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Second Stimulus Speculation Submarining Bonds and Supporting Gold

Posted by Larry Doyle on November 3, 2009 3:09 PM |

What are the biggest stories in the market today? Consider the following . . .

1. Warren Buffett makes his single largest acquisition ever with the $34 billion purchase of Burlington Northern

2. Ford posts surprisingly strong auto sales

3. Royal Bank of Scotland becomes the biggest banking bailout yet with another injection of capital

4. Johnson & Johnson announces plans to layoff 7% of its global workforce

Each of these developments is truly meaningful. Interestingly enough, numbers one and two are decidedly constructive while numbers three and four are clearly quite bearish about global prospects. Despite the magnitude of these stories, in my opinion, they pale in comparison to developments in the precious metals and bond markets today. What is happening? Let’s navigate.

The Treasury yield curve is steepening dramatically today with yields on longer term notes and bonds rising by 6 to 8 basis points, while shorter maturities are unchanged. A snapshot of the Treasury market is provided by WSJ Market Data.

Why is the curve steepening? What does that mean? What are the implications for other markets? All great questions. Let’s navigate further.

In my opinion, the Treasury yield curve is steepening as hints of a second economic stimulus package work their way through Washington. I definitely sense growing unease and anxiety over the state of the job market. The story about layoffs at Johnson & Johnson only adds fuel to the fire.

A second stimulus will only build upon the already out of control fiscal deficit which will need to be funded by increased government borrowing. As our borrowing needs increase, the demand for the funds will drive the price for the funds ever higher. The price is the interest rate on Treasury notes and bonds.

Why would the curve be steepening, though? Why aren’t rates on short maturity bills and notes also going up in sync with the longer term notes and bonds?  The rates on shorter maturity Treasury bills and notes is most heavily influenced by Federal Reserve policy. It just so happens Fed governors are meeting today and tomorrow and assuredly they will leave their current policy unchanged. That policy is one of very easy money with a Federal Funds rate of 0-.25%.

The prospects of (1) another economic stimulus package; (2) a continued policy of very easy money supported by an accomodative Fed; and (3) a steepening curve with a rise in long term rates, all collectively point towards a greater likelihood of inflation. What segment of the market gives us a hint as to inflation? Gold.

What is gold doing today? Rallying in a big-time fashion. Gold is up 3% on the day as Bloomberg reports, Gold Climbs to Record as India’s Central Bank Buys IMF Bullion:

Gold jumped to a record after India’s central bank bought 200 metric tons of the metal from the International Monetary Fund, heightening speculation that there may be more official purchases.

Gold futures for December delivery rose to a record $1,087 an ounce on the New York Mercantile Exchange’s Comex unit and traded at $1,084.20 at 1:28 p.m., up $30.20, or 2.9 percent. A close at that price would be the biggest gain for a most-active contract since March 19.

“This will encourage other countries and other investors, especially Indians, who are big buyers anyway, to jump into the market,” said Leonard Kaplan, the president of Prospector Asset Management in Evanston, Illinois.

The Reserve Bank of India paid $6.7 billion for the bullion, which it bought from Oct. 19 to Oct. 30. It was “the biggest single central-bank purchase that we know about for at least 30 years in such a short period,” said Timothy Green, the author of “The Ages of Gold.” “The only comparable event was the U.S.’s steady purchases in the 1930s and 1940s.”

Now what was going on back in the 1930s that would have prompted steady purchases by the U.S. government?

Oh, no. I’m not going there. That thought is a little too ‘depressing.’

What do you think?


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