While stock investors in recent weeks have continued zealously waging their great debate over the near-future destiny of the US equity markets, strange things are afoot in the massive bond markets. Bond yields, which have been stealthily heading north in the last month, have now picked up some steam and are appearing on more radars.
As I hammer out this essay on March 14th, the assassinated 30-year Treasury Bonds still trading in defiance of their widely heralded demise are yielding an incredible 5.82% and approaching the psychologically important 6% barrier. The castrati new so-called benchmark bonds, 10-year Treasury Notes, are now yielding 5.39%.
These long maturity yields are rising defiantly in the face of four-decade low yields in the short-end of the yield curve. 90-day Treasury Bills are only yielding a paltry 1.84%. These shorter "risk-free" bonds, of course, are indirectly keyed off the most brazenly manipulated market in the first world, the Fed-dominated Federal Funds market. The Fed Funds rate is running 1.81%, slightly above Alan Greenspan's latest artificially low target of 1.75%.
As we first explained in "Revolt of the Long Bond" last spring, the unanticipated diversion between short and long interest rates is becoming increasingly vexing for the Keynesian market manipulators at the Fed and the diehard Wall Street cheerleaders. If official government inflation statistics are to be believed, we are living in a glorious new utopia where the classical iron link between money supply explosions and price increases has been miraculously severed. Rising long yields on "risk-free" US government bonds mean bond traders are selling bonds faster than they are buying them, challenging current Wall Street mythology on inflation.
Why are the bond traders selling bonds, especially in this golden age of supposedly non-existent inflation and according to the perma-bulls the widely-alleged birth of a splendid new bull market in stocks?
If you ask those same perma-bulls who, like mentally-challenged parrots, repeat the same bullish gibberish every single day regardless of what the markets are doing or where in the classical long equity valuation cycle we may find ourselves, they will happily proclaim that bond traders are selling bonds so they can buy stocks. We don't think it is that simple though.
Bond traders generally operate on a higher plane than stock investors. Bond traders, unlike the typical stock investor, are very intelligent and are forced to pay attention to a huge array of crucial fundamental factors that intimately affect bond prices and yields. Stock investors often buy and sell on pure emotion and fashion, believing whatever the heck they want to believe, fundamentals be damned. Bond traders will be rapidly obliterated if they trade on fantasy rather than reality, so they strive to really understand what is truly going on and are far less likely to become emotionally anchored to a certain short-term market worldview.
Perhaps the fact that elite bond traders are wisely emotionally-detached from the markets and trade like realists is why they draw the continuous barrage of venomous hate and malice from the financial media and Wall Street community. For instance, the host of my favorite financial television show, the legendary Louis Rukeyser of Wall Street Week, often spends some of his entertaining opening monologue every Friday night attacking bond traders. I am still a big fan of Uncle Lou's even though he continually describes bond professionals as "bond ghouls" and claims that the only reason they exist is to revel in the misery of others. The talking heads on the General Electric Propaganda Network, aka CNBC, continually deride bond professionals as "bond vigilantes".
Webster's defines "ghoul" as "an evil demon that feeds on human beings and preys on corpses". Ouch! "Vigilante" is defined as "a person who takes the law into their own hands" and "done violently and summarily without recourse to lawful procedures". Wow! Talk about unrestricted vitriol from the perma-bulls! As is typical in history when an influential group cannot cope with changing conditions of reality, the perma-bulls in the financial media resort to ad-hominem attacks rather than discussing why bond yields are truly moving.
Bond traders are not evil demons and they are not lawbreakers! They are hard-working elite investment professionals who, just like stock investors, are trying to zealously preserve and enhance the scarce capital of their clients. As we explained in "Revolt of the Long Bond", bond players simply take the opposite side of the coin of financing capitalism and the American dream. Rather than choosing very high risk for potentially high returns through equity ownership, bond investors loan money to US corporations for a contractually-guaranteed lower return. Bond financing of corporations is probably as important an engine of economic growth as stock financing.
Because bond investors and bond traders strive to be objective and search for truth and fundamental reality so they can make superior capital management decisions, I personally have unlimited respect for elite bond professionals like Bill Gross and hold them in great esteem. It is tragic that the perma-bulls in the financial media waste so much of their time tastelessly attacking bond professionals rather than exploring why they are making the decisions they make.
While Wall Street continually belittles the huge and massively important bond trade, rising long yields are continuing to stretch the width of the yield curve. Essentially, the yield curve is simply the difference between long interest rates and short interest rates. In this essay we discuss the ever-evolving yield curve and use the term "spread" to denote the difference between long rates and short rates. We use the word "spread" rather than "yield curve" because we are looking at the delta between 10-year T-notes and 90-day T-bills.
As my whole investing life has been in the era of the venerable King of Bonds, the 30-year Treasury Bond, I still feel uncomfortable defining something as a yield curve when the Long Bond is missing. Just because some Rubin-era US Treasury sycophant tried to brazenly manipulate long-term interest rates after the 9/11 market dislocations last October by announcing the death of the Long Bond does not mean that it will not be resurrected. Actually, as the legions of Keynesian socialists in the bloated American government continue to aggressively spend money they don't have, I fully expect the 30-year T-bond to be officially reintroduced in the not-too-distant future as government financing "needs" explode. For now, however, we will grudgingly use 10-year T-note yields as the long end of the curve for our spread calculations.
In this essay we will examine the widening spread and ponder some potential implications from recent developments in the bond markets.
To begin, let's take a look at the raw data used to calculate the yield curve spread, daily closing yields for the new supposed long benchmark, the 10-year Treasury Note, and the short-term 90-day Treasury Bill. The dataset runs from 1985 to March 8th, 2002.
Interestingly, in the last 17 years or so interest rates have generally been in strategic downtrends, as both the short T-bill and long T-note yields indicate in the graph. For students of market history, the old trends in bond yields have provocative implications. No market moves in one direction forever, and after at least seventeen years of declining yields, perhaps we are due for the expected mean reversion to take bond yields back up to more historically normal levels.
The recent behavior of the 10-year yield in particular, the white line in the graph, is especially interesting. After falling almost without ceasing since the enormous interest rate dislocations of the inflationary late 1970s, the 10-year yield has not continued down along with the Greenspan Gambit stunt of short-term interest rate slashing. Rather than submitting to the irresistible gravity of low interest rates, the 10-year yield has bounced off of its recent panic bottom, originally dug during the Long-Term Capital Management derivatives implosion of 1998, and has headed higher ever since.
This rebellious behavior of long yields is certainly not typical during an easing spree. As Alan Greenspan has pointed out several times in recent testimony to the US Congress, even the master inflationist maestro himself views current high long yields as "troublesome". In the graph above check out the Fed's early 1990s easing, defined by the drop in 90-day T-bill yields, the black line above. Note that during this earlier rate-slashing extravaganza, the long yields docilely followed short yields down. Long yields didn't fall as fast as short yields and the spread between the two rose, but in the early 1990s long yields still did have some sympathetic responsiveness to Fed manipulations of the Federal Funds interest rate.
The spread, or difference between the short end and long end of the "risk-free" US government debt yield curve, is denoted with the blue line above and in all the graphs of this essay. Interestingly, in the last 17+ years this yield curve spread has never exceeded 4%, almost as if this is a natural limit at least in recent history for the delta between short and long interest rates. This implies that even in the worst-case scenario in the last couple decades, bond investors demanded at most an extra 4% to compensate them for the much higher risk of holding bonds for 10 years as compared to 90 days.
As noted by the arrow above, Greenspan's latest enormous gamble marked the most vertical explosion in the yield spread in recent history. We haven't yet back-checked all the pre-1985 historical data at Zeal Research, but I suspect that this spike in yield spread we have just witnessed is the most abrupt, violent, and largest in many decades, perhaps ever. It is certainly an anomalous market event that warrants careful consideration!
Also interesting to note, the yield spread only plunged negative three times since 1985. The shortest time, a very brief sojourn below zero in late 1998, was due to heavy bond buying and the Fed panic as the Russians defaulted on their sovereign debt and elite hedge-fund Long-Term Capital Management blew itself up through hyper-leveraged speculation in the fantastically complex and terribly unforgiving derivatives markets. As this particular plunge below zero was exceedingly brief and driven by sudden market dislocations, it is probably not worth categorizing as a classic inverted yield curve.
There were, however, two real inverted yield curves, marked by the yellow dashed circles above, when short Treasury rates exceeded long Treasury rates.
In 1989 both long rates and short rates were above 8%, which seems fantastically high to us now, but short rates were often even slightly higher than long rates. In 2000 we witnessed a similar phenomenon as the Fed vainly tried once again to ham-fistedly manipulate and micro-manage the dangerous equity bubbles that it had created by raising interest rates to try and siphon off the speculative excesses from the speculative mania the US equity markets had become. A negative spread or inverted yield curve is of paramount interest to investors because it has a perfect track record of predicting coming recessions.
The early 1990s recession is well known, and was first heralded by an inverted yield curve. Similarly, the 2000 inverted yield curve also heralds a coming recession. And no, the transitory negative GDP growth of Q3 2001 was probably not the recession prophesied by the latest inverted yield curve, as that quarter experienced the horrible September 11th attacks which definitely put a damper on economic activity for the last few weeks of the quarter. Although the perma-bulls desperately need to believe otherwise, we suspect that the real recession is still coming in 2002 or 2003. The many unique nuances of recessions and why what we witnessed in late 2001 is unlike any other recession in history (and hence probably not a real recession) is a fascinating topic and perhaps fodder for a future essay.
While the violence of the current spike in yield spread is probably unprecedented, viewing the spread in absolute terms does not quite do it justice.
For instance, if short-term rates are 4% and long-term rates are 8%, the spread is 4%. If short-term rates are 2% and long-term rates are 6%, the spread is also 4%. But, in relative terms these identical absolute spreads are very different beasts.
For example, if you own a corporation that has issued debt to finance your business, and the interest rate you have to pay on your debt goes up from 4% to 8%, you have to pay twice as much interest, a 100% increase in interest expense. Paying 8% on a $1000 bond costs twice as much as paying 4% on a $1000 bond.
But, on the other hand, imagine the effects of the same 4% change in debt costs computed from a lower base. If you own a corporation that is paying 2% and suddenly market conditions dictate that you must roll over your debt at 6%, the relative change in debt service costs is far higher. Paying 6% on a $1000 bond costs three times as much as paying 2% on a $1000 bond, even though the absolute 4% change in interest rates is identical.
The following graph helps illustrate the enormous magnitude of the current anomalous yield spread situation in relative terms. The blue line is the same absolute spread graphed above, while the yellow line is the relative spread calculated as the absolute spread divided by the short 90-day T-bill yield.
Since 1985 the average relative spread (spread divided by 90-day yield, in yellow graphed on the right axis) has been 37%. Following the early 1990s recession and in the midst of the accompanying Fed rate-slashing extravaganza, the relative spread ran up to 133% for a couple days in October 1992. But following this top the relative spread quickly shrank back down towards more normal territory, regressing through its mean.
The Greenspan Gambit short-term interest-rate manipulations this time around, however, have driven the relative spread up to fantastic heights, possibly never before seen in US history!
On January 11th and 14th of this year (a Friday and a Monday, back-to-back trading days), the relative spread peaked at the staggering level of 211%! This means long yields were 3.1 times higher than short yields, an amazing state of events. As I write this essay on March 14th, the 10-year yield is 5.39% and the 90-day yield is 1.84%, creating a 3.55% spread. The relative spread, the 3.55% absolute spread divided by the short 90-day 1.84% yield, is still breathtakingly high at 193%.
The big question for investors, both on the bond and equity side of the coin, is can this exceedingly odd and artificially-created situation last? We doubt it and don't think it is sustainable.
In studying the history of the financial markets, one of their most striking attributes is their perpetual tendency to revert to their mean over the long-term. Regardless of which market we are discussing, all markets tend to oscillate between two extremes over the long-term, with a well-defined average or mean in the middle. In the stock markets, for instance, which we have often discussed in these Zeal essays, there is a very predictable 17-20 year oscillation between very high stock prices and stellar overvaluation to very low prices and systemic undervaluation. Any long-term investor who doesn't understand mean reversion is doomed if they try to trade against these long trends.
As all famously successful traders and investors in history realize, from George Soros on the speculation end to Warren Buffet on the investment end, if a market is trading at some historical extreme, either on the high side or the low side, a great opportunity exists to make legendary profits by betting that the market will commence a mean regression sooner or later. This crucial concept is perhaps most evident during periods of unbridled speculative excess, classic bubbles.
It is no coincidence that the huge spike in relative spread in the graph above looks much like a bubble blow-off top of a speculative mania. If you look at a graph of the Dow 30 in late 1929, gold in early 1980, the NASDAQ in March 2000, natural gas in late 2000, or any other bubble, you will immediately notice that vertical spikes to bubble tops are always followed by a mean reversion, often occurring quite rapidly.
In analyzing the current huge relative spread spike, it would seem based on market history that the odds are extremely high that this anomalous condition will soon be rectified by a violent reversal to begin the mean reversion process. Indeed, looking at the graph above, it appears that the top in the relative spread was already made in January 2002 right before long yields started running higher again and market players began to suspect that the Fed was done slashing interest rates for this easing cycle.
If a mean reversion in the relative yield spread is inevitable, this implies that either short rates must rise dramatically or long rates must fall significantly in the coming year. For investors handicapping the future there is a gargantuan difference between these two possibilities.
If short rates rise dramatically, that is extraordinarily bearish for rampantly overvalued US stocks. Higher "risk-free" short rates mean less liquidity sloshing into the equity markets, more intense competition for capital from money-market and bond funds, and higher hurdle rates for capital investment. If short rates are heading higher in 2002, equity investors had better get the heck out of dodge and bond investors should defensively position their trades accordingly.
On the other hand, if long rates fall significantly, that is quite bullish for US stocks. Long rates, in a very real sense, are a major control lever for consumer spending. If long rates fall, mortgages cost less, car loans cost less, and American debtor consumers are able to borrow and spend more, buy bigger houses, and generally grow the economy which leads to corporate profits. Rising corporate profits, of course, are good for stocks as they reduce valuation multiples and give investors a fundamental reason to buy.
The current relative yield spread around 200% is not sustainable and either short rates must rise or long rates must fall for this anomaly to continue its expected mean reversion process. Which way will circumstances evolve?
We believe that the following graph, comparing absolute yield spread to the enormous MZM monetary inflation in the United States, offers some insights into this crucial question. The blue line is the same absolute yield spread from the previous two graphs, and the red line represents the most conservative possible measure of MZM money supply growth, a straight year-over-year percentage change in the US MZM money supply.
Not surprisingly, as the US MZM money supply inflates dramatically with mega-inflationist Alan Greenspan at the helm, the bond yield spread widens. The peaks and troughs above in the blue yield spread and the red year-over-year MZM growth rate match quite well. Bond investors demand higher premiums for lending their capital over time when monetary growth is high because they know it is the true textbook definition of inflation.
Elite bond traders, who are often very intelligent and diligent students of market fundamentals and history, fully realize that huge increases in the money supply are the very inflationary seeds of visible price inflation. Once freshly-created fiat money is dumped into the pipelines, there is no stopping it from sloshing into the real economy. Once the money has been created in cyberspace or printed, there is no calling it back in a fractional-reserve debt-based nation!
For bond investors living with contractually-fixed returns, inflation is lethal. If they see high money supply growth rates they have to demand higher returns to compensate them for the erosion in their real capital through incessant inflation. With year-over-year absolute MZM growth just coming off an enormous 21.3% peak late last year, it is highly unlikely that bond traders will aggressively buy bonds and bid down long-term yields. With extraordinarily inflationary tidings coming from the Federal Reserve's continued mismanagement of the crucial US money supply, why would any savvy bond investor accept a lower yield for risking their scarce capital over the long-term?
As the yellow circles on MZM peaks and troughs above indicate, recent MZM growth explodes, often in response to perceived financial crises in the US, and then collapses below zero once the immediate threat of the crisis, such as the 1987 stock market crash or early 1990s recession, passes. From the current breathtaking 20%+ peak in YOY MZM growth, recent history would suggest that we are rapidly approaching a time of collapsing MZM growth, perhaps even contraction for a year or so in the not-too-distant future, as unbelievable as that sounds.
If long rates, already near multi-decade lows and staring down the barrel of an enormous burst of US MZM money supply inflation, are not going to fall, a mean reversion in relative yield spread is only possible if short rates rise. As the Fed knows, very low interest rates like we are witnessing today are very unhealthy in the long run. They rob creditors and lead to all kinds of misuse and bad allocations of capital and can be very damaging if left artificially low for a long period of time. Just look at the insoluble mess that artificially low interest rates helped make in Japan! If bond investors and creditors cannot obtain a reasonable real short-term return on their capital, severe damage occurs in the financial markets and economy.
An electric shock or two may be good for someone having a heart attack to stimulate their heart to start beating again, but subjecting someone to continuous electric shocks is both dangerous and inhumane. Artificially low interest rates manipulated to stimulate an economy are similar. A little dose may be good, but a big dose is counterproductive and will cause the patient to rapidly continue to lose health, as in Japan.
The mean reversion of the relative yield spread is likely to occur through rising short-term interest rates, carrying them back towards their much higher mean (5.52% since 1985), not by falling long rates, which would drag them further away from their historical mean (7.14% since 1985). And, of course, if long rates continue to rise in the face of mega-inflationary monetary tidings, short rates will have to rise all the more to fix the anomalous relative yield spread!
The coming hikes in short-term interest rates will have widespread consequences for bond and stock investors alike. Bond investors will have to carefully position their capital so the increases in interest rates don't decimate the value of any current low-yielding bonds they may hold. If a bond yields 2% and short-term rates rise to 3%, the price of the 2% bond will fall until it yields the new market rate of 3%.
Stock investors will have an even rougher time in the coming rising short-term interest rate environment. Higher interest rates will put even more intense pressure on current ludicrously high US equity valuations as well as limiting excess capital flowing into the equity markets. They will also increase competition for stocks from swing capital that sloshes between stocks and bonds based on chasing the highest relative yields, potentially sucking capital out of the equity markets.
Rising interest rates also take a bite out of corporate profits in debt-financed corporations, which most of the major US market-darlings have become. In addition, if MZM growth collapses following the latest explosion as it has in the past, considerably less cash could flow into the US equity markets. Falling demand for stocks will lead to falling prices for stocks, not a good thing especially at current stratospheric valuations!
The extraordinary historic anomaly we are witnessing of a relative bond yield curve spread so high is utterly unsustainable. Something has to give soon and we suspect that it will be short-term interest rates. Perhaps the recent rises in the long yields are harbingers of the coming change in Fed policy, the bond market signaling that a major strategic trend shift in the interest rate environment is rapidly approaching.
Bond traders, unlike the average stock investor, or not easily fooled by hype and keep their focus locked on fundamental reality. They are selling bonds and bidding up yields for a reason. The rest of us should pay attention.