Since topping on June 13, 2003 the US Treasury Bond market (and Canada's) has taken one of its swiftest drops ever. In barely seven weeks the market fell more than $15 or about 14% (as measured by the 30 year US Treasury Bond Future that trades on the Chicago Board of Trade (CBOT)). Indeed the drop was so swift we did wonder how that compared with the immediate drop after a top in other years.
Since the long-term bull market in bonds started back in October 1981 we have of course seen many peaks rises and subsequent corrections. While there has been some impressive drops none, however, none have matched this one over the first six weeks. The closest was a 12% drop in 1987 in the first seven weeks following an important top. The 1987 market fell almost $20 to the bottom or about 24%. The worst bond bear since the bond long-term bull got underway was the 1983-1984 collapse that wiped 25% of value. In dollar terms, the worst drop was the 1993-1994 bear market that fell $21.31.
Bonds have been shown to go through cycles of roughly 3 years. While we have shown this in the past it is worth repeating. Since the major bond market bottom on September 28, 1981 we have seen significant troughs in 1984 (July 2 - 1008 days), 1987 (October 19 - 1205 days), 1990 (September 24 - 1071 days), 1994 (November 11 - 1509 days), 1997 (April 11 - 871 days) and 2000 (January 18 - 2000). The average is just over 3 years with the longest being 4.1 years and the shortest 2.4 years. This suggests that the next bond market low should occur sometime between June 7, 2002 and March 6, 2004. We are past the early date and we are past the average date of February 4, 2003. This bond bear should bottom sometime in the next 7 months and could easily have another 12%-15% to fall.
This carnage is coming against the backdrop of the lowest interest rates in years and after the Federal Reserve has cut the discount rate an unprecedented 13 times in the past few years. The huge influx of liquidity into the market particularly over the past number of months as Gulf War II unfolded has contributed in no small way to a bubble in the bond market, the mortgage/housing market and probably once again in the stock market. It has become obvious now that the bond and mortgage bubble can no longer be sustained. Once again Fed Chairman Greenspan has given the impression that low interest rates, an endless supply of liquidity and fear of deflation has led to a bond bubble. Some have called it Greenscam.
Fed Chairman Greenspan contributed to the pricking of the bond bubble by announcing that he expected economic growth to increase next year thereby lessening the need to cut rates further or intervene in the market through treasury sales. Oddly a few days later Fed Governor Bernake said that the Fed would stop at nothing to ensure long term growth including further interest cuts even to zero. Seems confusion reigns at the Fed.
But a drop of this magnitude in the bond market means there is no confusion there. So why is the bond market all in a dither? Well it seems that $450 billion budget deficits and the need to fund these deficits does have an impact after all. The recent US Treasury announcement that they need to borrow $230 billion in the second half of the year is enough to dampen the enthusiasm of any bond buyer. Upwards of half of this supply could be new money to finance the burgeoning budget deficit. And at least 40% or more of the supply is dependent upon the whims of foreign investors primarily Japan. With the US Dollar falling, yields at historic lows, and burgeoning supply the foreign investor has to be enticed with considerably higher yields especially a country like Japan that has its own problems and demands.
While bond yields have been low and are still low by more recent historical standards the rise in rates is putting pressure on particularly the mortgage market which is more sensitive to long term interest rates rather that more Fed controlled short term interest rates. Rising interest rates could put a damper on house sales, which have remained one of the few bright spots in the market. Already we are seeing signs that the housing market is cooling and the recent record sales of new homes could soon be just a memory.
In addition to the supply coming on the market as a result of the huge deficit, corporations have also being piling into the market to take advantage of the low rates. Of course homeowners have been doing the same thing. The burgeoning demands of the US government have clearly proven too much for the market and despite the low short term rates and the seeming endless supply of liquidity it has proven too much and the exit from the bond market began.
All this is coming against a background of continued high and unsustainable debt levels for both consumers and corporations, record US budget and trade deficits, low to nil savings by consumers, continued record bankruptcies for both consumers and corporations, huge under funded pension liabilities, continued weak economic growth in other countries and ongoing geopolitical risks.
While investors might complacently state that while interest rates have backed up from their recent lows (bond prices move inversely to bond yields) the Fed is keeping interest rates low, the yields are still low historically and therefore should continue to encourage both investors and the consumer. Finally the Fed is prepared to stand by and defend deflation and ensure economic growth through this policy of low interest rates and a never-ending supply of liquidity.
What they seem to forget is that the recent collapse in the bond market is also huge by historical standards and is signaling a severe problem. With the US dollar also turning around after a recent upside correction we should all be reminded that in 1987 it was a falling US Dollar and a falling bond market that caused the one of the biggest financial panics in history. Was there any sector that benefited? Well one gold. And the gold market now is breaking out with minimum projections to $400-$450 for the gold price.
We are showing two interesting inter market ratio charts. The first one is a weekly chart of a Gold/Bond ratio. We have used the nearest futures contract for both gold and US Treasury Bonds. Throughout the 1990's gold was falling against US Treasuries clearly favouring bonds over gold. Exceptions were clearly the 1993/1994 bear market in bonds in particular and as well the 1990 bond bear and to a lesser extent the 1999 mini bond bear where a spike is seen. Prior to that the best performance of gold against bonds was the 1987 bond bear. Since 2000 gold has been in an uptrend against bonds not only breaking the 1990's downtrend but gold has being going up even as bonds were going themselves to new price highs (yield lows). A remarkable performance for gold against bonds.
Our second chart is a weekly chart of the Dow Jones Industrials/Bond ratio. Throughout the 1990's stocks were clearly the place to be as the ratio rose steadily. There was a dip during the 1990 mini bear in bonds and stocks as well again during the 1993-1994 mini bear where bonds were better performers then stocks. There was also a strong pullback during the 1998 Asian meltdown. But since 2000 the ratio has been in a strong downtrend clearly favouring bonds over stocks. Of course there has been counter trend rallies but they have generally only taken us back to the down trend line. That is where we are now as clearly over the past few months in 2003 stocks have outperformed bonds.
But the rapid record drop in the bonds is a clear sign that something is amiss. As we noted above during the summer of 1987 we had a falling US Dollar, a falling bond market and rising gold prices. The stock market meanwhile was blissfully ignoring it all rising well into August before topping. In the fall we had one of the biggest financial panics in history in the stock market. Does history repeat itself? We don't know but the recent bond massacre should not be taken lightly. Our recommendation is that investors ensure that they are either out of the bond market or in short term maturities, and out of the stock market.
On the other hand investors should be fully invested in the gold market through stocks or even in gold bullion itself (three choices either the Millennium BullionFund1 (www.bullionfund.com, 416-777-6691) or Central Fund of Canada (CEF.A-TSX) (www.centralfund.com, 905-648-4196 or Central Gold-Trust (GTU.UN-TSX) (www.gold-trust.com, 905-304-4653). The size of the position is dependent of course on the risk profile of the investor but a minimum of 10% is recommended. The Dow/Gold ratio also continues in a downtrend and is currently at resistance as our chart of the Dow/Gold ratio shows. Meanwhile the US Dollar is firmly in a downtrend. The stock market continues to make what should be a top while gold stocks have clearly broken out on the charts. Investors have been warned. Buy gold, sell stocks and bonds.
1David Chapman is a director of the Millennium BullionFund www.bullionfund.com