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adios
09-22-2004, 04:33 PM
At least to me the rally in the bond market is incredible in light of the GDP numbers, employment numbers, and the recent Fed statements about the strength of the economy. Now that I've said this it's time to short the bonds /images/graemlins/smile.gif. The 10 year peaked in yield in May putting in a double top in yield (double bottom in price, I'm not a technician of any sort btw just reading the chart) at between 4.8% and 4.9%. Bonds have been in rally mode ever since. So far in the markets it's been a good year, not as good as last year but still good nonetheless. Housing market seems to be strong, rates low so MREITs have done well in this environment.

GeorgeF
09-22-2004, 05:20 PM
Low interest rates and low inflation will be the undoing of real estate (and many other businesses). Developers will keep building new and improved houses until real estate values collapse for the old and crummy ones.

AceHigh
09-22-2004, 10:16 PM
[ QUOTE ]
Housing market seems to be strong, rates low so MREITs have done well in this environment.

[/ QUOTE ]

I agree, I like IMH and you know who.

adios
09-24-2004, 03:42 AM
I wrote in my original post:

At least to me the rally in the bond market is incredible in light of the GDP numbers, employment numbers, and the recent Fed statements about the strength of the economy.

My take is that with the most people interpret the data as showing that an economic expansion is in progress. The bond market seems to be saying something else entirely. I think many expected the bond market to sell off after the Fed hiked short term rates this week but instead the bond market rallied. In todays WSJ Brian Wesbury, an economist, makes a case that bonds are going to get crushed. I found what I think are a few flaws in his rationale namely that IMO he overrates recent upward moves in the stock market. Here's a decent article analyzing the situation IMO. Note the following:

Yet the question is just how strong does the Fed think the economy is right now?

Allen Sinai noted that the Fed this week removed a key phrase from its August statement that said the economy was "poised to resume a stronger pace of expansion." Instead, it said the economy had gained "some traction…"

"They have given up on the economy growing in the [4% range] on real GDP,'' Mr. Sinai said. "That's what 'some traction' means. They threw out a sentence that said the economy was poised to resume higher growth, so they have given up on higher growth."

If that's the case, then the market might have read the Fed correctly. While Mr. Gross said there was no hint of a pause in the statement – which is exactly how I read it – in fact there was, and the Fed might be about to take a break in raising rates.

Always fun parsing Fed statements /images/graemlins/smile.gif.

Does Slide in Bond Yields
Signal the Sky Is Falling?
The Fed Is Raising Rates,
But Treasurys Are Rallying
September 24, 2004

Moments after the Fed raised interest rates by a quarter-point this week, CNBC anchor Ron Insana asked bond guru Bill Gross how he thought bond traders would react.

"I think when you check [the bond market], you'll see a selloff," said the head of PIMCO. "The market was looking for language that suggested a pause and certainly didn't get that."

Instead of a selloff, the market surprised Mr. Gross and many others – including me – with a rally that has so far taken the yield on the 10-year note all the way down around 4%.

In mid-June, two weeks before the Fed began raising its target for the federal funds rate – the amount charged on overnight loans between banks – yields were about 4.8%. So you can do the math: the Fed added 0.75 of a percentage point to short-term interest rates, and the long-bond has declined by more than that. The bond market simply hasn't done the Fed's bidding.

Compare that with 1994, when the Fed boosted rates to 6% from around 3% and the 10-year yield rose to around 8% from 5.5%.

Why bonds have rallied is the talk of markets this week. I can assure you – having read all of them – there are exactly 5,422 different theories that try to make sense out of the inexplicable market reaction. And every one of them thinks the other is way off base.

But to me, all it boils down to this: Either the economy is about to seriously weaken or we're on the verge of carnage in the long-end of the bond market. I'm at a loss to understand how anything else could be true.

To understand how low interest rates are now, consider what economists refer to as the real cost of money. "Cost of money" is simply a way of referring to interest rates. If you pay 4% to borrow money, then that's what money costs.

"Real" cost of money adjusts for inflation, or rather subtracts. It's real because if you're receiving a 4% interest rate, and prices are rising by 1%, then the value of the payment is actually 3%.

This is a critical measure for the Federal Reserve governors. It tells them the extent to which interest rates are speeding up or slowing down the economy. Higher real interest rates mean money is more expensive and it's costlier for businesses and consumers to borrow.

With three interest-rate increases since June, the Fed has hoped to make it costlier to borrow. It has succeeded only partly. Short- and long-term interest rates are both up from the lows of March – about three-tenths of a percentage point for the 10-year and by about a full percentage point for the two-year bond.


But since June, yields on both instruments have fallen. And real yields on the 10-year suggest monetary conditions have actually eased. They have fallen to 2.3% from 2.9% in June. (The calculation subtracts 1.7% for inflation, which is the consumer price index minus food and energy.)

So as the Fed has tried to make it costlier to borrow, the market has made it cheaper. Witness this week's decision by General Motors to offer 0% financing for selected models for six years.

Over the past 30 years, according to David Greenlaw, fixed-income economist at Morgan Stanley, the real yield on the 10-year bond has been around 2.6%. So we're below that level now. What's more, that average yield is for all parts of a credit cycle. Since we're supposed to be in the middle of an economic expansion, you'd expect the real yield to be above the average. The market is behaving as if we are at the end of a Fed tightening cycle.

Here's another way to consider what yields should be. The budget deficit and the current account deficit (the difference between what we import and export in goods and in cash) is now at about 8% of gross domestic product, or total economic output. Looking at the twin deficits is a way of gauging demand for money. If the government is borrowing a lot and the rest of the U.S. economy is borrowing a lot from foreigners, the demand for cash is relatively high. The last time we had twin deficits this high was in the 1980s and real yields ranged from 6% to 8%, according to Mr. Greenlaw.

So the deficit and the idea that we are still in the middle of an expansion suggests that real yields should be much higher.

Unless, of course, we aren't in the middle of an expansion. Earlier this week, I asked former Fed Governor Lawrence Meyer how he thought the Fed would view current market interest rates. "I do think there's probably some puzzlement," he said. "I would look at those numbers and say obviously the bond market doesn't believe my forecast because we think the economy is stronger…"

Yet the question is just how strong does the Fed think the economy is right now?

Allen Sinai noted that the Fed this week removed a key phrase from its August statement that said the economy was "poised to resume a stronger pace of expansion." Instead, it said the economy had gained "some traction…"

"They have given up on the economy growing in the [4% range] on real GDP,'' Mr. Sinai said. "That's what 'some traction' means. They threw out a sentence that said the economy was poised to resume higher growth, so they have given up on higher growth."

If that's the case, then the market might have read the Fed correctly. While Mr. Gross said there was no hint of a pause in the statement – which is exactly how I read it – in fact there was, and the Fed might be about to take a break in raising rates.

What the Fed does from here will depend on the data, of course, being weak. If it isn't weak, look out for a substantial backup in yields. Many economists believe the 10-year yield is headed to 5%, given the growth they forecast, and many think it'll happen before the end of the year.

There will be a pretty big financial dislocation if it happens quickly.

Ray Zee
09-25-2004, 04:53 AM
as our deficits increase and foreign countries see us as aless desirable place to invest, our interest rates must increase to attract that money to buy our govt. bonds. thus bond values go down. when you are less able to pay your bills your credit rating drops and you pay more to borrow. that is what is and will happen more to us. unless we get back on a path of decreasing our national debt.

adios
09-25-2004, 06:27 AM
I agree it's a matter of how much debt is too much.

crazymike
09-25-2004, 10:36 AM
Ray, I agree with your reasoning, it makes sense on first blush, but who can explain the fact that deficits have been rising for 20 years, but interest rates have been falling for 20 years? Foreign entities (OPEC n' China) are FLUSH with cash and need to buy our debt. They also need US to consume what they manufacture. Its a symbiotic relationship like the shark and the pilot fish. If the Foreign bond holders stop buying our debt and interest rates rise, the value of their holdings drop. So even though our debt seems high, its manageable as long as there's no huge shock to the system.

ngkent
09-28-2004, 02:52 PM
Treasuries have rallied as leveraged investors (like me) search for any kind of positive cash flow to pay off their liabilities...It took a while for it to catch up with US Treasuries because they were so low in the wake up the recent recession but if you look at bonds across the spectrum (ie Bank Debt, Junk Bonds, Investment Grade Corps, Euro Bonds) we have yields fall to unheard of levels. Luckily some of that is unwinding (Junk Bonds) but nonetheless it goes back to supply / demand before interest rate arbitrage, currency arbitrage, interest rate parities come into play...The fact remains there in NOTHING to invest in now on a macro scale that will provide a decent return giving the current economic environment and with so much money chasing yield, yields will eventually fall until something happens...be that good or bad.