August 17, 2003

Bullish on Bonds...

The Economist's "Buttonwood" is very bullish on bonds:

Economist.com: ...the yield on ten-year Treasuries popped up to almost 4.5%--some 140 basis points (bps, or hundredths of a percentage point) above their lows in June. This move has been both big and fast: bigger and faster, indeed, than the infamous rout in early 1994, when the market took twice as long to fall a similar amount.... Treasury yields are more volatile than they have ever been. This is a bit odd in some ways, since nobody expected the Fed to do anything anyway, and very few (the Fed included) entertain the prospect of its putting up short-term rates from their present 1% for the foreseeable future. In 1994, the economy was motoring and the Fed ended up doubling rates, to 6%. This time, the recovery, if any, will be weak.... What, then, has turned a small correction into a sharp sell-off? The biggest cause seems to have been the hedging activities of holders of mortgage-backed securities.... When Treasury yields fall, the duration of mortgage-backed portfolios also falls because homeowners swap old mortgages for new, cheaper ones. To hedge against this, fund managers buy Treasuries. Conversely, when yields rise, they sell Treasuries. As in 1994, this recently turned into a vicious circle of rising yields and more hedging.... If Treasury yields rise further, mortgage hedgers will exacerbate the trend. Also adding to volatility in Treasuries are banks, which have increasingly substituted Treasuries for corporate loans as loan growth has slowed. Since they are leveraged institutions (they have a small amount of capital backing lots of assets), with nowadays more or less mechanical risk-management systems that in effect force them to sell when losses mount, this probably also increases volatility.

But the recent turmoil notwithstanding, the outlook for Treasuries remains good. The strategists at CSFB, who think that Treasury yields could fall to 2-2.5% over the next couple of years, recently wrote a research note which explains why and which rubbishes the notion that low Treasury yields earlier this year were evidence of another bubble. Put simply, after an equity bubble bursts, it takes years, decades even, for investment, inflation and risk appetite to recover. All of which is ample reason for bond yields to fall a lot and means that they have further to fall...

If I were working for the Treasury or the Fed right now, I would have a lot of people thinking about how to measure the amount of positive-feeedback trading (i.e., respond to a price decline by selling more) that is triggered by VAR models and by the endogenous duration of mortgage-backed securities. This is not how a rational, sophisticated financial market is supposed to work.

Posted by DeLong at August 17, 2003 08:41 AM | TrackBack

Comments

"But the recent turmoil notwithstanding, the outlook for Treasuries remains good."

Yuch. Like becoming poorer? Let the Economist be your guide to investment. The Economist appears increasingly stuck in a British colonial time warp in general international coverage. At the least a low cost high quality municipal or corporate bond portfolio would now be a far better investment than treasuries. Take a look at Vanguard portfolios. High quality "high yield" bonds are also better priced again.

Of course, the idea is to follow the tape for some while on stock and bond moves. There was every reason to sell the 10 year treasury short in May, and so any rise in yields was bound to be accentuated. The Fed had to know this.

Right now at a 4.5% 10 year treasury, we can easily do a lot better in bonds and dividend paying "value" stocks.

Well, what can you expect, the neo-colonialist Economist supported George Bush as a sound economic choice.

Posted by: anne on August 17, 2003 09:21 AM

How about it? A 10-year treasury bond at 4.5%??? Absurd.

We can get 2.3% dividends from an S&P Value Index at Vanguard, pay less in taxes, and provided we can get 2.2% in annual capital gains over the next 10 yesrs do better than treasuries with less risk. How I do love the Economist.

Posted by: anne on August 17, 2003 09:40 AM

Even if bond yields were to decline again, the exploding internal and external American debt means that we have to expect interest rates to rise in future. Whenever economic growth picks up, even for a quarter, interest rates are going to rapidly climb.

Paul Krugman advised locking in long term mortgage rates early this year, and that was just the right advice. The Economist is welcome to buy all the treasury debt we have. I'll pass also.

Posted by: jd on August 17, 2003 10:01 AM

Much of the blame for the collapse in yields has been placed on Greenspan's apparent about-face on deflation.

Many of those prone to seeing a conspiracy rather than a cock-up behind every event in history have suggested that Greenspan and the Fed initially deliberately lied about deflation in order to drive down interest rates.

Pooh, a simple and good-hearted bear, does not believe that individuals of the moral calibre of a Greenspan or a Bernanke would flat-out lie to the markets or the American people. Instead, Pooh believes the Fed had become increasingly concerned that as a result of their public musings the U.S. risked talking itself into a really serious bout of the pernicious variety of deflation, and it consequently determined to play down the risks of the same. And no, this was not flat-out lying, but the kind of dissembling one must sometimes expect in difficult circumstances from high public officials.

Posted by: Pooh on August 17, 2003 11:41 AM

Economist - "This [move in Treasury bonds]is a bit odd in some ways, since nobody expected the Fed to do anything anyway".

Now, didn't FED made us belive that they would use "unconventional measures" like buying bonds, thereby talking up their price? Then suddenly Greeny put the whole bond-buying talk off, and Treasurys slid back all the way. Probably took some of our confidence in the FED with them.

Too bad :(

Posted by: Mats on August 17, 2003 12:02 PM

The empirical evidence is heavily against anyone being any good at predicting interest rates. That covers both the Economist and those who disagree with it.

Posted by: richard on August 17, 2003 12:25 PM

There is no need to predict interest rates, simply to know when bonds, as other assets, are decently valued. Bonds were a breeze to call in value terms from March 2000 through May 2003. There was a reason Warren Buffett bought billions of dollars of high yield bonds last fall, for example. Selling treasuries frpom May to the middle of June was as easy as pie.

Posted by: anne on August 17, 2003 02:13 PM

"Selling treasuries frpom May to the middle of June was as easy as pie." - you must be partying around the clock to celebrate your massive trading gains then?

Posted by: Mats on August 17, 2003 02:23 PM

incidently buffet also sold all his bonds holding some time before june and probably made at least 1bln. i would personally follow some other benchmark than sp500 value . it ends up with all kinds of dogs at least thanks to their committee tinkering and also how it is defined .

Posted by: badri on August 17, 2003 02:25 PM

incidently buffet also sold all his bonds holding some time before june and probably made at least 1bln. i would personally follow some other benchmark than sp500 value . it ends up with all kinds of dogs at least thanks to their committee tinkering and also how it is defined .

Posted by: badri on August 17, 2003 02:29 PM

Actually Vanguard has started using the Morgan Stanley style indexes rather than the S&P style indexes. I prefer the Morgan Stanley style indexes, mainly for tax purposes. The lower turnover also controls costs better. Still, the S&P index itself is awfully hard for an investor to beat over an extended time. No matter the arguments I read, I find long term indexing gives investors a very decided edge. Thank you John Bogle.

Posted by: anne on August 17, 2003 02:52 PM

anne, at the one hand, you say S&P is hard to beat, on the other hand, the tsy-bond market is easy to play.

why bother about the S&P then?

Posted by: Mats on August 17, 2003 11:00 PM

Because stocks as long term investments have been and should be a superior investment. Especially on an after tax basis. But, there are times as bonds go to evident extremes when they are fine investments. Relative asset values can change in dramatic fashion. Robert Rubin, who I think is superb, sold all stocks, and went to bonds in late 1999 and early 2000.

Posted by: anne on August 18, 2003 08:14 AM

The historical risk markup on bonds is in the area of 2-2.5%. With the current yield on 10 yr Treasury Bonds about 4.5% the implied inflation rate is 2.3%.

This suggests a fair time to buy TIP Bonds if you believe that reinflation is virtually inevitable. Should inflation moderate, then I'd expect the bond value to increase. Buying TIP bonds seems almost a no brainer now? IMHO

Posted by: Don Majors on August 18, 2003 12:23 PM

Wish I understood this better. I am very very suspicious of TIPS. My sense is that you are betting on the Fed being unable to limit inflation, and thus a bad bet. Still, I do not really get TIPS. I would much prefer high yield municipals or reasonably conservative high yield corporates.

TIPS strike me as either a smart short-term hedging device for professional traders, or a foolish sort of long-term hedge for small investors.

Posted by: anne on August 18, 2003 12:49 PM

Anne: I think TIPs are defensive/hedging investments that assure the inflation adjusted return of principal at maturity -- like ... at least getting your bait back at fishing. There are tax disadvantages in holding TIPS in taxable accounts. But, the financial bias for creeping inflation in social and USGov policies make them a good holding for aging, minor millionaire investors dependent on a scheduled positive throwoff of cash to maintain comfort without worry. The TIP price is now creeping up above 95 at which time it was a bargain. (IMHO)

I don't see DJI at 7500; or TIPs at 95

Posted by: Don Majors on August 19, 2003 05:19 AM

Anne: I think TIPs are defensive/hedging investments that assure the inflation adjusted return of principal at maturity -- like ... at least getting your bait back at fishing. There are tax disadvantages in holding TIPS in taxable accounts. But, the financial bias for creeping inflation in social and USGov policies make them a good holding for aging, minor millionaire investors dependent on a scheduled positive throwoff of cash to maintain comfort without worry. The TIP price is now creeping up above 95 at which time it was a bargain. (IMHO)

I don't see DJI at 7500; or TIPs at 95

Posted by: Don Majors on August 19, 2003 05:20 AM

Thank Thanks

Very nice indeed. I finally get it and agree.
Still, letís try equal shares of Exxon, Texaco, and Shell as a long investment.

Anne

Posted by: Anne on August 19, 2003 09:11 AM
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