What The Bond Sell-Off Means For Stocks

Includes: ITA, PPA, TLT, XAR
by: Acting Man

By Bill Bonner

The Dow dropped 71 points on Monday. Treasury prices continued to slide. The yield on the 10-year Treasury note (which moves in the opposite direction to prices) hit a two-year high of 2.88%. And gold held steady at $1,365 an ounce. Bond investors have been hit hard. For instance, holders of the iShares Barclays 20-Year Treasury Bond ETF (TLT) are down about 14% for 2013. Surely, there are some major financial problems hidden beneath these figures. Sooner or later, they will show up in the headlines … with the announcement of bankruptcies and defaults.

When bonds fall in price, yields go up. And along with them borrowing costs. This quickly squeezes profit margins … and can push some highly leveraged firms over the edge. Dear readers should be aware that most of the increases in earnings – used to justify higher stock prices – came from the financial sector. Most of these “earnings” have been artificial and unsustainable. They are a result of the Fed’s pushing down of Treasury yields. Financial firms borrowed super-cheap money … and played the long side of the stock market. But now – with borrowing costs rising and the U.S. stock market showing signs of running out of steam – the financial sector is likely to take some hits. Watch out!

Rising Treasury yields affect how Wall Street values stocks. That’s because Wall Street prices stocks based on the so-called “risk free” rate of return you can get in the Treasury market. The higher the risk-free rate rises, the less attractive future earnings in the stock market look by comparison. A low risk-free rate, on the other hand, makes future earnings appear more attractive by comparison. Higher bond yields also make the dividend yields on stocks look less attractive in a relative sense. This is presumably why dividend stocks are getting whacked.

Mission Creep

But let’s turn our attention to something else – national defense.

“Government,” as William Godwin wrote in his "Enquiry Concerning Political Justice and Its Influence on Morals and Happiness", “can have no more than two legitimate purposes: the suppression of injustice against individuals and the common defense against external invasion.” But that was many years ago. Since then government has enjoyed a substantial amount of “mission creep.”

It now promises everything – from roach control to better dentistry. For a politician, there’s no use in hewing to a strict interpretation of the Constitution or in admitting that the feds can’t really multiply loaves and fishes. Modesty will get him nowhere. Better to promise to smite the infidels and provide free cable TV. After all, if he doesn’t win the election he can’t carry out his real program. This is the same for all candidates: personal aggrandizement at the expense of others. But when it comes to mission creep, perhaps no department has crept further than the military; it has slithered around so far that it now menaces the security of the American people. The Pentagon man is no different from the deliveryman or the confidence man. His goal in life is to boost himself up by whatever means are at his disposal. But unlike the poor deliveryman or the confidence man (whose prospects are quite limited) the Pentagon man has the bogeyman on his side. Whenever the flow of power and loot slows, he pulls out the threat of invasion … like a burglar pulling out his pistol. This he waves in front of the public, inspiring fear and loathing. The good man sees his mother raped before his eyes by a horde of foreigners. The bad man merely loathes the foreigner; he can’t abide the idea of the outsider getting away with something.

Soon, they are all approving plans to transfer more of the nation’s wealth and treasure to the men in uniform … and those who supply them.

Keep the Money Flowing

Fear of invasion seems quaint and anachronistic – hardly necessary in today’s world. What external power is going to mount an amphibious assault on the United States of America? Who’s going to send drones against Washington? What foreign power will set up a military base in Texas or Oregon? But with no real fear of invasion, what’s the Pentagon to do? Invade someone else! The U.S. maintains military bases in 130 countries around the world. Nobody knows exactly how many … or where they are. Some are secret. Congressman Ron Paul once tried to add them up; even he couldn’t get a straight answer.

Yes, dear reader, times have changed. But humans have not. Give them the opportunity and they will turn into zombies. As the late Colonel John Boyd of the U.S. Air Force observed:

It is not true the Pentagon has no strategy. It has a strategy, and once you understand what that strategy is, everything the Pentagon does makes sense. The strategy is, don’t interrupt the money flow, add to it.

Boyd was a strategist. He saw that wars were won by lean and agile fighters who were able to improvise and innovate quickly as needs and opportunities arose. Bureaucracy does not support such warriors; it tries to get rid of them.

From William S. Lind:

Boyd is best known for coming up with the OODA Loop or Boyd Cycle. He posited that all conflict is composed of repeated, time-competitive cycles of observing, orienting, deciding and acting.

The most important element is orientation: Whoever can orient more quickly to a rapidly changing situation acquires a decisive advantage because his slower opponent’s actions are too late and therefore irrelevant – as he desperately seeks convergence, he gets ever increasing divergence. At some point, he realizes he can do nothing that works. That usually leads him either to panic or to give up, often while still physically largely intact.

Yet bureaucracy – zombies, looking out for themselves, not for the security of the nation – is what you get when you have too much money and no worthy enemies.

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