More on US Treasuries

The picture below tells the story. US 10 year bonds have been sold off sharply pushing the yield 0.5% higher in a little under a month.


Why? Well firstly as noted previously the usually strong demand for US treasuires has weakened as emerging nations such as China, Brazil and Russia look elsewhere for higher yielding assets and diversification.

Secondly strong global growth is stoking the flames of inflation. Interest rates are on the rise everywhere, the EU hiked recently, China and the UK are in tightening mode as is Japan albeit from very low levels. New Zealand hiked last week to 8% and the odds of a rate rise in Australia before the year is out are firming.

Thirdly the deterioration in the sub-prime lending market is forcing managers of portfolios of mortgage-backed securities (MBS) to sell off Treasurys to hedge their weakening loans. This, in turn, feeds on itself. As yields go up, the managers of MBS portfolios have to adjust their hedges. That is they have to keep selling Treasurys. Remember the graph of mortgage resets I posted a week ago? Clearly the MBS portfolio managers will be feeling some selling pressure for a while yet.

Also let's remind ourselves of a little economics 101. When the 10 year bond yield trades below the fed funds rate clearly the market is anticipating interest rate cuts. In the past 18 years the 10 year bond yield has dipped under the Fed funds rate just 3 times. Within 6 months of that dip a rate cut ensued. The 10 year yield has been below the the Fed funds rate now for more than 10 months and with renewed signs that inflation is on the creep the market has changed it's view of the short term direction of interest rates.

If we see more evidence of inflation picking up you can expect bond yields to rise to around 5.4% as the market prices in a rate rise. With housing still in the doldrums, rising gas prices, a whiff of inflation and the current quarter likely to show the most sluggish earnigns growth for a few years there is little positve news on the horizon for stocks.