March 15, 2006
FAILURE TO YIELD?
The U.S. current account trade deficit jumped to an all-time record high in the fourth quarter, rising to $225 billion--up 21% from the third quarter the Bureau of Economic Analysis reported yesterday. With the latest numbers, the tally for 2005 is in, and the red ink for last year has pushed higher to another unprecedented level. Indeed, last year's deficit was a record in both absolute-dollar and relative terms (as a % of the economy).
If you thought any of this would cast a pall over the mood of bond traders by suggesting higher interest rates, think again. In fact, the fixed-income set found reason for hope (such as it is from the view of a bond trader). As a result, buying was in evidence on Tuesday, and so the benchmark 10-year Treasury yield retreated sharply yesterday, falling to just under 4.70% from nearly 4.78% the day before.
One might argue that yesterday's decline in yield was merely a temporary pullback in an otherwise rising trend in the price of money for long-dated bonds of late. The 10-year yield was under 4.3% at one point in January, but as of Monday it was threatening to break above 4.80%.
Whatever new thinking dominates bond traders at the moment, at least one crucial aspect of the credit markets appears unchanging: the Federal Reserve is all but certain to raise the rate on Fed funds again at the FOMC meeting on March 27/28. The April Fed funds futures contract is priced in anticipation of another 25-basis-point hike to 4.75%, and more of the same is expected beyond. A 5.0% Fed funds, in short, looks like a reasonable bet by the summer, to judging by the futures.
Assuming no change in the 10-year yield, a 5.0% Fed funds represents an inverted yield curve (again) in no uncertain terms. Therein lies the great, familiar and so far unsatisfying debate that hangs over the fixed-income world, and a few other corners of finance as well.
One theory of what will come goes like this: rising rates will continue to pinch the world of real estate, which relies in no small degree on the affordability of mortgages, which of course are heavily influenced by the risk-free yields from long Treasuries. As the folks at Comstock Partners lament, the housing slowdown of late "is being exacerbated by high energy prices, continued Fed tightening, an inverted yield curve, rising long rates, and declining real weekly earnings. Moreover, for the first time since 1980 the U.S., the EU and Japan will all be tightening at the same time. In our view this combination is likely to result in a weakening economy and disappointing earnings at a time when the market doesn’t expect it."
The bond market hopes for no less, or so one might reason. Yes, rising rates for the time being will incur a capital-gains bite for bonds in coming weeks and months. But eventually, the higher rates will take an even larger bite out of the bull market in real estate. As a result, a wilting property market will convince consumers to tighten their belts, pull back on spending, and slow the economy, perhaps to the point of recession. This is stuff that dreams are made of for those buying bonds.
Of course, many have been anticipating that future for some time now, with nothing in the way of hard evidence to show for it in terms of consumer spending. Well, almost nothing. Yesterday's retail sales report for last month suffered a sharp 1.3% fall from January. A reversal of fortunes relative to January's 2.9% surge in retail sales over December. So much volatility, so little trend.
Much of the volatility in retail sales is due to the back and forth in auto sales. But there's no small danger in reading too much into consumer thinking by focusing on month-to-month sales of cars. Indeed, the U.S. economy is nothing if not overloaded with autos, and so volatility in sales in times of extreme and rising competition is hardly unusual. The days when General Motors was a relevant bellwether of U.S. fortunes has long since passed, as the carmakers shrinking presence in relative and absolute terms suggests.
Nonetheless, when and if Joe Sixpack cracks remains the big question, and the answer (whatever it is) will no doubt come by way of what happens in real estate. Joe and the trend in housing are hitched, for good or ill.
In theory, the bond market can and does anticipate the future, or at least try, by pricing a 10-year Treasury accordingly. We can argue about whether yesterday's ~4.70% offers sufficient compensation for what's coming, but the bigger question is whether the fixed-income set is up to the task of assessing future risk and reward. More than a little confidence has been lost that was once afforded the fixed-income set as an unwavering force of fiscal rectitude and ghoulish integrity. Even if traders are up to the challenge, there are any number of additional factors moving yields these days that potentially can cloud, obfuscate and otherwise complicate the price of money as it relates to basic economic fundamentals--foreign investors and derivatives, to name two of the more obvious variables.
It all boils down to one question that every investor must ask and answer in the here and now: Do you trust bond traders to prudently set the price of money?
Posted by jp at March 15, 2006 10:08 AM
In retrospect, maybe a lot of the important people got the CPI number a day earlier than the rest of us saps.
Posted by: quintsquarry at March 17, 2006 9:05 AM