Monday, July 02, 2007

Bond market update & outlook

According to Bloomberg News, the current turmoil in the debt markets arising out of the recent subprime and CDO mess is benefiting Treasury bond prices.

In fact, their recent article on Bear Stearns' effect on the treasury market even goes so far as to say that Treasury investors should be thanking Bear Stearns for "smothering the bear market" in bonds.

Here's why:

Traders who cut their holdings of U.S. government debt just a few weeks ago as retail sales increased and job growth accelerated are now snapping up Treasuries. Demand is being fueled by speculation that losses at hedge funds owning subprime mortgage bonds such as those managed by New York-based Bear Stearns and London-based Cambridge Place Investment Management LLP will spread and slow the economy.

The article goes on to detail past instances in which panic among investors and speculators has led to a "flight to quality". These periods of panic and risk reassessment are usually brought on by the sudden failure of a large investment fund, a catastrophe, or threats of war and geopolitical strife.

Indeed, subprime worries are not the only reasons being offered
today as bond prices rally. As Reuters explains, government bond prices remained firmly higher today due to security fears in Europe and the Middle East.

U.S. Treasuries rose on Monday, sending 10-year yields below five percent for the first time since early June, as global bonds rallied on recent security worries and shrugged off strong U.S. factory data.

Traders said attempted car-bomb attacks in London on Friday, Saturday's attack on Glasgow's airport in Scotland, and the killing of seven Spanish tourists and two Yemenis in a blast in Yemen kept a constant bid in the Treasury market.

Now that we've heard the explanations for the short-term movements, let's move on to the larger question. Is the bear market in Treasury bonds likely to be over ("smothered"?) due to the recent flight to quality in the debt market?

In my non-expert opinion, I would have to say no, this is not an end to a bear market in Treasury bond prices. If anything, we are closer to the beginning of such a move. Why?

Interest rates are very likely to go higher over the longer term, and the cycle towards higher interest rates (and higher inflation) has only been in force for the past two or three years.

The last big interest rate cycle in the West was the 1981-2003 downward trend in US interest rates which coincided with the twenty year-long bull market in bonds (I believe that's how people now refer to the period).

The next long term cycle is therefore likely to be a long-term rise in interest rates and a longer-term bear market in bond prices. Anything happening now is probably a short-term distraction from the bigger picture trend.

But the main thing to point out is that, whether I'm wrong or right on my forecast, we have to appreciate the importance of separating the shorter-term movements ("noise") from the structure of the longer-term trends.

While the event-driven moves make headlines on a day-to-day basis, we have to distinguish them from the greater overall picture and put their importance into the proper perspective.

Of course, if your investment or speculation horizon is much shorter, and short-term events take a dominant share of your attention, then these longer-term considerations may not mean much to you. But to those who are looking out to the farther horizon, these distinctions are important to make.