally, there has been near-limitless demand for 30-year paper from pension funds and insurance companies. Maybe something has changed?
What a Bond Bear Market Looks Like
Actually, we don’t really know what it looks like, because it’s been 30 years since we had one. A few things to think about—
Liquidity in treasury bonds is terrible. Which is amazing, right? Treasury bonds are supposed to be the most liquid instruments in the world. But Dodd-Frank came down hard on the credit default swap market, and that also had a huge effect on plain vanilla interest rate swaps, which have been around for ages and never posed a threat to anyone.
So people were driven out of the swaps market and into the futures market, which is imperfect, for technical reasons. Liquidity disappeared. It’s terrible. And in a post-Dodd-Frank world, you can’t go to a bank and ask for a bid on $100 million of bonds. Nobody will do it. Nobody will commit capital—too risky, too expensive.
So if we really are in a bond bear market, it’s going to be very disorderly. Remember the bond flash crash last October? That was just a taste. If there’s an asset on the board I would own, it would be interest rate volatility. Long gamma heaven!
The Risk Lives Somewhere
If the world’s biggest, most important asset class is going down for the dirtnap, who is going to get hurt? After all, the risk lives somewhere.
Answer: Baby Boomers.
They got wiped out in 2000-2002 and got killed again in 2008, at which point they said, “Screw it, stocks are impossible, we’re going all in on bonds.”
How do you think the PIMCO Total Return Fund (PTTRX) got so big? And more recently, the Vanguard Total Bond Market Index Fund (VBTLX)? I remember the days when the stock funds were the biggest!
One last thing to scare the pants off you, then I’m going to go. There is a concept known as duration that people use to measure interest rate sensitivity. The duration of the on-the-run 30-year bond is about 20 years.
So here’s the thumb rule: For every 1% change in interest rates, the price of the bond will decline by (approximately) its duration, in percent.
So if you own a mutual fund full of 30 year bonds, if interest rates go up one percent, your investment will lose 20% in value. If rates go up two percent, I mean…
I’d bet that two-thirds of bond mutual fund shareholders don’t even know the relationship between bond prices and interest rates. Boy, this is going to be fun. By Jared Dillian. The article The 10th Man: Double Black Diamond was originally published at mauldineconomics.com.
Stocks, bonds, art, housing, VC portfolios of billion-dollar startups… everything is on the line. Read… Afraid of Losing Trillions, Wall Street Fights Fed Rate Hikes
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So…… once rates go up, then it would be a good time to get into bonds if you want to live off the interest assuming you will hold it to maturity?
You may have to wait quite a while before bonds are a good buy again. Unless they suddenly totally crash, which I doubt. And don’t forget credit risk: When the money dries up, a lot of these over-leveraged companies go bankrupt. Bond bear markets are nasty.
The Fed and other Central Banks are totally messing with the markets. Stock markets, bond markets and even commodity markets. They are trying to make believe that we aren’t in a hugely deflationary period. Because they know the end game if a spiral develops downward due to all the debt that exists. So they are pulling (actually more like pushing on) strings to try and keep the entire system propped up.
These economic tensions are huge, all the way from each of us to the global level. Know one knows what is going on or what to expect.
Depending on your life perspective, things will muddle along or end very badly.
I turn 60 this summer with cash in the bank and everything paid for. I now do most of my purchasing with two ideas in mind….enjoying the day while health and energy levels are still good….and what will this leave for my family?
30 year paper is not on the list, and neither is 10 year paper. I am in the middle of the boomer pack and not the upper front end!!
My family will get a nice house and land in a safe rural area on Vancouver Island. They will get tools. I guess my son will take over the guns and stores as he lives close by. They can sell everything and/or split the cash if it is worth anything but there won’t be a bond or certificate in the mix. Nary a one. I used to buy short term bonds years ago after I got out of the market. I wouldn’t do it now.
I would never trust these foolish Govts. to ever pay anything back as this unfolds, no matter what the face value and return is supposed to be. With the coruption of Govt by big business there is one agenda being served and it won’t be the bond holders. Buying a Govt bond or muni would be like believing a new Middle East war is for democracy.
Like the old saying goes, “I have a bridge for sale”. Yeah, right.
We are kindred spirits. Who in their right mind would invest in any bond. What company can you trust when they are all borrowing to buy back their stock, which is just a massive liquidation of their equity. Even the rich are investing in real estate and art and not the bond market. There is no interest rate a borrower can offer that will make up for their lack of solvency.
This crash will be the last and be like no other the world has seen. It won’t be a quick and painful market crash.
It will be one crash after another, because we have a world full of bubbles.
You won’t be able to avoid it simply because you’re in the right asset class, or not in the wrong one.
We’re going to watch a multi-year crash that will become the norm. You will forget what it looked like to watch a market go up.
There will be no bailout this time, Jamie Dimon himself said so while he was saying that another financial crisis is coming.
Yes, he actually said that. Google it.
Can’t the fed just keep printing more and the plung protection team keep buying up assets to keep it going? Of course this makes no sense, but nothing had made sense over the last seven years…I mean the whole system is backwards…government should show financial responsibility instead of racking up debt like a drunken college student. As a citizen, why should I be responsible if even the government isn’t?
Yes, of course they could. Just like Bernanke could’ve bailed out Lehman to prevent 2008, but he didn’t. Was it because he made a mistake? He wants you to believe that, just like the FED wants you to believe they’re just a bunch of dusty, out of date boring scholarly types who don’t really know what they’re doing.
Yet, as dumb as Bernanke apparently is, he managed to pull the economy from the brink with just enough QE to create a recovery but not enough to cause inflation…after a crash.
Once we consider the FED’S beginnings, who owns it, and the power it wields, and who it serves, we can then realize it exists to enrich it’s owners, not us. Handouts to us from time to time are necessary evils to them, and will be repaid in blood.
The FED is not our friend and it’s interests are to extract wealth from citizens through a boom and bust system which it controls and profits from. Understand that and you won’t be surprised when they raise rates, and crash the markets.
“There will be no bailout this time”
it’ll be a bail in and i think that verbiage is in the Dodd/Frank legislation…..like George Carlin said “now they’re coming for your retirement money…..and they’ll get it”
Taleb in the Black Swan calls this denial of what’s coming a ‘normalcy bias’, it was this way yesterday, last week, last year…all my life. It will therefor be the same tomorrow. When the paradigm changes these folks will give deer in the headlights a bad name. And all the cheerleaders at CNBC and Bloomberg will cry out “who was I to know? Nobody saw this coming!” This isn’t a video game where you can start the game over.
We may or may not enter a bear market for bonds but …
“The banks are sitting on tons of cash and not lending it out, which you can see in this chart of excess reserves—”
The banks don’t lend excess reserves, they are only deployed when all other reserves are exhausted … as during a bank run. If history is a guide (1932-33) the bank(s) close (or are closed by banking authorities) before reserves on hand (vault cash) is exhausted. Whether Fed reserves would be deployed at all or not in the event of a crisis is something we would all learn the hard way …
If the banks close there are effectively no reserves at all. If the banks close and citizens cannot retrieve their funds there will be a revolution in the country, the bankers will be swinging from lampposts. USA is not Cyprus.
Loanable funds make up the smallest component of credit stream as banks simply lend into existence whatever funds are demanded. As such, supply vs. demand of loanable funds is largely irrelevant.
Lending capacity at the highest level is constrained by inability of end-users to borrow so as to retire the firms’ loans.
I keep telling people who believe in passive investing that the method has worked because we’ve been in a 3 decade period of (1) declining interest rates, (2) Boomer retirement investing, and (3) the Boomers have been held prisoner in retirement plans for decades.
By “held prisoner” I mean that if you realized income through dividends or capital gains in a tax-deferred account you were severely punished if you withdrew it before age 59-1/2. You had no choice but to roll it back into the stock and bond markets.
Everything went up due to a combination of steadily diminishing rates, Boomer savings, and forced reinvestment.
The passage of time is removing those retirement plan shackles, plus the Boomers are liquidating rather than accumulating. We now have a perfect storm of ZIRP plus divestiture.
I have a feeling that passive investing doesn’t work so well in reverse. Everything in finance is referenced to the risk-free rate, which has been artificially suppressed. Once that reverts to the “natural” value there will be hell to pay. Before Greenspan and then Bernanke pushed rates down the 1-yr was 6% in 2000 and 5% in 2007. What would a ZIRP world transitioning to a 1 year T-bill at 5% look like?
Then consider the effect of increased rates on government borrowing. It will likely cause numerous budget crises. Raise taxes on a beleaguered economy? Borrow more? QE 4, 5, 6, 7?
Before you write off the bond market, especially the corporate market, keep an eye on what Draghi does. Europe now has negative repo rates due to a shortage of collateral and – Draghi’s denials notwithstanding – the ECB may have to start buying corporate bonds. Watch for the front-running.
Then consider what has happened in the US. FrankenDodd has forced US banks to load up on collateral, and while the Fed is no longer accumulating it is still rolling over what it owns. That means a possible collateral crunch here as well, especially if there is a “flight to quality”. There are quite a few scenarios that could precipitate that.
In brief, I think there is a good chance that US rates will be further suppressed before they finally revert to a natural value. A truly desperate ruling class could push yields on the 10-year to 1%. If 10-year OATS can go to 0.35%, anything can happen.
Good comment Michael and I agree especially here:
“Then consider the effect of increased rates on government borrowing. It will likely cause numerous budget crises. Raise taxes on a beleaguered economy? Borrow more? QE 4, 5, 6, 7?”
The G-7 governments ( plus the smaller developed nations) have become utterly dependent on a Zirped world. Even Germany, which has no fiscal deficit now, woud find itself facing one were it to have to start rolling over its 75% debt to GDP bunds at normalized rates. For everyone else, the fiscal problems would be catastrophic. The Central Banks have built a mousetrap that has trapped them.
Interesting to read all this Wolf, while the prized Princeton Economist and eminent NY Times Opinionator Paul Krugman says just the opposite and that the world’s Central Banks HAVEN’T LOOSENED ENUF and s/b buying back more bonds and doing more monetizing of the debt. Best…PJS
Bonds away ! Look out below!
So, bond prices fall, rates rise? Good!! I would love to see the value of borrowed money at 3% above inflation for a change. Maybe that will squeeze borrowers, kill real estate speculation, cramp the marginal junk bonds, and make me (the rich guy) happy to buy good things for half off or more in the liquidation sale. Screw the indebted fools!
Would love to hear your views on Indian bond market scenario. Will India survive the bond bubble burst. Everywhere the rates are predicted to go up where as in India they are predicted to go down.