The Bond Market Explained

Includes: TLT
by: Bernard Thomas

What a week in the bond market. Prices of U.S. treasuries rallied following an agreement between both parties in Congress and the president to raise the debt ceiling and cut spending by $2.5 trillion. This follows a week when investors purchased large quantities of treasuries in a flight to safety in the event that the U.S. failed to raise the debt ceiling.

Investors purchased treasuries the week before a debt ceiling agreement was reached because if the U.S. did not raise the debt ceiling, the global financial system and capital markets around the globe could have been thrown into turmoil. Meanwhile, the U.S. would most likely have serviced its debt, uninterrupted, instead choosing to withhold payments to government spending programs, pensions and salaries. So if turmoil was avoided, why did prices of U.S. treasuries continue to rally?

The rise in U.S. treasury prices was due in part to the budget cuts and the fear that the U.S. would not be able to inject further stimulus if economic data indicated it was needed. The market fears a near stagnant U.S. economy or, worse, a recession. Recent data suggests that growth may indeed be slowing. Some of the slowdown can be blamed on supply disruptions in Japan and a consumer squeezed by higher food and energy prices. Although those headwinds appear to be temporary, new, possibly stronger and longer-lasting headwinds appear to be on the horizon, which should keep growth and interest rates low.

Spending cuts and higher taxes are part of the plan to address America’s budget crisis. These will create headwinds by removing money from the pockets of many consumers. Taxes are straightforward. The more taxes one pays, the fewer dollars one has left to spend. Budget cuts are less intuitive, but when you think about it, it makes sense. Budgets cuts means the firing of government workers and fewer purchases of goods and services by government agencies. Although one can argue that such measures are good over the long haul, headwinds are created by such measures in the near term. The U.S. is undertaking austerity measures similar to those European periphery countries should undertake, but refuse to do.

Europe is a mess. European leaders are choosing to throw cash at the problems whenever the bond market votes with its feet and shows its reluctance to finance periphery nations, at least not at affordable rates. The markets are losing their patience. The recent rally in U.S. treasuries is due in part to a no vote on the way European officials are handling their ever-growing crisis.

The global economy is slowing. China is fighting its own real estate bubble and trying to slow inflation with less accommodative polices. This does not mean that China will stop growing. The country is so far behind developed nations in the west it cannot help but grow. It can grow at a robust pace almost by accident. However, if this is all the growth we can get in our economy based on exports (the exportation of manufactured goods has been one of the few bright spots in the U.S. recovery); with China in an economic bubble, what happens when overseas demand slackens?

The U.S. consumer is overleveraged and is sitting on depressed real estate. Add to this plight no wage growth and more layoffs, and the consumer is in no position to lead the economy back from the depths of despair. It could be many years before the consumer can lead the way and even then he might tread more cautiously.

Consumers will spend again, but they are in the midst of an economic hangover. Just as in an alcohol-induced hangover, one must take some time to recover from one’s drunken binge. They will drink again, but it is possible they will be a bit more responsible the next time around. Surveys of the under-30 set indicate that they eschew the 4,000 square foot McMansions and $50,000 SUVs. Older consumers are also learning to spend more judiciously. Consumer spending may peak at levels seen in the 1980s or before when the consumer is back in the game.

Banks are not going to lend to anyone but the most qualified borrowers. This is for several reasons. It is not easy to securitize loans to lower or even mid-quality borrowers, at least not at rates that would entice borrowers. Investors are demanding higher rates of return for investing in such loans and there are fewer of these investors.

Also, banks will not hold them on their balance sheets. For one thing, they could be criticized by regulators for having too much risk on their balance sheets. Another factor keeping banks from lending to higher-risk borrowers is that politicians will accuse banks of predatory lending if they lend to those whose ability to service their debt is in question. Instead, banks will continue to engage in a carry trade in which they borrow at near-zero-percent rates on the short end and purchase 10-year treasury notes. Even with a rate of 2.50% on the 10-year U.S. treasury note, banks can earn over 200 basis points without incurring much, if any, risk.

Some may criticize my thesis and point out that S&P’s recent downgrading of the U.S. sovereign credit rating to AA+ will cause a selloff of U.S. treasuries. Any such selloff will be short-lived (and a bit stupid). Most investors who buy large quantities of U.S. treasuries can still own them even if they are not AAA-rated. They have an exemption for U.S. government debt.

What could push long-term U.S. rates higher is if the Fed engages in QE3 or similar stimulus. When the Fed instituted QE1 and, especially, QE2, long-term rates trended higher. This confounded investors and Fed officials alike. I have explained this earlier that quantitative easing, like traditional easing, is inflationary in nature. It tends to weaken the dollar and pushes prices and long-term rates higher. This is exactly what happened with the first two rounds of QE. The positive effects on growth diminished with each round of QE, but the negative effects on inflation (pushing it higher) increased. A QE3 would likely cause this trend to continue.

An idea of the Fed eliminating the 0.25% rate paid to institutions for deposits held at the Fed has been floated. The thinking is that if banks are no longer earning this 0.25%, they might be more inclined to lend that capital. More likely results would be the purchasing of U.S. treasuries or expense cuts (layoffs and the canceling of expenditures). This would put a heavier lid on long-term interest rates.

Weighing the recent economic data, large layoffs announced by businesses, government policy decisions (necessary though they were) and the lack of arrows in the Fed’s quiver, and poor economic growth, relatively low interest rates appear to be what is in store for at least the next year. I would not be surprised if the Fed funds rate was left unchanged throughout 2012 and beyond. If someone approaches you with the idea of buying floating-rate securities pegged off of short-term reference rates, don’t walk, run.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.