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Rising bond yields – any cause for concern?
On Monday 5 April 2010, the 10 year US treasury bond yields crossed 4% for the first time since June 2009 (see chart of $TNX below). Bulls believe this is a good sign. Bond yields typically rise and bond prices fall when the economy improves because investors will pull money out of safe, government-backed bonds and opt for riskier investments, like stocks, that have the potential for bigger returns. With rising consumer sentiment numbers and a good jobs report last Friday, some investors think this is the case and most major US market indices made a new 18 month high on the same day.
However, a recovery is not the only reason why bond yields go up. Yields also go up when there is a higher perceived risk of default. The bond yields for Greek bonds also went up to over 7% recently and that is definitely not due to rosy economic expectations. Despite taking draconian austerity measures to reduce spending and promises of a bailout by the Eurozone/IMF on March 25, yields have remained stubbornly high as international bond investors demand to be properly compensated for the risk that they are taking. Greek bond yields are more than two times that of German bonds because Greek debt is seen to have a much higher risk of default than Germany’s.
Could the rising yields in US treasuries also be due to increased risk? Some analysts think so and they have attributed it to:
- The ballooning US debt and budget deficit
- The ending of the Federal Reserve’s program to buy Mortgage Back Securities on 31 March 2010.
Impact of rising US debt/budget deficit
In a paper written by Michael Cembalest, Chief Investment Officer of J.P. Morgan Private Banking, he points out the following about the U.S. budget deficit:
- It is the largest peacetime deficit and debt/GDP ratio
- Deficits are harder to reduce today because a much larger component is mandatory spending (vs. discretionary or defense spending). In 2015, entitlements and interest payments will make up 71% of government expenditures.
With such an unhealthy budget deficit, I won’t be surprised if international bond investors would demand a higher yield from the US government as they have done from the Greek government when they found out how bad their budget deficits were. In order to reduce the U.S. budget deficit, the government will have to cut spending or raise taxes. Obama’s administration does not seem to like to cut spending, so taxes will probably rise. In order for the US budget deficit to be reduced to an acceptable level of 3% by 2015, some options are:
- All taxes raised by 15%, or
- Individual taxes raised by 30%, or
- Raise top to brackets to 70%, or
- VAT tax of 7.7%
Clearly, this will be very difficult to implement without public revolt so there is a strong possibility that the US will take other “underhanded” measures to solve their debt problems which is to print more money (don’t we all wish we had this option to pay our debt) or default on the debt. Both these measures will not be good for the bond investors, hence they need to price in this risk by demanding a higher yield.
Impact of ending Fed Mortgage Back Securities program
In the latest Outside the Box newsletter from Investorinsight.com, Barry Habib of Mortgage Success Source says prior to this program, mortgage rates were above 6%. During the past fifteen months, the Fed purchased $1.25 Trillion in Mortgage Back Securities (MBS), which represented 80% of the mortgage market. Now that the Fed program has ended, it’s reasonable to assume that mortgage rates will rise back towards those levels. Although mortgage rates in the US are not pegged to the 10-year Treasury Note as some have reported in the media, there is normally a strong correlation between 10 year bond yields and mortgage interest rates. Mortgage rates are actually based on the pricing of these MBS. Ever since the subprime crisis caused many of these MBS to become worthless, nobody other than the Federal Reserve have been buying these risky assets. When the Fed stops buying them, yields have to go up to entice “for profit” investors to buy them.
Another analyst who is very worried about how the mortgage market will react when the Federal Reserve stops its massive MBS buying program is Meredith Whitney. In a video interview on CNBC, she thinks banks will be even more reluctant to extend housing loans if they cannot securitise these loans and then sell them as MBS and this could lead to a double dip in the US housing market.
Stock investors just looking at the normal economic indicators like improving GDP and job numbers are ignoring the elephant in the room which is massive government debt and budget deficits which are impossible to reduce using normal measures. When I first started investing in stocks, I never paid much attention to the bond market but over time I have learned that the bond market is very important. The global bond market is twice the size of the global equities market so stock investors who ignore the bond market do so at their own peril. Former Fed chairman Alan Greenspan says bond yields are like the canary in the coal mine – when the canary faints, you better head for the exits.
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