Distant Early Warning

posted on October 18th, 2008 filed under: Real Estate News

The U.S. has enjoyed decreasing borrowing costs for 25 years, ever since the Fed under Paul Volcker slayed the inflation dragon.  Inflation worries were stoked in the past year as oil and commodities spiked, and Volcker himself emerged to warn that the Fed was behind the curve.  Now he doesn't look so clairvoyant, as oil and commodity prices have collapsed and fears have swung from inflation to a deflationary Second Great Depression.

As the Fed and Treasury have waged all-out war against the financial crisis over the past month, yields on long-dated Treasuries have risen significantly.  Just a fluctuation, perhaps.  But a couple of the investment world's most well-known voices recently sounded a warning about the health of the 25-year-old bond bull.  Jim Rogers declared U.S. bonds to be the last bubble yet to pop.  And Julian Robertson said his favorite trade right now is a "curve steepener" — a bet that long-bond yields will rise while short-term yields stay low.

The possibility of a bond bear — falling prices and rising yields – might strike fear into the hearts of equity investors.  The higher the yield on guranteed government debt, the harder it is for stocks to compete for investors' dollars.  Falling prices and rising yields fed the great bear of the late '60s to early '80s, while rising prices and falling yields fed the great bull of the '80s and '90s.

Is a great bear for bonds ahead?  Are we headed for that '70s show?  Let's compare.

In the '70s, inflation clearly broke out to the upside.  This time it has not, at least by official measures.  (It is possible that the books are cooked, see www.shadowstats.com.)



Fed policy reflects the eternal inflation-recession cycle.  They raise rates to ward off inflation, then lower rates to deal with the resulting recession.  On this score, the current pattern resembles the mid-'70s.



And what about the longer-term rates that Rogers and Robertson expect to rise?  The 10-year yield (for which data go back furthest) rose from the early '70s right through the devastating 1974 recession, and did not relent until well after inflation turned down.  Even then, yields made a tellingly higher low before climbing again toward their dizzying peak in the early '80s as inflation returned with a vengeance.

At present, there is absolutely no sign of that pattern.  To the contrary, yields remain extraordinarily low.



Keep in mind that the pattern of higher lows in the '70s was part of a much longer trend, stretching from the early '50s to the early '80s, as shown below.  We're way down the back face of that mountain, and it's hard to imagine yields can go much lower than they have already gone.  But have we reached an inflection point?


Whether Rogers and Robertson are right will require more evidence than we have so far.  At a minimum, a few significant higher highs and higher lows need to be established.

Even if that happens, it is an open question whether the stock market will face serious headwinds.  The stock market did very well, thank you, during the '50s and much of the '60s – the first half of the last secular rise in yields.

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posted by // This entry was posted on Saturday, October 18th, 2008 at 4:52 pm and is filed under Real Estate News. You can follow any responses to this entry through the RSS 2.0 feed.

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