Will The Bear Market In Bonds Finally End?

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Includes: BIL, DFVL, DFVS, DLBL, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FTT, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SST, TAPR, TBF, TBT, TBX, TBZ, TLH, TLO, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: D. H. Taylor

Summary

The Fed is raising rates due to an expanding economy.

Tax cuts are looming, albeit they are likely to take time.

Foreign central banks are dumping treasuries.

Interest rates are likely to move dramatically based on many variables.

The Federal Reserve is in the process of raising interest rates. At the same time, the Republicans are wanting to cut taxes to fuel an economy that is already expanding. Simultaneously, this is that very moment in time when the Fed also needs to address removing the massive QE programs that were put into place to save the world's economies. There is no way the Great Bear Market in interest rates can survive.

Since the highs of the 1980s the bond rate has been on a very long, slow decline. Rates were at this level once before during the 1940s. But, that was the turning point for rates being that low at that time. I believe we are about to see the same event occur again; interest rates are going higher.

One of the biggest things that scares me about bond rates is the Federal Reserve's assets. Here is the chat that shows what I am talking about:

In 2008, the economy was reeling from the financial crisis. The Federal Reserve took massive steps to shore up the economy the best they could. However, one of the things they did was buy huge amounts of debt as you can see above. The two biggest categories were Treasuries and MBS (Mortgage Backed Securities).

There is an inverse relationship between price and rates with bonds. If you buy in a way to push up the price as high as you can, then interest rates drop. The opposite effect would happen that if you sold off your bonds then interest rates move higher.

The Federal Reserve held about $800 billion in assets just prior to launching their QE programs. They ended their bond purchasing program with some $4.5 trillion in assets; a multiple of over 5 times. That is a massive amount of purchasing. We are now at that point where the Fed is going to have to address the removal of the QE that they used to save the economy.

Ostensibly, the Fed could just let the paper term to maturity. This would then allow the assets to evaporate. That would take years as a lot of this paper is 30-year MBS. In the meantime, the Fed is starting to push up interest rates on the short end of the curve.

At the very least, with short-term interest rates moving higher, the longer end will normalize to about where the market was during the 2005 economy:

That puts the long end at just above 4.5%. That alone would be enough to qualify as a bear market (in price) with an interest rate move from the low of 1.37% to that future rate of 4.5% on the 10-year.

But, it is the amount of reserves that were matched by banks in the Fed system that has been built up. The Federal Reserve does not print money by buying Treasuries as you would think. Instead, the banks that match these reserves are the ones that are going to be doing the "printing".

Ordinarily, an increase in reserve balances in the banking system would push down current and expected future levels of short-term interest rates; such an action would serve to boost the economy and variables like bank lending and the money supply. If maintained for too long, a relatively high level of reserve balances and a low level of short-term interest rates could lead to the buildup of inflation pressures. However, with short-term interest rates already near zero, an increase in reserve balances by itself cannot push short-term interest rates much lower. As a result, the current elevated level of reserve balances has not generated an increase in inflation pressures.

Banks are irresponsible, though. The financial crisis showed us that. If a bank has the ability to lend out money or rein in inflation, the bank will choose the former as that bank is in the business of earning profits and loans are how that process happens.

Keep in mind the sheer magnitude of the amount of assets that were purchased during this time. It cannot be that there will be an orderly removal of all these assets. Further, assets in custodial holdings at the Fed from other central banks are on a sharp decline from the past several quarters, from TeaParty.org as of December:

Trump has been promising a tax cut. That would add a great deal of fuel to the U.S. economy, that which is already seeing a great deal of growth. The Fed has reacted to this potential in their latest meeting and is ready to begin moving on interest rates.

If you factor in a tax cut with an economy that is expanding along with interest rate hikes, removal of the QE could become a daunting task and may actually force the Fed to push interest rates even further. Pushing the hand of the Fed like that may push interest rates to exacerbating levels. The great bear market in bonds may very well be done with. And interest rates will be heading higher; much higher.

I am looking to short bonds for a very big move to the downside.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in U.S. 10-YEAR TREASURY over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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