Plunging Bond Market and Implications for Gold

Since early May, the most dramatic events have occurred not in the stock market but in the bond market. Yields for the 5-year T-notes surged by almost 40% while the yields for the 10-year T-Bonds rose by almost 30% in the past 5 weeks. Both benchmarks have broken their multi-year downtrends in the past week.

The 10-year yield is now approaching 4.0% while less than half a year ago it was only at around 2.0%. Short end yields also soared last week. 3-month T-bill yields rose by more than 40%, while 2-year yields appreciated by 37% and are now yielding 1.32%.

While this is all happening, the stock market remains strong. Does this mean that the Fed & the federal government have been successful in their reflationary policy and that money is leaving bonds and going into stocks?

Are the short term yields rising in an anticipation of a rate hike by the Fed in September? And most importantly, are the longer term yields rising in an expectation of a return of economic growth? Finally, does this in sum mean that we are in early stages of an equity bull market and a gold bear market?

We certainly don’t think so.

The 10-year treasury yield is determined by two components: (1) real GDP growth expectations and (2) inflation expectations. When the majority of economic indicators (despite some recent improvement) remain in a deeply recessionary territory, it would be erroneous to forecast any near term economic growth. It is most probable that when the growth does return, it will be rather sluggish.

The main reason for this is that the world’s developed economies will continue to struggle through the current deleveraging cycle which could last years.

It becomes apparent why money is leaving bonds if we take a look at the inflation expectation metrics.

As for the spike in the short term yields – it appears to be only a temporary occurrence caused by what was considered to be a better than expected non-farm payroll report. In reality, the unemployment situation remains horrible. The economy lost 345,000 jobs last month while the unemployment rate rose to 9.4% and will reach double digits before too long. The US economy needs to add about 200,000 per month in order to keep up with the population growth and keep the unemployment picture steady.

Market pundits insist that unemployment is a lagging indicator but let’s remember that the mortgage default rate and many other economic perils are almost directly affected by this “lagging indicator”. The roots of this economic crisis lie in the housing / credit bubble and the subsequent mortgage crisis and deleveraging. Higher unemployment will lead to more mortgage defaults further undermining the banking sector and fueling the deleveraging process.

Rising yields along the entire yield curve have led to just one indisputable result: mortgage rates have now risen from 4.75% a few weeks ago to 5.45% on Friday. The ability of the Fed to control the mortgage market is practically non-existent and despite its attempts, the MBA refi index fell by 43% in the past four weeks. Liquidity is shrinking again. How could one believe that the Fed could soon afford to begin fighting inflation?

What does all of this mean for gold and gold stocks? The market views gold above all else as an inflation hedge. Providing excellent evidence for this is an almost ideal correlation between inflation-protected TIPS and gold.

Soon the illusions about the Fed’s intent to begin fighting inflation will disperse and gold’s correction will end. What we have been witnessing in the gold market in the past 15 months is a long-term bullish consolidation. The most probable resolution to this gold consolidation is the beginning of a new bull phase in the next several months.

This is an excerpt from a Resource Stock Guide Newsletter dated June 6, 2009.

Disclosure: No positions

Comments

[Chandragupta:]

Bond yields are rising because there is too much of Government paper around. The Government needs to pay more and more to sell additional paper. Stocks are rising because of excess liquidity in the system - it has to flow somewhere, so some of it is getting into equities (balance into commodities). In fact, it won't be an exaggeration to say that another stock bubble is building up. Gold is rising because it is the inverse of Dollar: An alternative Global currency, a safe haven when the Dollar collapses and there is chaos all around.

Jun 09 12:19 PM

[BigOlDave:]

Boris,

Nice, crisp analysis that confirms what a lot of us suspected would be happening. But I never thought of the correlation between gold and TIPS. Thanks for the insight.

Can't say that I'm as hot on gold as ChandraGupta, but he also has some good points. I have bets on the commodities and the Aussie via CurrencyShares Australian Dollar Trust (FXA), but think gold has outrun itself at these prices (I'm a buyer at a 5-10% retracement.

I also like bets on recovery of international trade via Navios Maritime Partners L.P. (NMM), Brazil and telecom via Tele Norte Leste Participacoes SA Sponsored ADR (TNE), and recovery of electronics via Himax Technologies Inc (HIMX).

What do you think of my approach?

Dave

Jun 09 12:48 PM

[Larry House:]

Gold is and will be a good place to be.

Jun 09 05:38 PM

[Mad Hedge F...:]

Gold up, bonds down. I have watched many countries go bankrupt over the years, as my collection of defaulted bonds hanging on my wall attests. Governments borrow so much that the cost of the debt service exceeds the national budget, so the country has no choice but to quit paying. I am starting to see disturbing parallels here. Bush took the national debt from $5 trillion to $12 trillion, and Obama will inflate it to $17 trillion by the end of 2010, boosting it to a frightening 82% of GDP. The cost of the borrowing is rising too. Today a 1% jump in bond yields raises the federal interest burden by $50 billion. The Congressional Budget Office says that figure will explode to $170 billion in ten years. Can you see the same hockey stick, hyperbolic, exponential growth in obligations that I do? Interest rates will soar to double digits, the dollar will crash, and private borrowers will get crowded out of the market, taking the economy into the tank. People blanche when I tell them that my target for the PowerShares US Lehman leveraged short government bond ETF (TBT) is $200, but the logic is inescapable.

Jun 09 07:01 PM

[MarkitWacha:]

I agree with the Mad Trader's comments above. The interest rate will at least reach the levels we saw in the 1980s.

Regarding your prediction for a bull market for gold, the market will have to overcome the fact that 60% of gold's use is for luxury items first. That means that the consolidation is partly a result of this part of gold's demand/supply curve. So, put off your prediction by 6 months, and I would agree. I see the luxury segment overridden by those seeking inflation protection, and a tenacious bull market starting in 6 months when the market is first spooked by inflation reports (due to crude oil jumping this month, gasoline reflecting the jump in 3 months, and food reflecting the gasoline jump 3 months after).

I also see a bull market in other scarce resources, too. Commodities are the place to be in uncertain times.

full disclosure: long TBT, DBC

Jun 09 08:12 PM