Good Evening: After months of seeing equities get most of the headlines, the Treasury market has elbowed its way back into the spotlight during the past week or so. Today this attention reached a fever pitch, as yet another steep drop in long dated government bond prices finally started to impact not only the wire services but also the stock market. Until today, equity investors viewed the Fed’s attempts to control various interest rates with little interest and even less concern. No more. Rising rates of interest for Uncle Sam mean a higher mortgage rates, a rising budget deficit, and a threat to any nascent recovery in the housing market. In short, the green shoots are at risk of being trampled, and investment decisions will only get tougher as 2009 progresses. Investors might be best served by investments that benefit from uncertainty itself.
Wednesday started innocently enough, with the only economic data points more or less matching expectations. Mortgage purchase applications rose a tad, though refinance applications did take a tumble during the latest reporting week. This piece of news was taken as no more a threat than North Korea’s announcement that it would henceforth ignore the 1953 armistice ending the Korean war. As for equities, Monsanto disappointed its shareholders with a lower full year outlook, and GM announced that its debt for equity swap proposal was doomed. That GM is now likely to enter some form of bankruptcy should come as a surprise only to those investors who willingly suspend their disbelief, and I believe the GM news had little, if any, effect on today’s outcome.
Analysts and economists also tried to dismiss the existing home sales data as unsurprising, but a peek beneath the surface reveals otherwise. Though existing sales rose a bit and just about matched consensus expectations, the source of the small uptick in volume was troubling. As BAC-MER points out in their piece below, volumes were boosted by foreclosures, and the supply of unsold homes actually rose. More worrisome, at least for Jim Cramer and others who expect a bottom in housing any day now, is that the April figures were flattered by low mortgage rates. The huge drop in bond prices over the past week and the accompanying rise in mortgage interest rates bodes ill for future home demand. BAC-MER economist, Sheryl King, says, “So far in May the numbers suggest the upturn in sales has stalled-out as, mortgage rates have edged higher and mortgage applications for purchase are down 2.4% compared to the April average”.(source: BAC-MER piece below)
Higher interest rates may unravel hopes for a bottom in housing, but these concerns were nowhere to be seen as stocks opened for trading in New York. After opening near the unchanged mark, most of the major averages stayed within shouting distance of yesterday’s close until just after lunchtime. The notable exceptions were a beta-chasing 1% gain in the NASDAQ, and a slow leak of equal measure in the Dow Transports. The Treasury then announced the results of what turned out to be a decent 5 year note auction, but it didn’t stop longer dated government securities from falling further. Nor did it matter that Moody’s affirmed the U.S.A.’s AAA rating (see below). The 10 year note yield spiked 17 basis points by day’s end, bringing the yield on this benchmark security to 3.72% (see chart above). As you can see, today’s closing yield compares to just over 2% in December and 3.2% just last week. Confirming the growing concern among long term Treasury investors, the spread between 2 and 10 year notes widened to a record 275 bps (according to Bloomberg; see below). And the final ignominy on the interest rate front belongs to mortgage rates, which, despite large mortgage purchases by the Fed, have now risen an unscripted 50 bps or more during the past six trading days. Bernanke and company may convene to consider additional purchases, but what they may well decide is that they are trapped.
The increasing burden of these higher rates finally caused equity investors to sit up and take notice this afternoon. The S&P 500 dropped 1.5% from its high in the early afternoon, pausing briefly to test support at the 900 level. When that support gave way late in the session, the S&P fell a further 1% to close with a loss approaching 2%. The damage to the other indexes varied, with the NASDAQ losing only 1.1%, and the Dow Transports shedding almost 3%. The carnage in the bond market left currency traders a bit perplexed. Would falling bond prices cause investors to shun the dollar, or would higher interest rates attract them? This conflict was resolved by a smallish gain in the greenback. Commodities were surprisingly unruffled by all the motion in the other markets. Precious metals were mixed, but new post-panic highs in crude oil helped the CRB index post a modest gain of 0.4%.
During most of the 1980’s and 1990’s, the so-called bond vigilantes ruled the Treasury market. The Fed may have kept either money supply or short rates on a tight leash during this period, but large institutional investors (think: PIMCO, et al) would shun longer dated Treasurys if growth spurted, if inflation perked up, or if the politicians monkeyed too much with the federal budget. When inflation was later deemed to be conquered and when our nation’s budget deficit briefly went into reverse ten years ago, this breed of bond investor went on extended leave.. Given the savage beating the Treasury market has taken in recent months, it appears the bond vigilantes are back at their posts. One of the original vigilantes, Bill Gross, seemed to issue a call to arms only last week when he described the potential funding perils facing our government. If so, shouldn’t we all just become vigilantes ourselves and load up on shares of the TBT, the “ultra-short” Treasury ETF?
Given my previous rants about the structural mess we’re getting ourselves into with all the massive bailouts and Treasury issuance, readers may be surprised when I say “no”. The TBT and all the other “double” and “triple” exposure ETFs are not proper investments. They are rank speculations, and they tend to track poorly over time. Plus, I think there’s a chance that both Treasurys and the U.S. dollar enjoy a short term bounce before the week is out. The TBT has been on a one way tear higher lately, and today’s volume pushed past 10 million shares (by way of comparison, the volume was less than 1 million per day until 6 months ago). It’s simply been too easy to make money being short government securities in recent days, and the fact that Bloomberg was plastered with bond market stories today tells me the short side is getting crowded. I’m NOT saying Treasurys are a good long term investment at these levels, and I truly believe we face funding issues on the horizon. But I am saying that TBT longs are at risk if bonds find a bid later this week.
If I’m wrong, and Treasurys continue to sink, then equities will likely follow. Rising long term interest rates will stifle both the economy and corporate profitability. So what’s an investor to do in this dicey environment? Rather than messing around with leveraged ETFs, investors who worry about a potential funding crisis and other less than happy outcomes would be better served buying precious metals and the companies that mine them. These investments, too, can suffer nasty spills from time to time, but I see them as a lower risk way of investing when facing uncertain outcomes. If Treasurys keep heading south until chaos reigns, then gold itself should shine. If all the stimulus should somehow work and the economy recovers, then stocks will rally and carry the miners with them (especially if inflation perks up). My point is that we don’t know what will happen next. Since the precious metals and their equities benefit from uncertainty, they are a decent choice for a portion of one’s portfolio. The only way they will really get hurt is if the imbalances disappear and tranquility returns to the global economy. I’m comfortable taking the other side of that trade.
— Jack McHugh
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