US Bond Market Tipping Point?

Ever since the market turmoil of the last several years started to get peoples' attention, bond watchers have been looking for a moment when things would go critical.

While the stock market is well understood public indicator of the health of the general economy, it's small potatoes. The bond market is no less than the US government's ability to fund its own operations. In addition, since traditionally the US gov's debt was considered "riskless" (except for inflation), other debts pay a premium to the US gov's borrowing rate.

What bond watchers have been waiting for is a point when Federal Reserve (and Treasury) would be faced with a "Sophie's Choice" moment. Do you want to fund the next bailout, or risk sending your borrowing costs so high that you risk the solvency of the US govt? It's going to come down to a choice between the US Dollar, The Bond Market, and the Stock Market.

The Banks

Since the Fed is owned and operated by and for the banks, obviously, they would like to save the banks. In order to do this, the Fed is trying (at least) a few things.

1.) Increase the banks profitability.
2.) Stop the erosion in their assets.
3.) Increase private investment to short up their balance sheets.

Although I believe that their have been huge funnels of funds into the futures market in order to prop up the equity markets, it is only conjecture based on what I've seen in price/volume action there -- and subject of many a tin-foil hat forum. So, I will just say, the recent rise in equities has made it possible for many of the banks to do secondary offerings of stock to raise billions.

To stop the erosion of assets and increase profitability, the Fed decided it would (artificially) hold down long term interest rates. That would make mortgages and refinancings cheaper and more abundant (fees) and (hopefully) stem the decline in US Real Estate (loans against which most of their asset base is comprised of).

In order to push the market out of its natural range, they announced a program where they would buy 10 year notes in the open market, pushing the price up, and the yield down on these instruments. The Fed deemed this activity "quantitative easing".

While the announcement of this plan, immediately pushed 10 year note yields to around 2.5%, as traders have predicted, consistently buying a security above the market will ensure that you shortly become the entire market.

Fearing inflation, holders of longer term bonds have been moving their money to us gov debt with shorter maturities. Basically, they don't want to lock in a historically low rate if the Fed is able to stoke inflation again.

On Wednesday there was an epic "dislocation" in the rates of 10 year paper and a subsequent (and related) move in mortgage bonds. Banks and mortgage brokers were updated multiple times throughout the day as rates moved up almost a full percentage point in some cases.

While a move on a 30 year fixed rate mortgage from 4.5 to 5.5 sounds trivial, it was enough to make a lot of refinancings financially unviable, and make some contemplated offers for purchase impossible. While some lucky people had locked their rate earlier, lots hadn't, as the believe was, the almighty fed would hold rates down.

The Bond Market or the Dollar?

For the remainder of the week, the Fed had a decision to make: let long term rates continue northward (to their natural price), or intravene and risk stoking inflation and killing the dollar.

With more big auctions this week (the US Treasury trying to raise more money for its operation), the decision was made to throw the US Dollar under the bus. The dollar was down between 1 and 2 percent against most major currencies as the long end of the curve was bought down once again in an attempt to stem the tide.

Since I penned this short article -> US Dollar Double Top, where I basically called a double top in the value of the us dollar, the dollar index has moved from 90 to 80. On Friday it went through the psychologically important 80 level like a hot knife through butter.

What About the Stock Market?

Now that most of the banks have gotten their secondary stock offerings out of the way, I think we are at a dangerous time for the stock market.

If the value of the US Dollar starts to threaten it's earlier multiyear lows (in the low 70's) and/or the supply in the US bond market starts to outstrip demand again, look for the Fed to drain the swamp again and scare money back into US Gov debt as they did last fall.

Although I think risk assets (like us stocks in general) are overvalued right now, if the dollar continues to fall, they could go higher as a hedge against inflationary pressures....if/when we reach 72 on the dollar index, it will be another sophie's choice moment, and unless there is a really good reason to prop the stock market I believe it will be thrown under the bus again.

Short, Medium, Long Term?

There are some credible arguments that say:

short term -- everything is sunshine and strawberries,
medium term -- everything is going to hell in a handbasket
longer term -- people in search of less and less risk continue to move towards shorter and shorter maturities...with the eventual arrival at federal reserve notes themselves (bank of sealy).

go cool,
UruguayGuy

p.s. if this happens, we could see some real "funny" business since the size of the bond market dwarfs the number of actual federal reserve notes (paper currency) in circulation.....some deep thinkers even think that paradoxically, frn's could become "priceless" and be driven out of circulation (?!!?!) :) well, not sure how we would combat the counterfeiting at that point, but it's an interesting hypothesis.