Speculating on the End Game for This Cycle

Interest rates are the hot topic once more. The pressing question: when will the Fed hike rates?

Inflation chatter has been in a bull market of late, and the bond market is again focused on the risks. The benchmark 10-year Treasury yield is roughly 4.2% as we write, up from March 17’s 3.3%, which wasn’t far above the generational low of 3.07% set back in June 2003.

The run in yields should surprise no one in a world where prices of commodities–food and energy in particular–have surged. But the fixed-income set, for all its current fears, hasn’t been a reliable and steady barometer of pricing worries. That’s not entirely odd, since bond prices (and their yields) are subject to two key drivers that are often in conflict, and the influence of one or the other waxes and wanes.

The first might be called the run-for-safety factor. In times of financial and economic stress, Treasuries and other high-quality bonds are seen as a safe harbor. When investors are fearful, running for cover in government bonds is a popular strategy. But the urge to seek financial safety competes with the fear that the safety will come at the price of owning an inherently low-return investment that gets sideswiped by inflation.

No one expects to get rich holding Treasuries, although that limitation is enhanced by the assumption that one can’t lose money in governments bonds. While that’s true in nominal terms, it’s not always so after subtracting inflation, i.e., calculating real returns.

Consider that the Lehman Bros. Government Intermediate index posts a 3.49% annualized total return for the five years through May 31, 2008, according to Morningstar. Slim to begin with, but it’s far slimmer once you realize that inflation (measured by the Consumer Price Index) rose by an annualized 3.09% over that stretch.

The real return may very well be negative for Treasuries in coming years, depending on what inflation does. That leads to the question: Does the current 4.2% compensate for future inflation? The fact that inflation (a la the CPI) over the past year through May also happens to be higher by 4.2% surely raises some doubts about how to answer.

The good news is that the bond market seems to be on board with the idea that inflation may yet climb higher before the central banks of the world muster the backbone to fight the threat. In other words, sellers have the upper hand in the bond market these days, which is why yields are climbing. For strategic-minded investors with cash to invest, the prospect of purchasing Treasuries at higher yields brings hope to an otherwise gloomy market aura. Even so, this editor still prefers to see higher yields before making a serious commitment to Treasuries.

For what it’s worth, our view is that fear is still rising in the capital markets and will reach a level that we haven’t seen so far in the correction that’s been unfolding since last summer. It seems to us that the many have held out hope that what has been happening over the past six months was just a minor bump in an otherwise intact bull market. As the evidence mounts to the contrary, investors are seeing the light and paring back risk exposures.

In the stock market, the S&P 500 is off roughly 14% from last October’s all-time high, although compared with October 2006 the market’s flat. As the markets fall, we’re inclined to buy, although what would really whet our appetite for ratcheting up asset allocations in stocks and bonds would be a sign of capitulation in the markets. So far, we haven’t seen that, although we expect that the white flag will go up later this year, or perhaps early in 2009.

The catalyst for this capitulation, we speculate, may be when the world’s major central banks bite the bullet and begin raising interest rates in something approaching a concentrated action. But that’s still a ways off. In the U.S., the political season is in high gear and the idea of raising rates may be a non-starter near or after the November elections.

In Asia, meanwhile, there are growing signs that rates need to rise, as a Financial Times story today reminds. Real short-term interest rates in a number of key Asian countries are negative, as they currently are in the U.S. That’s fine for a few quarters, but it’s a monetary profile that no self-respecting central bank can long tolerate. But for a number of reasons, rate hikes aren’t imminent.

We’re convinced, however, that after a few more months, the central banks will see the light and do the right thing. Commodity prices can’t be allowed to rise unfettered. A bit of demand destruction is needed to reign in the bull market in oil and other raw materials, and it’s up to the central banks to make the tough decisions on this front. No doubt, when that time comes later this year, or perhaps early next year, many investors will run scared when the news hits the streets. That will be the time to pick up asset classes on the cheap. Meantime, we’re watching and waiting.


Originally published at Capital Spectator and reproduced here with the author’s permission.

One Response to "Speculating on the End Game for This Cycle"

  1. akmi   June 23, 2008 at 6:40 pm

    My guess is yields will fall in an intensified flight to safety bid after US retail sales slump after the tax rebates wear off and commodity prices corrode private spending. Once US retail sales join the parade of economic negatives, then perhaps commodity prices will fall, ameliorating inflation expectations. If they don’t fall, then inflation will further crimp consumer demand, pushing us deeper into a recession. Either way, the US doesn’t win and Treasury yields will fall in the flight to safety and stay overvalued in terms of real yield until a sustained recovery is underway.