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When will this Bond Market Rout End?

Interest-Rates / US Bonds Jun 15, 2007 - 09:22 AM GMT

By: Money_and_Markets


Mike Larson writes : If bond traders thought the worst was over last week, they had another thing coming to 'em. Long Bond futures prices fell Monday … dropped sharply Tuesday … bounced Wednesday … then slumped again yesterday. All told, Treasuries lost value in seven out of the past eight days.

Meanwhile, 10-year Treasury Note yields have soared! They're up more than three-quarters of a percentage point from their December low. In fact, 10-year yields briefly touched 5.30% this week, the highest level in five years.

The reasons for the ongoing sell-off are the same ones I've warned you about for the past several weeks: Rising inflation pressures … higher foreign interest rates … reserve diversification by central banks … and now, out-and-out capitulation selling by bond investors who can't take the pain any more.

Just this week, for instance, we learned that import prices jumped 0.9% in May. That was three times the 0.3% increase forecast by economists. Even if you strip out all fuels, you get a hefty 0.4% rise in "core" prices — something that has to be unsettling for bond traders.

Wholesale inflation is also climbing. The Producer Price Index gained 0.9% last month, topping the 0.6% gain that was expected. Core PPI rose 0.2%, the biggest increase in three months.

Fortunately, you've been prepared for this for ages . Martin and I have been writing for months about the need to keep your fixed-income money in short-term debt. We've sung the praises of Treasury only money funds, 3-month and 6-month Treasury bills, and even exchange traded funds (ETFs) that hold short-term Treasuries. And just a few weeks ago, I issued an urgent " Get out now! " alert, telling you that long-term bonds were in big trouble.

The key question now is: "How much further can bonds fall?" Well, the Consumer Price Index for May is being released this morning. That's the big kahuna for bond investors, and if the data is a lot better or worse than economists expect, things could change quickly. But my general takeaway is this:

Bonds can … and probably will … fall further

I've talked about the big-picture fundamental reasons why bonds are vulnerable. But now I really want to dig down into the nitty gritty of how bonds work. Hopefully, it'll help you understand why we're seeing the selling we're seeing — and make you a better fixed income investor in the process.

First , it's customary for longer-term Treasuries to yield more than shorter-term Treasuries. That's because the chance of inflation rising significantly over the next 10 years is higher than the chance of inflation rising significantly over the next six months or two years. Bond buyers therefore typically demand higher yields on longer-term debt to compensate them for that inflation risk.

Since 1980, in fact, the "spread" (or difference) between 2-year Treasury Note yields and 10-year Treasury Note yields has averaged +0.775% — or 78 basis points. In other words, it's normal for 10-year notes to yield, say, 5.78% when 2-year notes yield 5%.

But starting in late 2006 and continuing through earlier this year, the market got nutty. Long-term rates fell BELOW short-term rates — an odd state of affairs called an inverted yield curve [Editor's Note: See " The Big Bond Squeeze " for a more in-depth explanation of this phenomenon.]

Why? Bond investors were essentially betting the Federal Reserve would cut interest rates. But those bets are now blowing up in their faces . Ongoing inflation pressures, an uptick in economic activity over the past month or two, rising foreign interest rates, and more all add up to no chance the Fed will cut. That's causing investors to run for the exits.

But here's the thing: Even after all the recent selling, the "2-10 spread" I described earlier was STILL just +0.14%, or 14 basis points, yesterday. That's far below the 78-point average.

Just to get back to normal, 10-year yields would have to shoot up to 5.87% … a lot more than they have already! And that's assuming 2-year yields stay flat. If they rise, 10-year yields will have to rise even MORE.

Do you think the stock market is prepared for a whopper of a move like that? I sure don't. I think it would be the kiss of death for vulnerable home builders, commercial REITs, and other interest rate-sensitive stocks.

Past selling squalls went much further than this one, too!

I'm sure more than a few bond traders have been swilling Maalox lately. But the fact is, long bond futures are still down only about 6% in price from their recent peak. That pales in comparison to past "selling squalls" that we've seen …

Major Bond "Selling Squalls"
Timeframe % Decline
Fall 2001 12.0%
Summer 2003 16.6%
Spring 2004 12.7%
Summer 2007 5.6% (so far)

Mega-Squall #1: Back in the fall of 2001, post-9/11, the economy was in chaos. We had just been hit hard by terrorists and policymakers were looking for some way to help heal the financial damage. The Federal Reserve had cut short-term interest rates, but long-term rates barely budged.

So what did the government do? It announced a plan to stop selling 30-year Treasury Bonds. That caused prices to soar as it instantly gave existing bonds "scarcity value."

But shortly thereafter, bonds gave up all their gains … and then some. Within a few short weeks, bond prices had plunged by 12%.

Mega-Squall #2: In early 2003, it looked like nothing would go right for the economy. The war with Iraq had just started. Employers were shedding jobs. GDP growth was anemic.

Meanwhile, inflation was steadily sinking toward 0%. Federal Reserve policymakers were openly fretting about deflation. That sent long bond futures prices through the roof — from just below 110 all the way up to 124 in a few short months. Ten-year Treasury yields fell all the way to 3.11% — the lowest level in decades!

But it didn't last. Evidence of an economic rebound began to emerge, and investors began to dump bonds like a hot potato. Selling triggered more selling and before you knew it, long bonds had dropped almost 17%.

Mega-Squall #3: In early 2004, bonds were on a roll because it looked like the economic rebound was faltering. But then in rapid-fire succession, traders got hit with the news that consumer confidence was rebounding … inflation was picking up … and spending was improving.

That got the selling started. And then a few days later, a report flashed across the tape: The economy created 308,000 jobs in March. All heck broke loose in an instant. Bonds suffered the biggest haircut since 1996, and kept on falling, ultimately finishing down almost 13% from their high.

In other words, the selling we're seeing in bond futures today could have a LOT further to go . A 12% decline would put us all the way down around 99, versus a recent price in the high 105s. As for interest rates, I think we're headed to 5.5% on the 10-year note first, then somewhere in the high 5s.

That doesn't mean we won't see short-term bounces in bond prices and dips in interest rates. After all, no market travels in a straight line. But it does mean you should continue to follow the advice we've been doling out — namely, avoid long-term debt and rate-sensitive stocks.

Until next time,

By Mike Larson

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john j schwarzenbach
16 Jun 07, 17:10

if the war in Iraq ever ends the market will react strongly in favor of bonds as the war time spending suddenly dries up, unless of course if we resume the Arms race with Russia to take up the slack.

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