Are Bond Yields Set To Soar? Not So Fast

Via Eric Hickman of Kessler Investment Advisers,

US Treasury yields have risen sharply in the last four weeks with 10yr yields higher by about 50 basis points. We are the first to admit that we didn't see this coming, but other than the secular and political interest rate bears, no one else did either.

Direct causation is hard to find. While the economic data has improved in places, the prices have moved much more than the facts. For just about every good piece of data, there was an equal piece of bad news. For instance, where the jobs report showed an unemployment rate improving to 7.5% from 7.6%, the broader underemployment rate (U6) that includes those that would like to work but haven't looked for a job in the last 4 weeks, worsened to 13.9% from 13.8%. Durable goods orders came in better than expected, yet Industrial production came in worse than expected. New home sales were
more than expected yet Building permits were less than expected.

For the whole picture, it helps to consider indicators that combine individual data for the month into a single number. All of these show a slowing, not improving economy. The Chicago Fed National Activity Index showed a decrease in aggregate activity, the coincident indicators index (correlates well with real GDP growth) grew at just an annualized rate of 1.2%, and our 'Kessler Interest Rate Economic Indicator' modeled after the Chicago Fed National Activity index is showing a decrease as well.

Then of course, there is Ben Bernanke who made the slightest hint to the possibility that a tapering of purchases could begin "in the next few meetings" if the economics warranted. It wasn't so much what he said on its face, but just that the markets hadn't imagined this possibility was even entertained by him until that moment. But trying to position a trade based on the impact of the Fed quickly becomes a reflexive exercise going no place because the Treasury market finds a way to reflect macroeconomics despite them. The history of the Fed shows that economics always trumps their effects. This isn't to say that at any given moment, the Fed may have interest rates at a different level than they otherwise would be, but it isn't useful to use this as a reason to buy or sell because a change in their buying could just as easily mean that the economy will be weaker and thus rates would fall as that they would cause rates to rise.

Regardless, yields have risen dramatically and we are not trying to dismiss it. The price is the price, however; it is important for us to express our thoughts for where we think yields are ultimately going, especially when there is virtually no one out there to make this case. We also realize that the market never trades based on what the economy looks like now, but rather where it thinks it will be.

And so, what this recent yield back-up boils down to is that the market is expecting that there is self-sustaining, above trend, GDP growth coming. It isn't often that prices become this divorced from fundamentals. Expecting self-sustaining above trend growth is hoping, not the result of a careful analysis.

We continue to think that no matter how forceful this back-up has been, or where it ultimately peaks, we will see new low yields in the Treasury market before this cycle is over.

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We cannot know if this yield backup has run its course but from our perspective, it isn’t a question of “if”, but “when” yields resume their downward trend. As always, we look forward to the time when economics deem a shift from being fundamentally long to fundamentally short interest rates, but we do not see this yet.

 

Here is why we think they won't stay up here for long- (7 Short-Term and 3 Long-Term reasons)


Kessler Market Comment 05-29-13