Interest Rate Roundup

Wednesday, January 10, 2007

Thinking outside the bond box

There's been this little theory bouncing around in my head about bonds for a while now. It could be total bunk. But why not throw it out on the table? There's nothing to lose after all!

First, understand that the behavior of long-term Treasury note and bond yields during this Fed hiking cycle was extremely unusual. Long-term interest rates usually follow the federal funds rate higher until the tail end of the hiking cycle. That's when bond buyers start positioning themselves for the end of the hikes ... and the start of the next round of cuts ... by stepping up to the plate, buying bonds, and driving long-term yields lower. Later on, the Fed cuts short-term rates.

That didn't happen this time around. In fact, yields on 10-year notes and 30-year bonds haven't moved much at all despite the 17 short-term interest rate hikes, which drove the federal funds rate up by 425 basis points.

Second, let's stipulate the CAUSE of this was the recycling of excess funds/dollars on the global markets. The exploding trade and current account deficits, and the explosion in money and credit creation we've seen in recent years, flooded the world economy with liquidity. Lots of those dollars accumulated in China, Japan, and other Asian goods-producing/exporting nations. Ditto for the Petrodollar economies in the Middle East.

They were simply overwhelmed with cash, and needed to invest it somewhere. Lots of it has flooded into commodities ... commercial real estate ... stocks ... and other assets. But tons of it also ended up getting dumped into bonds, despite rising inflation, rising short-term rates, and the falling dollar (all of which traditionally lower the value of bonds, especially for foreign bond holders)

The money has gone into different sub-sectors of the bond market at different times. Corporates seem to be the flavor of the moment, according to this recent Bloomberg story. But the impact seems clear to me -- surging liquidity has held long-term rates down by providing a steady source of funds for investing in yield-generating assets.

Third, IF that theory is correct, ask yourself what the impact of a slowing economy and lower liquidity would be on bonds? Traditionally, you'd see HIGHER bond prices. After all, slowing growth and slumping liquidity tends to lower inflation. But if surging liquidity and the strongest global growth in decades didn't cause bond prices to plummet (because of the liquidity/cash recycling effect), why would the opposite cause prices to rise? A liquidity drain may very well have a perverse impact this time: It could lead to a DECLINE in bond prices and a rise in interest rates.

It's just a theory, of course. But given how oddly bonds have behaved throughout the recent Fed rate hiking cycle, it's as good as any. It won't get tested until we see the aforementioned liquidity drain, though, and we haven't seen one yet as far as I can tell.


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