Those who follow me know that I predicted long ago that there would be a secular downtrend of long-term yields (I stated that in spring 1994) and that there would be very large undervaluation of Long-Term Treasury Yields.
That secular downtrend date from 1981 when the 30 Years US Treasury Bonds was 14.5%. That article explains why I think that it will end very soon. (Click to enlarge)
Long-term yields can be conceived as some sort of (complicated) options of short-term yields (with a strike of 0% and a value of the underlying asset equal to the implied volatility of short-term rates over the period. As such they have a fair value when short term rate are 0% at a given (implied) volatility. My evaluation of these yields are 4.60% for the 30 Years US Treasury Bonds and 3.60% for the 10 Years US treasury Notes.
Because these options are difficult to arbitrage when undervalued (complicated) and because banks are structurally longs in long-term investments (it is their jobs after all). These yields can be undervalued for quite a long time particularly when pushed down artificially by Quantitative Easing.
However these undervalued yields become unsustainable when they get too far from their fair value or stable equilibrium. Any crash we know of came from a sudden normalization of the yield curve.
My personal evaluation of that "too small" yields come from the observation of the 30 Years US treasury Yields shortly after the minimum reached after the bottom of the Great Recession.
I concluded that these unsustainable low yields should be between anything below 3.40% range for the 30 Years US Treasury Bonds and 2.50% for the 10 Years US Treasury Notes.
Although these yields are necessary to generate the prevalent slow growth I conclude that now a return to their stable long-term equilibrium is in the way. That return can be caused by a small external shock.
Although dismal news are in the pipeline I think that long term rates should be soon be bottoming as the undervaluation of long term yield become unsustainable from a n option valuation point of view..
This will have dramatic financial and economic consequences:
First, an increase of long-term yields with no increase of expected profits will necessarily translate in a sharp fall in stock values. It is the mechanism,of any market crash we have witnessed. Anyone familiar with financial mathematics know that present value are much more sensitive for low yields than they are for high yields. So the amplitude of that crash should be bigger than anything we have witnessed yet.
Secondly, the fact that yields would go significantly higher means that the available funds for investments necessary for fueling the prevalent weak economy will suddenly disappear creating a sharp decrease of money supply (M3) and investments and hence a sharp drop of GDP employement, prices and profits. Third that increase in unemployement and higher deflation expectation will decrease consumption. Those will be compounded with the previously discussed drop of stock values.This discontinuous behavior of long-term yields will generate a catastrophic behavior of stock markets and of the economy. Timing: The most probable date of that bottom would be September 8th, 9th with a dismal 30 Years US Treasury Bonds auction after an exceptional good 10 Years US Treasury Note Auction on September 8th. Auction 10 Years US Treasury Bonds on Oct 7th, 2009. Auction 30 Years US Treasury Notes on Oct 8th 2009.
Auctions are good dates for reversal: look at the reversal on the Oct 9th which is the beginning of the last wave of the significant increase on long-term yields.
Disclosure: No position
