Rates Rising While Prices Plunge: Beware Bonds

Includes: BIL, ITE, TLO
by: Thomas J. Feeney

The President’s National Commission on Fiscal Responsibility and Reform concluded its work last week. The bipartisan group released a list of politically difficult recommendations, which predictably raised hackles on both sides of the aisle. The committee was unable to garner the necessary 14 of 18 votes needed to bring the deficit-cutting proposal before Congress. In the days following the failed vote, the committee has effectively been patted on the head and told to go away.

With Fed Chairman Bernanke’s appearance Sunday on "60 Minutes" and President Obama’s Monday announcement of the next chapter in the government’s rescue package, the die has obviously been cast in opposition to the recommendations of the deficit reduction committee. The ongoing policy can be summarized as: spend more, tax less. There is no pretense of fiscal or monetary probity. This is, of course, a continuation down the politically easy path we have traveled for a few decades. Nobody is ever reelected for advocating the unpleasant medicine of fiscal austerity. The argument is always that we can’t possibly promote austerity measures in the current dire circumstances (whatever those conditions happen to be in the instance being examined). We’ll take the tough steps when the environment is more favorable. History makes clear, however, that the time for unpalatable financial retrenchment and discipline never arrives. And it never will until either a crisis forces it or we establish term limits so that legislators can focus beyond the next election.

The newly proposed rescue efforts may or may not succeed in boosting our economy onto a self-sustaining trajectory that can function without ongoing government support. It will certainly further inflate the already humongous debt balloon that hovers over our heads. It will guarantee that many more IOU’s will be passed along to our grandchildren and their grandchildren. Moral hazard runs rampant.

These concerns and others are starting to worry the bond vigilantes. Since late August the 30-year U.S. Treasury bond yield has risen from just under 3.5% to slightly under 4.5% today. On an intraday basis the 10-year U.S. Treasury yield has risen in merely two months from just over 2.3% to scarcely over 3.3% Wednesday. This has happened despite the Fed’s clearly expressed intent to lower interest rates by direct purchases of Treasury paper. Over the same time frame corporate and municipal bond prices have likewise been hurt, their declines accelerating over the past several weeks.

One can never be sure why markets behave as they do. It is likely, however, despite current disinflationary conditions, that a growing number of fixed income investors are beginning to focus on the potential for serious inflation as the ultimate reward for uncontrolled spending and monetary stimulus. Precarious state and city budgets certainly concern muni bond investors, and the specter of a growing number of European countries in need of bailouts undermines confidence in a general sense.

Although not directly related to the level of rates, fear inevitably grows when Bank of America (NYSE:BAC) has to pay $137 million to federal and state authorities for municipal bid-rigging practices, and federal authorities are conducting an expanding insider trading probe.

We have been warning of dangers in the bond market for the last couple of years, albeit short of a negative forecast. We held a rather agnostic view of the probable course of rates through most of that period. We have, however, repeated our warning in numerous seminars and written commentaries that the risk of being wrong in bonds at these historically low yields is considerably greater than the reward for being right. We remain of that belief, although we will continue to look for strategic opportunities for bond ownership following sharp run-ups in rates.

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

About this article:

Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here