Interest Rate Roundup

Thursday, June 07, 2007

WHY rates are soaring ...

About two weeks ago, I wrote a piece about why interest rates appeared to be on the verge of a big move higher. Obviously, we're starting to see the move now. Here is a link to the original piece from 5/25, and here is the relevant copy if you don't feel like clicking through:

Why the Snoozefest in Bonds May Be Coming to an End

When professional traders want to speculate on U.S. interest rates, they primarily use bond futures. And for several months, 30-year Treasury, or "long bond," futures prices have been fluctuating in a range — roughly between 109 16/32 and 115.

Remember, bond prices and yields (meaning, interest rates) move in opposite directions. But when bond prices go nowhere, interest rates remain stable. For example, the yield on 10-year Treasuries has vacillated between 4.43% and 4.90% for about nine months.

The primary reason for the lack of action in bonds? The economy has been trapped in what I call "Stagflation Lite."

See, inflation remains above the Federal Reserve Board's preferred range. Typically, that would drive bond prices lower and interest rates higher.

However, economic growth has been weakening — the economy expanded just 1.3% in the first quarter, the smallest gain in four years. Economic weakness typically drives bond prices higher and interest rates lower.

Bottom line: We've seen a big battle with a lot of bloodshed … but no real progress on either side. Thus, bond prices and interest rates have been stuck in neutral.

That may finally be changing, though:

1. China diversification fears — When it comes to currency reserves, China is the 800-pound gorilla. Its reserves topped $1.2 trillion in March, up 37% from a year ago. That accounts for 23% of the world's reserves, far ahead of the next largest player (Japan at 17%).

China's money pool is swelling because the country is running massive surpluses with its trading partners. In the past, it was content to just let the vast majority of that money sit in low-yielding U.S. Treasury bonds and other debt instruments. At last count, it had more than $420 billion of them.

Now, China is now looking to diversify its reserves into other investments. It's setting up a reserve-management business that will take those funds and invest them in all kinds of instruments — foreign stocks, Chinese firms, and more. We just learned, for example, that China is giving $3 billion to private equity firm Blackstone Group.

If China stops buying so many Treasuries, who's going to step up to the plate? That's a question bondholders can't answer, so they're turning into nervous sellers.

2. Inflation concerns are winning out — It was easy for bond traders to ignore high inflation readings a few months ago when the economy was falling apart, housing was crashing, stocks were tanking, and oil and gas prices were slumping.

But a few recent economic readings (initial jobless claims, industrial production, etc.) have leveled out. And while the news on housing isn't getting better, it isn't getting much worse, either (A note from today: That has changed since I wrote the piece with the news that for-sale inventories have soared to all-time highs). Plus, the global stock markets are rallying sharply.

As a result, fixed-income investors are finally focusing on the elephant in the room: Inflation. The fact of the matter is that import prices, producer prices, and overall consumer prices are all still rising at a decent clip. The so-called "core" Consumer Price Index isn't rising as quickly as it was a few months ago, true. But it remains well above the Fed's comfort zone.

3. Foreign interest rates keep on climbing — I've said it before and I'll say it again: While our central bank has wussed out in the anti-inflation fight, foreign central banks have not.

The European Central Bank is raising rates. The Reserve Bank of New Zealand is raising rates. Central banks in India and China are raising rates. And so is the Bank of England (BOE). In fact, policymakers at the BOE even considered raising rates by half a percentage point at their most recent meeting, rather than the customary one-quarter of a percentage point.

Until recently, those foreign rate hikes mostly impacted the U.S. dollar — driving its value down. Now, those rate hikes are starting to push up U.S. interest rates, too.

So if you're wondering WHY we're seeing carnage in bonds, that's my take.


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