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Is The Government Bond Bubble Getting Ready To Burst? UPDATE #2 >>

Posted by Larry Doyle on May 21, 2009 2:41 PM |

With equities down 2-2.5% on the day, one might think the safety of U.S. Treasury debt would be in vogue. Well, not so. In fact, the Treasury market is BREAKING down as I write this. The 10yr U.S. Treasury note has backed up to a 3.36% rate, which is a full 16 basis points higher on the day. This is a very significant move. What’s happening?

Well, let’s revisit my original commentary on April 30th and my subsequent update on May 7th.

What has changed today from then? Very little aside from S&P putting U.K government debt on watch for potential downgrade. Can the U.S. be far behind?

The demand for credit by global governments is swamping the market. If equities go up, down or sideways, I think U.S. Treasury 10 year notes are headed to at least a 4% rate and potentially much higher. (They started the year at approximately 2%, so they have already gotten pummeled).

Please recall that U.S. Treasury funding needs this year will very likely exceed the debt issued in 2006, 2007, and 2008 combined!! As I see it, the overall delevering process – in which individuals, corporations, and governments need to pay down debt via asset sales or refinance the debt – continues unabated. On May 7th, I wrote:

I have tried to highlight my concerns on interest rates for the entire year. Despite the Federal Reserve “cutting checks” to buy hundreds of billions in U.S. Treasury bonds and mortgage-backed securities, the global demand for credit (meaning global governments, companies, and municipalities issuing MASSIVE supply of bonds) is driving rates higher.

As I wrote in my post from April 30th, the U.S. Treasury market has been faced with underwriting tens and now hundreds of billions in government debt on a regular basis. The 30yr government bond auction today was not well received and interest rates have moved higher by 10-20 basis points (.10 to .20%).

What are the implications of higher rates?
1. Increased cost of financing the deficit.
2. Upward pressure on other rates, primarily mortgage rates.
3. Longer time for economy to improve given higher interest costs.
4. Given the massive global government deficits, the access to credit for private enterprise is negatively impacted. This is known as crowding out.

As I referenced the other day, “We Still Have To Pay The Bill.”

Bloomberg reports, Treasuries Tumble as Bond Sale Draws Higher Than Forecast Yield.

From my piece at the end of April:

The equity markets have rebounded significantly over the last seven weeks. The Dow and S&P are now down approximately 4-6% on the year. The tech heavy Nasdaq has distinguished itself and is up approximately 10% on the year.

At this juncture, if the equity markets are implying that the economy will not slip into Depression, then the bill for the stability in equities is being transferred to participants in the bond market. Government bonds are facing an almost weekly avalanche of tremendous supply. This week the market is absorbing over $100 billion in 2yr, 5yr, and 7yr Treasury securites. Take a deep breath and next week the market is faced with over $75 billion in 3yr, 10yr, and 30yr government securities. The Treasury is likely going to sell 30yr government debt on a monthly basis!!

The Federal Reserve has been the biggest buyer of Treasury and mortgage-backed securities. The Fed’s balance sheet may be large but it is not endless. What have 10 yr. Treasury securities done on the year? Even in the face of massive buying of these securities by the Fed, the 10yr has backed up almost 1% to a current level of 3.1%. That rise in rates is very significant.

I have maintained and continue to maintain that interest rates will move higher given the overwhelming demand for funds by global governments to pay for deficit spending. Central banks around the world may try to hold the respective bond markets up and interest rates down but investors will continue to demand a higher rate of interest in the process.

As government rates move higher, mortgage rates, and other corporate rates will likely move higher as well. If we get a whiff of early signs of inflation which I believe is coming these rates could ratchet higher and the bubble in the government market would not merely burst but would actually explode.

Having fewer banks on Wall Street means larger slices of the profit pie for those still standing. However, having fewer banks also means lessened liquidity and risk-taking overall. Bigger deficits mean higher rates which lead to a slower economy and longer recovery period. Turbo-Tim, Big Ben, and Barack need to factor that dynamic into their economic equations. Principles of Economics 101.


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