Bonds Background
Stocks were pummeled again today as European woes continued, and money flowed into the Dollar and US Bonds.
Gold recovered last week’s downfall, and is now about $1200/ounce. Oil and gasoline were steady, and at recent lows.
In the news today……
Koreas – I warned that the sinking of a South Korean frigate last month could lead to a conflict between North and South. The South has now accused the North of sinking their ship, and is proving it to by showing pieces of the torpedo that sunk their ship. The North leader has proven unstable, and this could escalate out of control very quickly. American and South Korea have announced military exercises as a show of strength in the area – a warning to the North. In particular, you can bet that US submarines will be stalking North Korean submarines to let them know that they could be blown out of the water whenever the US wanted them blown up – this would be a cat and mouse game played in deadly earnest. Wild cards are very dangerous and could easily affect our economic future.
10 Year Treasury Bonds – interest rates are dropping very fast as the crisis in Europe is pushing money into US bonds. The 10 Year Treasury which affects US Mortgage rates are causing mortgage rates to come down. Now is the time to lock in those lower rates if you are thinking about it. The lowest mortgage rate could hit 4.5% for a 30 year fixed. In any case, the rates in your area are coming down.
Financial Reform – will be reconciled and passed sometime in the future. Part of this bill could contain a provision that removes the “too big to fail” protection for banks, and the rating agencies have declared that major banks will be downgraded if this happens. You can bet that if this happens, then bank stocks will fall dramatically, and drag the entire stock market down with it. Another big negative for stocks.
Tonight’s Dinner Conversation……
Bonds – yes, today I am going to talk about that boring subject – bonds. Most people don’t consider bonds an investment – just something that other people, possibly sophisticated people – invest in, and it’s boring because it moves slowly. Nothing could be further from the truth.
As part of my on-going series of discussions on investments, bonds cannot be left out. Bonds are one of the key indicators of the economy. Let’s talk about what has been happening in bonds, and let’s start with the government’s involvement. I’ll stick with US Treasury bonds in this discussion, but the ideas are equally true for other issuers of bonds – like state or county or city bonds, or corporate bonds, etc.
The FED sets the interest rate for the FED Funds Rate which is the rate that the FED sets for lending to banks for overnight loans. It also sets the FED Discount Rate which is the rate that one bank lends to one another for short terms – longer than overnight. The FED has held the FED Funds Rate down to ZERO percent (actually 0 to 0.25%) for the past 18 months. It just can’t get any lower than zero.
Bonds are known by their yield, term and quality. The yield is the interest rate paid on the bond. The term is the amount of time that the bond goes before the issuer pays back the principal plus interest. Interest is paid periodically. The quality is set by an outside rating agency (Moody’s, S&P, etc) and is supposed to give you an idea of how safe the bond is – in other words, whether the issuer will default on its obligation to pay back the principal and interest. You can buy insurance on the bond, in case the issuer defaults, and the insurance is called a CDS, or credit default swap – but we’ll leave this complex topic out of the current discussion.
The FED has the best risk of all bond issuers, and the US FED has always had a AAA rating, and the US Government is supposed to be the best risk in the entire world. That’s the headline. But, the times, they are a-changing!!!! The bond rating companies have said that the US Treasury bonds are risking a downgrade in the next few years because the Federal Government may not be able to pay back its future bonds because of its ever increasing debt.
In a normal market, the shorter the term, the lower the interest rate paid. In other words, the FED Funds rate for Treasuries should be the lowest rate paid, then the one month a little higher, and then the 3 month a little higher, and then the 6 month a little higher, and then the 1 year a little higher — you get the idea. However, we don’t always have “normal markets.” And here is one of the most important things to notice about bonds. If there is an “inverted interest rate curve”, and this means that the interest rate decreases with increasing terms – the US economy is in deep trouble. It means it is very probable that the stock market will crash, and the economy is going into a recession within the next 2 years when you see an inverted yield curve in US Treasuries.
So, where are we today? The short term rates are zero. And, the FED has held them down for a long time. Why? In order to help the economy grow by having the cheapest rates possible. In more truthful language, the FED is bailing the big banks out by allowing them to earn high profits (the difference between the interest you pay to them and the interest they pay to the FED). The FED is also buying the toxic assets of the big banks so they don’t have all that junk in their portfolio (but YOU now have it on YOUR books). The Treasury is allowing the banks to set the value of their assets to any value they want, and not to value it to the current market value (mark to market) – and this allows the banks to appear solvent when they are bankrupt in reality – think Citigroup, Bank of America, etc.
The FED generally sets interest rates to the point where interest paid by banks to investors is a little higher (one or two percent) than the inflation rate. The inflation rate is about 3% right now according to the government (but you can’t trust that number as it understates inflation so the government can keep Social Security payment increases to a minimum). So, in a perfect economy (which we don’t have right now – just look at the unemployment rate) the FED Funds Rate should be about 3 %, and banks would be paying 4% to 5% on savings rates. Remember those gold old days? So, today if you have savings, your buying power is eroding because the interest you are being paid on your savings is less than the inflation rate.
My point is that the FED must sometime in the future increase interest rates, and increase them significantly. When that happens, the longer term rates like the 5 year Treasury and 10 year Treasury and 30 year Treasury will also increase in interest rates. The amount of their increase will depend on what the future of inflation looks like. If future inflation looks high, then those rates will be substantially higher. If we look like we are going into a depression (a very bad recession) then the longer term rates will be less than the short term rates – and we would have “an inverted yield curve.”
One observation that I’ve made over the past decades is that WHEN the FED changes direction in its rates (as the FED has only gone LOWER in rates to its current FED Funds Rate), then it continues in the new direction for A LONG TIME. And by a long time, I mean years and years. The next change in direction must be UP, and when it happens, it will go up further and faster than you can possibly imagine.
The FED would massively increase the FED Funds Rate if inflation really shows up in the economy. At the end of 2008, the FED increased the money supply (and money supply is the classic definition of inflation) by about 200%. Since then, the amount of inflation (increased money supply) has been zero – or that 200% increase in money supply has stayed out there and is constant. When that money gets into the economy and starts circulating, and that takes a couple of years typically, then “Price Inflation” will kick in, and you will be able to measure it whenever you go to the store, and it will be reported to you as CPI (Consumer Price Index).
How can you make money from this economic phenomena? Bet that bonds interest rates will go up. Remember that bond values and bond interest rates are inversely proportional for longer term bond rates (like 15 years and out). So, a 10% increase in bond interest rates (from 4% to 4.4%) would be a 10% decrease in the value of the bond. Just think of that. A miniscule change in interest rates like 4% to 4.4% would create a 10% change in bond values. Now you get the idea os why I don’t think bonds are boring. How do you bet against bonds? You short them.
Here are the last numbers for today:
Dow Jones 30 Industrial – 10,066 (down 127)
10 Year Treasury Bond – 3.23% (down 0.02%)
Euro – $1.2375
Gold – $1187 (up $17)
Oil – $70.07 (up $0.02)
Gasoline – $1.97 (up $0.01)
