Bond Market on the Precipice

12/22/2010 10:50 am EST

Focus: BONDS

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

The reprieve from rising interest rates is unlikely to last long, write Pamela and Mary Anne Aden of the Aden Forecast.

Interest rates have spoken, making their big move this month, and it happened very fast. In fact, the recent action could mark the beginning of the end of the mega bond rise that’s been in force for nearly 30 years.

In just a few weeks, the ten-year Treasury yield soared from 2.75% to 3.52%. That’s a huge rise, especially considering that interest rates have been so low for a long time. The 30-year yield was equally dramatic. It surged to 4.60% from 4.25%. Both rates experienced their largest rises in more than two years.

Bond investors know the Federal Reserve’s monetary policies will result in inflation. So demand for bonds has been low, which has driven long-term interest rates higher. The bond market is very sensitive to any inflationary signs, because inflation eats away at bonds’ value. And even though US inflation is still low, that’s unlikely to be the case for long.

The Writing’s on the Cereal Box
Aside from the Fed’s measures, bond investors have seen world food prices climbing for the past five months to a two-year high. And they seem to be losing faith in the Fed, spurring a change in sentiment. This will be confirmed if the 30-year yield now stays above 4.54%, its 80-month moving average. Currently, it’s just above this level.

It’s going to be extremely important to see what happens next. The 80-month average identifies the mega trend of the 30-year yield. The mega trend doesn’t change often. But once it does, the new interest rate trend lasts for a long time.

In the 1950s through the 1970s, for instance, the mega trend was strongly up, and this coincided with the last big inflation. The trend has been down since the early 1980s, coinciding with a period of low inflation. If this changes, it’ll be a huge deal. It would mean that interest rates are going much higher in the years ahead. This probably won’t be obvious in the early stages (like the 1950s).

A Temporary Boost for Housing
Contrary to what many believe, note that the 30-year yield and housing generally move together. As crazy as it seems, if interest rates go up it’ll provide a boost for housing, at least initially. That’s probably because rising rates will be viewed as another sign the economy is recovering, which will further enhance consumer sentiment.

At some point though, rising interest rates will not be good for the economy, stocks, and certainly not bonds. If a mega trend change is indeed on the horizon, bond prices will eventually plunge and you wouldn’t want to be holding debt.

This would also apply to municipal bonds. As we’ve recently seen, they too have been hit along with the Treasuries and this will likely carry into the future, especially considering the sad state of affairs in many states.

Interest rates are headed higher but they’re now near overbought. Rates will probably take a breather at some point before they head higher.

This may take some time. The mega trend must clearly confirm itself. The key is a sustained rise in the 30-year yield above 4.54%, and ideally above 5% to be even more certain that it’s the real deal.

[The Adens correctly anticipated bonds’ recent drubbing, and if they’re right that rates are headed higher still investors may want to consider shorting Treasuries through an ETF recently recommended by Doug Fabian. For more on the implications of the rate spike, see a recent post by Jim Jubak—Editor.]

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