The most extraordinary week you never read about
James A. Bianco, Bianco Research
Aug. 1, 2003
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Note: This is Bianco's Commentary from last week. It was adapted from the notes that accompanied Bianco Research's August 1, 2003 Daily Commentary/Newsclips service.
Why the bond decline might not be close to ending
This has been one of the most extraordinary weeks in the history of the bond market:
Yesterday the trading range of T-Bond futures was 3 25/32 –- its largest such range in the 26-year history of this contract. This is equivalent to an 800 point range in the Dow Jones Industrial Average.
T-Note Futures set a record in volume (over 1 million) and the Bond contract had its largest volume on a “non-roll day” (“roll days” are when traders are rolling from an expiring contract to the next contract. This action effectively doubles typical volume).
The 10-year yield is up over 136 basis points in less than 40 trading days. It has been 16 years since the bond market has had a bad stretch like this. In other words, this is truly a historic bond market rout.
The total return of the 30-year Treasury Bond was -11.03 percent in July. This is its worst month ever (previous record was -7.78 percent in October 1979). The total return for the 10-year Treasury Note in July was -7.08 percent, its second worst month ever (worst was February 1980 -7.92 percent). The Lehman Treasury Index was down 4.39 percent in July, also its second worst month ever (worst was a 4.91 percent loss in February 1980).
Swap Spreads have widened from 40 basis points on Monday to a peak of 70 basis points today. The swaps market has not seen a move like this since the Long-Term Capital Management crisis in late 1998. So, how has the turmoil been playing in the financial press?
The Wall Street Journal: Treasurys Fall Sharply Under Weight of Data Access
"Optimism stemming from stronger-than-expected economic data crushed Treasurys, with declines exacerbated again by forced selling by investors in mortgage-backed bonds. In a day of extraordinary volatility, yields -- which move inversely to prices -- pushed to their highest in a year. The 10-year note yield briefly rose above 4.5 percent, a level not seen since July 31, 2002. Swap spreads, mortgage securities and agency debt were hammered as well."
This story was not mentioned in the "What's News" page or on Page C1. Rather, it was buried on page C11. The move in wheat futures had a higher billing than the bond market.
The New York Times: No story about the bond market rout yesterday
The Washington Post: No story about the bond market rout yesterday
Bloomberg.com: Treasury Notes Head for Weekly Loss on Signs Economy Rebounding
"U.S. Treasuries were headed for a sixth week of losses in seven as traders said there are signs the economy is gaining momentum. Reports today showed the jobless rate fell in July while manufacturing expanded. Other reports this week showed the economy grew more quickly in the second quarter than analysts forecast, and initial jobless claims declined. Ten-year Treasury yields have soared from a 45-year low on June 16, to reach the highest in year earlier today."
Bloomberg reports the facts but does not convey any sense of urgency.
As we detail below, we believe the catalyst for this move is the bond market's rejection of the "new" Fed policy of fighting deflation (by creating inflation). The bond market is intent on having one of two outcomes:
- Interest rates move high enough to "offset" all the Fed's deflation-fighting policy (i.e., interest rates go high enough to "kill" the prospects of more inflation) or,
- Interest rates go high enough to get the Fed to "re-think" this policy.
How do we know when the bond market has achieved its goal? At a minimum, interest rates must rise enough to scare the hell out of everyone. One indication of this type of fear may be these events becoming the big story in the financial media. Our fear is bonds will keep collapsing until they become the top financial story. Only then do we know they have accomplished their task of “offsetting” the Fed's easy policy. Currently that point is nowhere to be found.
Why bonds are getting killed -- Thank the Fed's worst mistake in a generation
Grant's Interest Rate Observer: In The Museum of Bad Ideas
"On Oct. 6, 1979, the Federal Reserve vowed to lay inflation low. Chairman Paul A. Volcker delivered the news at an emergency Saturday press conference. In recent months, the Fed has vowed to raise inflation up. Gov. Ben S. Bernanke so declared last week in a talk at the University of California at San Diego. There was no drama in the timing or staging of the Bernanke exposition (a midweek affair in an academic setting). The magic was all in the content..."
We believe Jim Grant is exactly right! He also makes the exact same points we made in our Commentary earlier this week. Grant argues that the Fed is making a tremendous error in trying to fight deflation by creating more inflation. As he puts it:
"Yet, with Bernanke, there is one intractable problem. And the problem is, in our opinion, that he is wrong. He is wrong in his premises, wrong in his analysis and wrong in his prescriptions. In policy, he is anti-Volcker. In thought he is anti-Mises, anti-Hayek, anti-Ropke and anti-Rothbard. He is the decathlon champion of monetary error."
This is exactly correct, and the bond market now understands it as Grant lays it out. As we argued in our Commentary, the bond market was under the mistaken belief that Bernanke's deflation talk meant the Fed was buying bonds. Once this was put to rest in late June, the bond market then came to the realization that Bernanke was really suggesting the bond market's worst nightmare -- the Fed intends to create inflation.
We believe Grant is also correct in suggesting the Bernanke policy is the "book-end" to Volcker's "Saturday Night Massacre." This means the Fed policy of the last 24 years (the only policy virtually every bond trader has ever known) of defending the bond market's interest effectively ended with the adoption of the new Bernanke deflation-fighting view.
(On Saturday night October 6, 1979, Fed Chairman Paul Volcker announced in a hastily called press conference that the Fed would target money supply in an attempt to bring inflation under control. This meant interest rates would go as high as necessary to halt the rise in inflation. The following week the bond market collapsed. This was arguably one of the most important policy
shifts in the history of the Fed and laid the groundwork for the greatest bull market in bond market history that began in September 1981.)
The current bond market collapse is rooted in the belief that the Fed is fighting a problem that does not exist -- deflation. If there is a small amount of inflation in the economy and the Fed's easing policy is designed to create more inflation -- nothing could be more bearish for bonds. Rising inflation when real 10-year yields are near their post-September 1981 lows is asking for a collapse in the bond market. That is exactly what is happening. Real 10-year rates have averaged 4.4 percent since September 1981 and set record lows under 1 percent this year.
To quote Dallas Fed President Robert McTeer earlier this week -- "I'm not sure what 'on hold' means. We've got the target Fed Funds rate down to 1 percent and we've got money supply growing fairly rapidly. We may be on hold, but we're on hold with the accelerator down to the floor." Can a Fed Bank President possibly say anything more bearish for bonds?
The bond market vigilantes are reasserting themselves. Unless Greenspan et al. can quickly convince the market it has the correct policy (that is, strongly argue the case that deflation is an immediate concern that needs to be dealt with now), we believe interest rates will continue to rise until they either "offset" all the Fed's deflation-fighting policy (i.e., interest rates go high enough to "kill" the economy) or high enough to get the Fed to "re-think" this policy.
Conclusion
Many commentators (including us) have argued/joked that Fed policy is really designed to foster a bull market in stocks. Well, it appears that the Fed has actually changed policy to do exactly that. Furthermore, it is feared, if this new policy causes chaos in the bond market -- so be it. The Fed is acting if it is no longer worried about the interests of bond investors.
However, the bond market still has one weapon -- it can drive interest rates high enough to remind everyone why James Carville wanted to be reincarnated as the bond market (because, as he said, it has the power to scare the hell out of everyone). What level in interest rates "scares the hell" out of everyone? That is where this rise in interest rates will stop.
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