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Why Bond Yields Rising And Ramifications For Forex Stocks Commodities: A Quick Review




Much attention over the past weeks has focused on falling US bond prices and attempted explanations. Here’s what you need to know.
A Global Movement Out Of Government Bonds
 
It hasn’t been just US government bonds, but rather a general selloff in government bonds including those of other developed nations like Japan and Germany too. Theories for the selloff include:
 
 
·         Markets are shifting away from belief in a double dip recession as Northern Europe and US figures point to slow but steady expansion
 
 
·         Rising commodity prices and manufacturing PMIs in Europe, the US and China, along with improving corporate earnings, may suggest that the inventory rebuild cycle  is now being followed by a capital investment cycle, which in turn would mean more jobs, spending, real growth
 
 
·         Markets see US, EU continuing to follow loose money policies to fund various bailouts and stimulus programs until growth returns, which makes bonds a bad investment
 
 
·         Other potentially inflationary forces in the US include:
 
o   President Barack Obama's agreement to extend some Bush-era tax cuts sparked alarm among Treasury investors worried about the ballooning budget deficit that could ultimately bring inflation
o   The tax cuts would stimulate the economy, also a negative for bonds, driving up inflation and potentially allowing the Federal Reserve to avoid extending its bond-buying program and thus reducing bond demand.
o   An overall improving economic picture that suggests higher inflation and the need for higher rates.
 
 
·         In Europe: Even the core economies are seen as ultimately forced to spend for PIIGS bailouts
 
·         In Japan: The government remains committed to stimulus and deficit spending. This hasn’t been a near term problem because most of Japanese debt is domestically funded by frugal local savers and institutions. However, with 25% of the population over 65 that demand is shrinking.
 
 
In sum, anticipated higher growth and inflation make it reasonable for those who bought historically low yielding bonds based on earlier assumptions of deflationary pressures and extended low yields are decreasing their bond holdings to adjust for a more growth/inflationary 2011.
 
Short Term Ramifications
 
If this trend continues key effects on asset markets include:
 
·         Volatility in forex markets: Currency prices follow interest rate increase expectations more than anything else. Thus the currency connected to the fastest falling bonds (and thus rising yields) will see the strongest appreciation. Rising US yields relative to German and  Japanese government bonds has been very supportive for the USD.
 
·         Rising USD pressures other currencies (the USD is the primary counterpart of all major currencies) and commodity prices. Of course as long as China and other emerging market commodity demand continues we may not see commodity prices suffer.
 
·         For the US economy, rising bond prices bring rising mortgage rates, which undercut the fragile health of the already double-dipping US real estate sector and, the financial sector which issues and holds these. They get hit with a double-whammy.
 
·         Mortgage applications have already decreased due to rising rates, cutting their operating income.
 
·         Higher mortgage costs also cut real estate prices and thus encourage further defaults, hitting their balance sheets.
 
 
Potential Longer Term Disaster Scenario: Von Mises’s Prophecy Realized?
 
If we are seeing the beginning of a longer term bond bear market, from which rising interest rates would follow, that could be potentially disastrous for the developed economies given the already huge and growing size of their debt service.
 
For example, despite long term Japanese bonds paying only about 1%, Japan’s debt service comprises about 25% of its budget. A mere rise of 1% would double that debt service to more than half of Japan’s total budget, forcing Japan to either print money and devalue in order to pay (and thus further drive down bond prices and drive up rates) or ultimately be forced into default as no one wants to receive increasingly depreciating Yen. The same potential exists for all developed economies coping with high deficits.
 
This is in essence a realization of the warning of Austrian School economist Ludwig Von Mises. Here’s a summary of his belief about why expansions brought about by credit expansion. It’s an oversimplification but still a useful one.  
 
To see the full article click on: http://www.fxinsights.com/Why-Bond-Yields-Rising-And-Ramifications-For--Forex-Stocks-Commodities:-A-Quick-Review/

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