Ten Year Yields Moving Up - Why the Bears Can't Be Right

Processed Meat Debate
Economic Disconnect has been having a back and forth with the fun blog Illusion of Prosperity as of late concerning a certain processed meat known as SPAM. I eat salads 3 times a week (Mon-Wed-Fri) and include SPAM as my lunch meat of choice. It seems that there is a basic lack of understanding of the wealth of products offered by the Hormel (HRL) company in this space, so I thought I would wade in.

First off, there are many SPAMs. There is turkey SPAM, Lite SPAM, Low Sodium SPAM, and SPAM made with Bacon, which really is a masterpiece. You may also be interested to know that SPAM now is available in single serve packs so you do not have to open an entire can! It's true, see them here. SPAM is the perfect guilty addition to my salads as I hate salad dressings but find I need a little substance to the lunch.

The company Hormel Foods and I can offer my full endorsement of SPAM. The stock, as things stand, I like as well and am thinking about taking a small position to protect my SPAM source. Of course, if I like a stock then Tim Knight hates it, and so HRL is a leading short candidate for Mr. Knight. I say, buy what you like.

Mr. Practical from Minyanville
I really miss the writings of Mr. Practical on the Minyanville site. While he still offers posts from time to time, his writing has dropped off in frequency. On Wednesday his insights were spot on as usual:

Those declaring the economy is now recovering do not understand (still) the problem: we are stuck with too much debt. The government’s solutions are to create more debt, as their next to be announced PPIP does. But an economy grows from production, not lending at the wrong price. This is a long term problem; the government has only addressed the short run symptoms.
Let me give you an example. Sixty to 70% of our economic growth depends on consumption. In order to “reflate” an economy (still the wrong way to do it but I will give the bulls the fact that you can drive up nominal asset prices by devaluing a currency), you need people to borrow money and spend it. In 2002 consumer debt as a percentage of disposable income was an all-time high of 90%
Apparently that was still low enough to spur consumers into borrowing money against their houses and spend it. This drove the ratio up to 135%! By the first quarter of 2009 the ratio dropped to about 130%. Just look at what damage that did as consumers tried to get out of some debt. The ratio is still at least 125% (we will know for sure in at the end of June as the numbers are quarterly). There's no way to know for sure, but logic says to reflate from that high level of debt is going to be virtually impossible.

Mr. Practical hits the nail on the head.

Trying to reflate assets prices may have worked if those asset prices were at some lower to medium level. As things stand, homes and many stocks were at all time highs and thus cannot participate in a reflation campaign. At least not with an intact dollar. Simple analysis often is the best, see Occam's Razor.

10 Year Yields Moving Up; Why the Bears Cannot be Right
The big story of the past two days has been the monster move up in yield (lower price) for the 10 year treasury (^TNX). A 20% move up is very substantial, though it is from extreme lows.

The coverage of this move has been very broad, with both bloggers and mainstream media joining in. From the blogroll, Jesse's Cafe had these comments and this chart:

[click to enlarge]

And Mr. Denninger at Market Ticker had this to say and had this chart:

To start, let me say that I agree in total with what Jesse and Karl are saying. I think that the move up is a repudiation of US debt and signifies a bond market revolt against money printing. Let me be clear, that is what I think.

And thus, I am most likely totally wrong.

For this kind of reasoning to be the catalyst behind the drop in 10 year prices would amount to something making sense in the markets.

We know by experience that this is unlikely. Perhaps impossible.

The Fed's plan is to keep loan rates (especially mortgages) depressed at all time lows to allow further debt expansion and roll over. They have been explicit on this point. We can debate the merits of such a plan (I hate it) but it is what it is.

So how does this fit in with the current market action? Is this the bond market dislocation many (myself included) have been looking for?

I say it is not.

In last Friday's post I linked to work done over at Housing Doom that showed foreign buyers for debt were on a record tear as of late. We know that for foreign debt holders to grow a brain in regards to the dollar and their overweight treasury holdings would signal a real change in thinking. I cannot imagine anything of the sort is going on. So what is?

My first hint comes from a blip in this Yahoo Finance story from Wednesday:

Some traders fear demand for Treasuries could weaken as the government issues massive amounts of debt to fund its financial and economic rescue programs. The Federal Reserve has said it would buy up to $300 billion in Treasury debt this year as part of its efforts to keep borrowing costs low. But investors are now concerned that the central bank isn't buying as much as some had hoped.

Catch that?

Traders are concerned that Ben Bernanke is going Quantitative Easing lite, and not QE on steroids with protein shakes on hand!

Now there is a "market" reason I can understand!

The 10 year is going up in yield (and down in price) because the market wants Bernanke to really get the money printing going. The market wants lower rates. The markets needs lower rates. The market wants an open ended commitment to lower rates. That this process is self destructive and may outright collapse has no meaning to the market, those are rational thoughts.

Any two day span in any instrument is too short a time to make a firm judgement. At this point I would attribute the jump in 10 year yields to market forces putting pressure on the Fed to make good on their promise to go "all in" with QE. With green shoots flying up all over the place, the recovery must not be disturbed, lest anyone really starts to look at the stock market's valuation against expected earnings. I mean, no serious disconnect there?

So what I think is happening is the Fed is being gamed into buying as many treasuries as the market deems necessary to ensure low rates. The recent examples of profligate spending by the US seems to have made many think we can indeed spend (borrow) whatever we want and there will be no one to do anything about it. Maybe they are right.

Today, the bears are wrong. Next week they may be right. When they are right, things are going to get all post Lehman-esque in a hurry.

Disclosure: Love SPAM and this may influence my judgement on the stock; looking to start a position soon.

Comments

[Jimmy Lathrop]

Your article is well-written and makes sense, but to pull an old canard from Frank Gorshin - riddle me this: If the Fed has allocated 300 bn to repurchase long-dated debt and they have bought 130 bn already, do you really think that 170 bn out of all of that outstanding long term debt is going to bring the yield curve down? Mr. Market can be quite irrational but to think the drop in the bucket is going to calm down the traders isn't particularly believable. Sometimes the answer is just staring you at the face - investors don't believe the US will be able to make good on the long term debt, or they believe, like Ben Stein, who is wrong often, that the US will substitute PIK for the long term notes when they become due. As long as politicians have short-term goals like getting reelected, and financial firms have short term goals like propping up share prices and ensuring bonuses for management, investors are waking up to the fact that the long term is the stretch from the end of Friday's trading to the open of market on Monday.

2009 May 28 07:33 AM

[Economic Disconnect]

Jimmy L,
I think the long term reasons for the treasuries action are very real. Given that, I still think this is a "triple dog dare you" (from the film "A Christmas Story") to the FED to commit much more than the remaining 170 billion to purchases. What number is "desired" is speculation, but again notice the lack of vision in throwing a QE fit at this point.

2009 May 28 09:12 AM

[reluctantQuant]

equity boys, equity boys... love watching them look at bonds.
the relevant item in this context is the price move in treasuries, not the change in yield. Yes, yields are backing up hard and fast, but there's a reason that bondland talks about yield in some contexts and price in others. the value of a current ten year note has dropped roughly 4.5% since the new issue settled from a price of par-ish to 95-21 this morning.

Half of the SA peanut gallery is screaming over the threat of inflation, the other half screams when yields move up 50 bps. I'd be glad to let yields start to normalize sooner rather than later. Remember Rosenberg's Rule #10. "As a predictor, Mr. Bond gets it right most often." And a steepening curve is a positive forecast relative to recent conditions, folks.

--rq

2009 May 28 10:25 AM

[Economic Disconnect]

reluctant,
if rising yields are indicitive of a recovering economy and not something else than the bond market is most assuredly wrong here. My 2 cents, well 0.2 cents after hyperinflation or my 2.00 after hyperdeflation.

2009 May 28 10:33 AM

[Jimmy Lathrop]

ED, the triple dog dare threat was made painfully clear to the head of the Dallas Fed on his most recent trip to China when they repeatedly asked if the government intended to monetize the debt. That was their diplomatic way of saying, try it and we'll put our money somewhere else. I know, it sounds crazy, but it may actually give our leaders pause.

2009 May 28 12:28 PM

[robert99]

Excellent article; I also like spam, as well as HRL.

2009 May 28 12:58 PM

[Economic Disconnect]

Jimmy L,
would love a real transcript of that meeting!
robert99,
obvioulsy you have excellent taste and I agree on both counts.

2009 May 28 01:03 PM