Have Treasury Bonds Peaked?

01/20/2009 11:00 am EST

Focus: BONDS

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

Mary Anne and Pamela Aden, editors of The Aden Forecast, say interest rates are at record lows, and Treasury bonds look very overbought.

The Federal Reserve literally slashed its interest rate to the lowest level ever. The official [federal funds] rate is now zero to 0.25%, making it the lowest rate in the industrialized world. That’s right: US interest rates are now lower than rates in Japan! 

Treasury bills, which are the most liquid, have been in greater demand than Treasury bonds. This is amazing, considering that T-bills are still paying no interest, but again, it clearly illustrates how nervous global investors are.

And there’s good reason for this: More jobs were lost in 2008 than in the past 63 years, and home prices recently experienced another record drop. As you’d expect, this is affecting consumer spending, which is suffering its biggest slump in 66 years. Retail sales are basically following home prices. That is not good news, because if consumers aren’t spending, it’s going to prolong the recession.

Making matters worse, the US is up to its eyeballs in debt. So, of course, people aren’t spending, which means that the government will have to do all the spending, and that’s what it’s doing.

But now that the Fed has dropped its interest rate to near zero, pumped trillions of dollars into the banking system, and it’s bailed out so many entities that we’re beginning to lose count, its options are running thin.

Nevertheless, the Fed says it will use all of its available tools to contain the financial crisis, with the next step being buying Treasury bonds. This will add more reserves to the banking system, fueling even greater money creation. That, of course, will be very inflationary, looking over the valley once this recession has run its course.

The very early stages of this shift may just be getting started. The ten-year yield has collapsed and it’s extremely oversold. At the same time, bond prices have soared and they are at the most overbought levels ever. This tells us that bonds are now headed lower and interest rates are going higher—perhaps not quickly but rather steadily higher.

In fact, that’s what’s been happening in recent weeks, and we expect these moves have a lot further to go, especially since these markets reached such extreme levels. This could be in response to a general feeling that the crisis is not going to get worse, optimism over Obama, the willingness to take on a little more risk, too much supply, less demand for safety, concern about future inflation, and so on.

Whatever the reason, it looks like the days of soaring bond prices are over. As you know, the huge surge at the end of 2008 was in reaction to the global financial meltdown and it was a panic spike. If you have bonds, continue to hold them for now. They’re still a good investment, and they probably will be as long as the economy remains weak.

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