My Two Cents - "Bonds in the Tank?"

6/8/2007

On first glance, it might appear that this is a baseball column. Certainly, Barry Bonds has had a tough time getting decent pitches to hit out the park recently. Such has also been the case with the bond market. As of the time of this writing, the yield on the 10-year has touched 5.25% indicating a shift shift in thought. There are two sides to every story, and like most other situations the ramifications are far-reaching.

First, let us also make clear the role of the Fed and financial markets in the determination of interest rates. When interest rates and the Fed are mentioned, they are referring to very short term rates, in particular the rates that banks charge each other for overnight loans. When we talk about longer-term rates, these are set by the bond market. Bonds are traded in a fashion similar to stocks. Their price and yield are inversely proportional. If the price of a bond goes down, the yield rises and vice versa. Bonds of varying maturities up to 30 years are available for purchase. The yields of these various instruments make up what is referred to as the yield curve.

Bond prices have a direct impact on mortgage rates. The Fed doesn't control mortgage rates directly through changes in the discount or overnight rates. The Fed can act clandestinely to 'work the yield curve', however. Higher yield rates on bonds have a profound impact on mortgage rates. The headlines have told the story in recent weeks as mortgage rates have continued to trickle higher. Obviously, this is going to create some problems. For a while, cheap loans have fueled the housing market and through it, consumer spending in the form of equity withdrawals. As rates rise, we are going to see a constriction in these loans and we've already been through what the results of this will be. The ramifications could prove to be very negative for the housing market, consumer spending and the economy in general. Note that GDP in the US is at a stall rate despite massive growth in the M3 monetary aggregate. In terms of inflation, the monetary authorities don't seem to be getting as much economic bang for their fiat bucks.

One possible good spinoff effect of this could be a stronger dollar. Indeed, we've seen the US Dollar Index climb just a bit out of the basement recently, but the move has been anything but spectacular. In particular, the sudden spike in rates over the past week has sent shock-waves through the stock market, but hasn't had nearly as profound effect on currency markets. The dollar index is up about 1% during this time while the DOW has lost nearly 3%. It appears to me that despite a very favorable shift in the interest rate environment that the dollar is still the red-headed stepchild of financial assets. In this case, this little bit of good news is actually a horrible prognostic indicator.

While a week certainly doesn't constitute a trend, it is certainly a development that is worthy of our attention. Higher interest rates down the road will put further pressure on the largest engine of consumer spending and that is the cost of borrowed money. Plus, higher interest rates are inflationary in that they force the US government to come up with higher payments to foreigners in order to finance the national debt. Where will this extra money come from? Taxes? Maybe. Most likely though it will come in the form of even more monetary inflation that will cause further rises in interest rates and thus begin a toxic cycle. Couple that with a contraction in consumer spending due to rising costs of borrowing and Ben Bernanke might have to send a fill-in to Congress come this summer. He'll be much too busy buying gas to fill his fleet of helicopters.

Editor's Note: Confused about how the pieces fit together? Check out last night's broadcast of "Beat the Street" on www.my2centsonline.com/radio_archives.htm where I discuss these and other issues with a caller. On the site, you may also download other episodes or podcast the show. Don't miss a single episode!

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. This article and other information is located at http://www.my2centsonline.com Please feel free to distribute, copy or otherwise disseminate this information.