inside the belly of the BEAST...
When "short-term rates exceed long-term rates, INVERSION [occurs]."
Sound unpleasant? It is.
What LESSONS can we learn?
According to David Rosenberg, an economist at Merrill Lynch, "in the last three decades there have been five Fed-induced rate INVERSIONS . . . and the economy slipped into RECESSION a year later all five times."
The last one was in 2000: The Fed held its key rate at 6.5% in the second half of that year.
But as the economy weakened, bond investors began to sense that the Fed soon would be easing credit. Long-term bond yields slid.
By the end of December 2000, the 10-year Treasury note yield was 5.11% — about 1.4 percentage points below the Fed's short-term rate.
The Fed began cutting its rate in January 2001, but it was too late. A recession began in March.
- When bond investors suspect that the FED will ease credit, long-term bond yields DROP.
- When long-term bond yields drop, RECESSION follows.
Small problem: the FED's main concern is making money for its shareholders.
Not only would staving off recession be counterproductive, but as the following excursion demonstrates, the Fed really only dictates short-term interest rates.
Once the genie's out of the bottle, all bets are off!
Now stay with me, because it gets a little sticky inside the belly of the BEAST:
"[T]he Fed [recently] boosted its short-term rate from 1% in June 2004 to the current 4.25% . . . meanwhile, the 10-year Treasury note yield [has] declined, from 4.58% to 4.44%."This is beginning to look like a self-fulfilling prophecy.
But, "in its post-meeting statement [the Fed announced] that 'some further measured policy firming is likely to be needed.'"
So, Wall Street figures "the Fed's benchmark rate . . . will rise to at least 4.75% by spring."
BUT, "even the longest of long-term rates — the annualized yield on 25-year T-bonds — currently is below 4.75%." [mercy!]
"[which means] investors face the prospect of earning LESS on longer-term securities than . . . in very short-term, NO-risk cash accounts, such as six-month T-bills."
Investors become convinced that interest rates in general will soon come down because historically, after inversion, "the economy [is] poised for a sharp deceleration or a full-on recession."
But wait, put yourself in the mind of a potential bond investor:
"To buy a 10-year Treasury note, which currently pays a yield of 4.44%, you'd have to believe that even if shorter-term rates climb above that level next year . . . they won't stay there for long."So, what's your point?
"The bond market is pricing in some event that would cause the Fed to cut rates" later in 2006, said an economist at Lehman Bros . . . "most likely, a marked economic slowdown."What in the hell does that mean?!! Are they buying or are they selling?
And, how does that affect the long-term yield rate?!! You told me that when long-term bond yields DROP--RECESSION follows!
Simple. It's all about supply and demand.
"Some on Wall Street believe that demand for bonds has remained robust, keeping yields down, because of a global savings glut — meaning that so much money is looking for a place to go that investors . . . are forced to out-compete one another for bonds, depressing returns.Hmmm, that means the money supply is already HYPERINFLATED and the only thing that saves us from catastrophic inflation is people hoarding cash because they think it's still worth hoarding.
Others think "rates stay low because many investors are permanently poised to rush into the securities as a haven should . . . a financial calamity or a massive terrorist attack [occur]."Too bad a financial calamity that wipes out the value of the dollar would make buying bonds useless, SUCKERS!
Would you look at that? Bondholders have been raking in the dough since 1926, while everyone else suffers the vagaries of inflation, generation after generation.
Still others "contend that bond yields have softened because the market believes inflation has been vanquished in the long run . . . government bond returns have averaged 2.3 percentage points above the inflation rate since 1926. [!!!]
If inflation falls back to, say, 2%, a 4.44% bond yield would look fairly generous.
Coincidence? I think not. Try causal relationship.
Finally, it's always possible, however unlikely, that "the economy will stay strong," that the new Fed Chairman Ben Bernanke "will keep lifting short-term rates," and that "longer-term interest rates will rise as well," averting INVERSION.As always, we SUFFER so that they can PROSPER.
Then, "investors obviously would be better off waiting to lock in bond yields at more attractive levels. And THEY'D BE PAID TO WAIT, as yields . . . continue to rise."
"Morgan Stanley . . . believes the Fed's benchmark rate will reach 5% in the second quarter, and will hold there through 2006."How HUNGRY is the BEAST? I don't want to know.
If he's right, we're going to find out how hungry global investors really are to own long-term U.S. bonds at these yields.
Is RECESSION around the bend? I'm not sure.
But, one thing's certain. The ILLUSION can't last forever.
So please, do what you can to help spread the word.
We must stop this monster before it devours us all.