The US Treasury market has exaggerated significance in the financial world. As the “risk free” asset, American Government debt is the benchmark to which all other investments are compared. The future value of any investment is calculated using Treasury returns as the discount rate. The market has importance way beyond its internal dynamics, and is massive ($9.2 Trillion as of 2011), so any sudden move is notable and deserves our attention.
The problem is that the bond market and its participants have an image problem. To most investors, bonds are boring and a little obscure; just the mention of the yield curve or duration is guaranteed to cause mild nausea in the vast majority of the US population. Market participants feel the same way. The bond guys are a breed apart. They quote things backwards, talk a different language and, in normal times seem to get excited about miniscule moves. I seriously believe there is a reason Rick Santelli isn’t in the studio with the rest of the crew on “Squawk Box”. These guys are just different.
What traders of other instruments understand, though, is that, for all its quirks, the US bond market is really the leader of all others. Its unique role as parking place for the world’s cash means that every trader in the world pays attention, knowing that moves in other markets will most likely be signaled there first. This interest just isn’t replicated by the casual investor. I mean, “The Dow Jones closed today at…” is a fairly common refrain at the end of network news broadcasts, but when was the last time you heard “US 30 year yields touched….” on ABC, CBS or wherever?
The last couple of weeks, however, have seen Treasury yields and prices cross over into mainstream news. There has been talk of a “bond bubble” for years, and doom and gloom predictions that it would all end badly, but QE kept forcing prices up and yields down. The 30 year bull market in bonds seemed like it would never end. Of course, we knew it would. “When?” was a much trickier question, though. Even brilliant minds when it comes to bonds got it wrong; remember Bill Gross’s shorting of Treasuries and subsequent apology to shareholders?
The last few weeks’ price action in Treasuries would indicate that the oft predicted end has arrived. The questions now are, will it be an ordered exit or a bursting bubble and what is the significance for other markets, most notably stocks, going forward?
Your view on those questions depends largely on how you view this move. I believe it is inevitable and healthy. Eventually, the cumulative effect of the Fed creating $85 Billion out of thin air every month had to catch up with the effect of them using that money to buy bonds. The market has begun to give more weight to the inflationary pressure caused by this unprecedented bout of money printing, and discussion of the tapering and eventual end of QE has moved those concerns to the fore.
As 10 Year Note rates have risen and prices fallen ( the i-Shares 20+ Year Treasury ETF, TLT, has lost 16.2% since the highs in late April) bond investors have taken a serious hit, something for which the aforementioned 30 year bull market has left them unprepared. If we accept, however, that the recent move is simply a normalization of the Treasury market and represents expectations of moderately higher inflation to come, then the worst is over, and from here the positives of the move outweigh the negatives.
If this is the reason for the recent spike in yields it is unlikely to continue much longer, as I don’t think many expect real raging inflation, and the exit from what was a very crowded space in the years following the recession can continue in an orderly manner. This cash that is released from bonds will seek a home, and in even a mildly inflationary environment, stocks will look like a good bet. This move, then, is natural and needed. It will enable real interest rates (after inflation) to return to the positive, and contribute some upward pressure to the stock market. All is for the best in the best of all possible worlds!
I am lucky. I live a comfortable life at the beach, have a beautiful wife and three great kids and am generally happy. Maybe this is why I can look at a move that has some predicting the end of the world in financial terms and see a positive. It could be that, or it could just be that, once again, the predictors of doom and gloom are sensationalizing their case.
Given what we have seen for decades and the Fed’s response to the events of 2008/9, we shouldn’t be surprised by a reversion of rates toward the mean. Nor, in my opinion, should we be unduly worried.