Bonds Have Jumped the Shark

11/16/2010 12:30 pm EST

Focus: BONDS

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

Pamela and Mary Anne Aden, editors of the Aden Forecast, warn that the rise in interest rates has only just begun.

The big concern [with quantitative easing by the Federal Reserve] is this: The US finances its debt by selling Treasury bonds. So, the Fed is now becoming one of the biggest buyers of US debt. The Fed buys these bonds with money it basically creates. This is called monetizing the debt and it has many repercussions. A weaker US dollar and higher inflation, for instance, are two important effects.

In this case, however, the amounts involved are way beyond anything ever seen before. This is uncharted territory, and that’s why countries like Germany, China and Brazil are criticizing the Fed’s actions. They know it’s over the top, and at this point, no one really knows how the final outcome will evolve.

For this reason, the 30-year yield is rising strongly. It’s not only leading the way for other rates, but it’s also a strong sign that the bond market sees inflation ahead. As we’ve often mentioned, inflation is the bond market’s worst enemy.

Bond investors are nervous. And guess who owns the most US bonds in the world? It’s China, which explains why their criticism over US monetary policy has become more frequent. And they’re taking action. For the first time, China has invested more in hard assets this year than in US bonds. They’re buying copper, iron, and commodities in other countries. Rather than focusing on the US, they’ve been diversifying into other currencies, countries and products, and it looks like this trend will continue over the long haul.

This tells us that the smart money is slowly moving toward the exits. The Fed says they’re going to keep interest rates low. That’s fine, but the Fed can’t control the massive bond market. If [bond investors] feel the risk of holding bonds has grown, they’ll drive long-term interest rates higher. Rates will have to rise to make bonds more appealing, which now appears to be taking place.

The 30-year yield has been bottoming in recent months. This month, it rose half of [a percentage point], which is a big jump considering interest rates are so low.

We believe this is just the beginning. If the economy starts picking up steam as the markets are indicating, combined with the Fed’s inflationary monetary policies, [rates] could go a lot higher. The real test will be the 4.55% level on the 30-year yield. That’s the 80-month moving average, and it has identified the mega-interest-rate trends going back to the 1930s.

The rate is still below this level (it closed Monday at 4.41%—Editor), but that’s the most important number to be watching. If the 30-year yield eventually rises and stays above 4.55%, it’ll mark a whole new inflationary ball game.

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