Revolt of the Long Bond

Adam Hamilton    May 18, 2001    4505 Words

“Bond.  James Bond.” 

We suspect that most of the citizens of the first world today would instantly recognize those famous words spoken by Ian Fleming’s debonair British super-spy.  The marvelous James Bond character has been a fixture of adventure fiction for decades and a plethora of classic movies has emerged from Fleming’s (and later John Gardner’s and Raymond Benson’s) incredible books.

One of the most excellent attributes of James Bond is his unshakeable coolness under pressure.  Whether suspended above a shark-infested death pit in some evil billionaire tycoon’s lair, strapped to a table while a laser beam moves to cut him in half, or single-handedly recovering a stolen nuclear weapon from some malevolent organization, James Bond is always cool and always under control.  Bond is also mysterious and alluring, a man most guys would love to be and most women would love to be with.  He lives a life of adventure, marches to his own drummer, is a leader, and always comes out of any situation hyper-successful.  James Bond is a fictional icon of our modern age.

In many ways, the financial bonds of the investment world have similarities with the dashing James Bond of the fictional realm.

Like James Bond, the bonds of the investment world are also usually rock-solid under pressure.  The global bond market is immense, and bonds are among the most difficult market in the world to influence, even if one is a very large player in the world markets.  Bill Clinton was reportedly told when he became President that the global bond market could exact a veto on any of his economic policies and the performance of the US economy depended a great deal on the bond markets.  Clinton reportedly swore and became agitated at the revelation, but he gradually came to realize it was true.  The bond market is simply gargantuan and has a monstrous effect on virtually every economy on the entire planet.

In contrast to the mammoth bond market, the vaunted Dow Jones Industrial Average is comprised of only 30 stocks.  Anyone with a few billion dollars to burn can move the Dow dramatically at will, as strategic purchases or sales need only be made in a fraction of the 30 blue chip stocks and the index will follow the money around like a little puppy on a leash.  A few billion dollars in the bond market, on the other hand, is a trivial amount of money and ultimately chump change.  Bond markets are so hefty that they are almost impossible to influence.  Like James Bond, the bond markets do their own thing and are not easily bullied around.

The bond markets also seem mysterious and sophisticated to most people, like Fleming’s British super-agent.  Bonds are on the opposite end of the investment spectrum from stocks.  Unlike stocks, you won’t find your neighbor’s 12-year old kid day-trading bonds in his spare time.  Bond traders are almost exclusively professionals or people working for professionals.  The average bubblevision-watching, perma-tech bull, mainstream American investor probably doesn’t have a clue how the bond markets work or what dynamics are at play there.  Tragically, the average investor almost certainly doesn’t even care, even though bonds have a vast influence on global equity markets.

At the most basic level, bonds are not complicated at all.  They are perhaps easiest to understand when contrasted with the equity stocks with which we are all very familiar.

When you participate directly in a stock offering and buy an equity interest in a company, you give the company some of your capital in return for the potential to realize excellent returns from your fractional ownership interest in the business.  Nothing is guaranteed, however.  Although you wouldn’t know it from the mania hype pervading the US equity markets today, stock ownership is very risky.  It is very easy to lose money as an equity investor.  If the business you invested in doesn’t do well, the stock you purchased will eventually drop in price as its fundamentals deteriorate.  If, God forbid, the company in which you bought stock goes bankrupt, you will be the last class of investors to get paid any residual value, which may turn out to be absolutely nothing.  Equity investors have no guaranteed return, face huge risks, and are left holding the bag when a company cannot make it in our hyper-competitive economy and is forced to close its doors.  In order to offset these very substantial risks, equity investors are offered fractional participation in all upside potential if the underlying business grows and thrives.

Bonds, on the other hand, are the antithesis of equities.  Bonds represent debt.  A bond “investor” is more properly called a “creditor”.  A creditor loans money to a company subject to strict terms under a written contract.  In return for putting their capital at risk, the bond creditor is guaranteed a stream of payments from the debtor company.  Every quarter or year a bond creditor receives a cash interest payment from the company that borrowed the creditor’s money.  After a pre-defined amount of time, the bond creditor (we will bow to convention and call them “investors” from here on out) will receive their entire original amount of money loaned (the “principal”) back from the company.  The bond investor faces substantially lower risks than an equity investor, but has to settle with lower potential rewards in return for the mitigated risk.

Payments of interest on bonds, usually due every quarter, are non-negotiable by the company after the bond is created.  No matter how well or poorly a company is doing, it is legally obligated to pay its bond investors their promised payments for use of their capital.  If a company has cashflow problems, it still has to pay its bond investors.  If it can’t, it is forced into a state of “default” and the bond investors can pursue specific legal remedies.  In sharp contrast to an equity investor, a bond investor is first in line to receive payment if a company is forced to declare bankruptcy.  Bond investors accept lower guaranteed returns for lower absolute risk, and equity investors face high risks in the hopes of attaining high returns.

In addition to corporations, many other entities need money so they borrow it on the global bond market.  These other entities include governments, non-profit organizations, cities and states, and virtually every other large entity you can imagine that periodically needs cash injections.  It is almost impossible to overstate the importance of the global bond markets today.

In the current interest rate easing cycle, Alan Greenspan’s Federal Reserve is widely being heralded as the savior of the bull market.  With the Dow Jones Industrial Average smashing through 11,000 like a .50 caliber bullet through a piece of rice paper following the fifth 50 basis point rate cut since January, the conventional “wisdom” is that all is well in the US economy and hence the equity world. 

Do the bond markets concur with this bold assertion?  In this essay we will briefly try to discern what the critical global bond markets think of Greenspan’s almost unprecedented work of the last few months.

Before we begin, however, it is important to understand that bond market prices are determined by supply and demand, just as in any other equity, commodity, or derivative.  When more bonds are demanded than supplied, the bond prices rise.  When more bonds are offered than are desired, bond prices drop.  Simple Economics 101 supply and demand principles are at work in the global bond markets. 

A potential point of confusion must be addressed, however…  Bond prices are NOT the same as bond yields, and in fact bond yields move in lock-step opposition to bond prices.

Imagine a bond with a $1000 price yielding 10%.  Each year the bond investor (creditor) is paid $100 (10%) in turn for their $1000 loan to the bond issuer (debtor).  Now imagine that demand for bonds increases dramatically, and the bond price is bid up to $1200.  What happens to the yield?

As we alluded to above, a bond is a contractual obligation.  The $1000 bond in our example, even though it is now selling in the open markets at $1200, STILL only pays out $100 per year in interest, the 10% yield on the $1000 original face value of the bond.  The market price of the bond has risen, but the underlying contract defining the bond has not changed.  It still pays out $100 per year per the original contract.  BUT, with the bond now selling at $1200, the yield for someone who buys the bond today at $1200 drops significantly.  NOW, the bond still pays out $100, but $100 of interest on $1200 invested is only yielding 8.3% ($100/$1200) after the bond’s price is bid up.

Bond yields, therefore, always move in the OPPOSITE direction of bond prices.  Although professional bond traders often think in terms of bond prices, the rest of the world talks about bonds in terms of YIELD, not price.  We will also focus on bond yields in this essay.

One of the more interesting features of the debt market, which includes bonds, is there is a whole continuum of different maturities on various debt instruments.  One can lend money to a US corporation for a very short period of time, less than a month, or lend money to the US government for 30 years.  Money can also be lent for virtually any time period in between.  There are generally bonds available that can satisfy the time horizon of any bond investor.

ALL bonds, regardless of their maturities, are measured in reference to the bonds issued by the sovereign government of the United States of America.  These bonds are issued by the United States Treasury and are considered “risk-free” investments by the vast majority of global financial market participants.  All US Treasury debt instruments are bonds, but they are technically divided into “bills”, “notes”, and “bonds”.  Short-term Treasury bills, or T-bills, have maturities of less than one year.  T-notes have maturities of greater than one year but less than ten years.  The venerable Treasury bonds have maturities of ten years to thirty years. 

Arguably the most important bonds in the world are the US Treasury bonds that frame the near and far end of this 30 year spectrum, the three month T-bill on the short side and the 30 year T-bond, affectionately known in market circles as “the long bond”, on the long end.

Although not discussed much in the mainstream media, the cumulative effects of Greenspan’s frantic interest rate cuts are greatly illuminated when viewed in reference to the T-bills and the long bond.  Greenspan and the Fed really only exercise control over two key short-term interest rates, the Federal Funds Rate and the Discount Rate.  The federal funds rate is the interest rate US commercial banks charge each other for borrowing money overnight in the federal funds market.  The discount rate is a related and usually higher interest rate that the US Federal Reserve system charges banks for directly borrowing from the Fed.  In this essay we will concentrate on the fed funds rate and its interaction with the 3 month T-bill and 30 year T-bond.

Our first graph runs from January 2000 to mid-May 2001 and shows the federal funds rate graphed with the YIELD on the 3 month Treasury bill.  All data in this entire essay is weekly data obtained directly from the United States Federal Reserve.  The fed funds rate is graphed in the yellow columns and the Treasury rates are superimposed as blue lines.  Greenspan’s incredible machine-gun staccato series of frenzied interest rate cuts of the fed funds rate are outlined by the dashed red circles.  The fed funds rate viewed from the perspective of short Treasury yields is most interesting.

First, it is important to realize that technically the federal funds interest rate is NOT directly set by the Fed, only a TARGET for the fed funds rate is decreed.  Hence the non-conformist yellow columns periodically popping up in the graph above.  The inter-bank market for fed funds sets the actual fed funds rate at any given time, which is close to the Fed target as the Fed tries to actively manipulate the fed funds rate, but it usually is not exactly on target.  If we had graphed the fed funds TARGET above instead of the actual rate, the yellow blocks would be very clean and uniform, but not as reflective of the real-world economic environment.

The hyper-important part of this graph begins at the white arrow.  Notice that the “risk-free” 3 month US Treasury bill yield began to plunge well before Greenspan and his band of merry marauders decided to bailout the over-extended technology speculators.  Interestingly, this macro turn began in late November 2000, which was actually before the December FOMC meeting where the Fed threw its engines into full reverse and dropped its inflationary bias for an economic weakness bias.  You probably recall the mega equity rally in mid-December on the news the Fed thought the economy was deteriorating and might have to begin cutting rates.  Only in the surreal world of Wall Street is bad news considered good if it might lead to a fabled rate cut!

Although many market events could have caused the sharp downturn in T-bill yields before the Fed tipped its hand, we wonder if this marked the beginning of a large exodus of capital from the US equity markets into the relative safety of United States bonds.  One of the primary groups of entities owning T-bills is US money market mutual funds.  A money market fund buys short-term debt instruments like T-bills and is widely considered to be a “cash equivalent” to many investors.  As the NASDAQ continued to crash and burn late last year and the capital sitting in money market accounts swelled, maybe the additional demand for capital refuge in short Treasuries drove up the T-bill price and therefore lowered the yield. 

Whatever the reason it occurred, this sharp trend change in T-bill yields is very important.  As is readily apparent in this graph, Greenspan looks to be simply chasing the T-bill yield.  His three scheduled 50 basis points fed funds cuts and two ridiculous emergency 50 basis point cuts appear to be desperate moves attempting to get the Federal Reserve caught up with the plunging most important short bond yield in the world, the US T-bill yield.  After all, it doesn’t make much sense for an extremely short-term overnight loan between commercial banks to be much more expensive than a three month loan to the US government.

This idea, that Greenspan and his gang are merely playing a desperate game of catch-up with the massive bond market, has potentially huge implications.  A complex mythology has sprung up around the prowess of Greenspan.  His bullish disciples are coming out of the woodwork these days and they zealously proclaim that Greenspan has engineered the legendary “soft-landing”, a fanciful economic concept that was considered all but impossible only 15 years ago.  If Greenspan is simply trying to bring the command-and-control Fed-decreed short rate in line with the free-market determined T-bill yield, maybe he really HAS lost the illusion of control of the US economy.  Is the short-term bond market forcing Greenspan’s hand?  Why is the Fed way behind the eight-ball as defined by T-bill yields?  These are important questions that all investors and speculators playing the US equity markets should carefully mull over.

One final point from this graph.  It is likely that we WILL see further interest rate cuts as long as the 3 month T-bill yield continues to plummet.  The T-bill yield should be monitored closely by all market participants.

The probable goals of Greenspan’s almost unprecedented interest rate policy actions are simple, to re-liquefy the faltering US economy, attempt to protect the US banking system from a deflationary implosion, and buttress the stock market, which has become incredibly important in the US economy and US consumer confidence game.  Greenspan’s modus operandi is simply to flood the markets with liquidity in the desperate hope the equity bubbles will be ignited once again and the US economy can live happily ever after.

A more aggressive Federal Reserve goal for the rate cuts may also exist.  By slashing short-term interest rates, the Fed is effectively shredding the rates of return on all short-term debt instruments, including the ones held by money market funds.  With money market rates of return dropping dramatically with the Fed largesse, there is a serious possibility that the Fed is trying to strong-arm the cautious US investor sitting prudently on the sideline in “cash”, money market funds, back into the equity markets.  With money market rates of return plummeting from above 5% to around 3% in some cases due to the latest Fed actions, many US investors may decide that money market rates of return are too low so they may jump back into the risky equity markets to try and obtain a higher return on their capital.

Of course, the people who can make or break Greenspan’s latest gambit are the US consumers.  Unlike our hero James Bond who is always in control, Greenspan is at the mercy of the US consumer.  If he can convince the US consumer to spend, spend, spend, US corporations will see their profits recover as consumers buy their wares and the stock market will rise and US economy improve as the consumers spend their way to the rescue of the US economy.

For a lot of reasons, many of which we articulated in our earlier essay “Consumers to Rescue Wall Street?”, we do NOT believe the US consumer has the ability to ride to the salvation of the bulls on a mighty white steed like they are eagerly anticipating.  The US consumer is getting fired and laid off by the millions, consumer debt is at record levels, homes are leveraged to the hilt, stock market “wealth” has evaporated for many small tech investors, and the consumer is simply too overextended to spend money they do not have.

Although most contrarians scoff at the notion of US consumers rescuing the US equity markets in the coming year, the equity bulls still loudly trumpet this idea and it is central to their bullish case.  The action of the 30 year T-bond in light of Greenspan’s fed funds rate cutting extravaganza is VERY ominous, however, and it pounds another jagged wooden stake painfully into the heart of the idea of the US consumer riding to rescue Wall Street.

As in our first graph, the yellow columns are the fed funds rate and the red circles are Greenspan’s frantic 50 basis point interest rate cuts.  The blue line in this case is the 30 year T-bond yield, the “long bond yield”.  Note that when the fed funds rate exceeds the 30 year T-bond yield the “yield curve” is considered “inverted”, and when the long bond yields more than the fed funds rate the yield curve is considered “normal”.  We also plotted the US average 30 year mortgage rate in red, which is absolutely crucial to the fanciful bullish thesis that US consumers will spend the US economy out of having to painfully work off the excesses of the NASDAQ bubble which devastatingly burst last year.

First, please note the lower white arrow.  Midway through the extraordinary series of five interest rate cuts, the bond market revolted and the US T-bond yield quit falling with Greenspan’s rate cuts.  Rather than following Greenspan’s lead and easing, the US long bond yield began to rise quite rapidly after the third 50 basis point rate cut in March.  The blue dashed line marks the apparently major reversal of the T-bond yield trend.  If T-bond yields are rising, that implies that T-bond prices are falling, that global bond investors are persistently selling US long bond debt.  Why?  Before we address this question, let’s jump back to the US consumer briefly.

For the US consumer, there is NO more important interest rate than the 30 year mortgage rate.  Most US consumers choose to borrow money to buy a house, and most borrow money for 30 years.  For those who do use debt to finance their homes today, which is unfortunately virtually everyone, their single largest monthly expense is the mortgage bill.  In order for the consumer to begin spending money they don’t have again en masse, the consumer must have their monthly mortgage bill reduced to gain some additional cash to pump into the sagging US economy.

Of course, a 30 year mortgage increases the cost of a house by many times over the life of the house, as interest payments far exceed the original cash cost of the house.  In the first 15-20 years of a mortgage, interest makes up most of the monthly mortgage payment.  The easiest way to cut down consumer mortgage bills is for mortgage interest rates to be reduced.  If the US consumer is to get the extra cash to bailout the Wall Street tycoons, then their mortgage bills must be reduced via a reduction in mortgage interest rates.

Unfortunately for the perma-bulls and their patron saint Greenspan, the mortgage interest rates have stopped cooperating with the Greenspan gambit of rapid-fire rate cuts.  Other than a small initial reaction to the first emergency rate cut in early January, the 30 year mortgage rates in the US have not responded favorably at all.  The second white arrow above marks this ominous development.  The red dashed line is a hard support level for mortgage rates that has not yet been broken.  It is also unlikely to be broken in the future either as long as the 30 year T-bond yield is revolting against Greenspan’s machinations and heading back north.  Also note that the spread between long bonds and the 30 year mortgage rate is currently at its narrowest point in the entire graph.  Either mortgage rates have to rise soon or else the long bond yield has to fall in order to bring this spread back in line.  Our bet is on the former, as long bond yields have LOTS of good reasons to continue to head higher.

If mortgage rates don’t plummet soon, the already slackening wave of home refinancings that is providing a temporary burst of cash to the debt-laden US consumer will also shrivel up.  Without lower long bond yields and hence lower mortgage rates, the ever-popular bullish prophecy that the besieged US consumer will spend his way to Wall Street’s rescue later this year probably doesn’t have a snowball’s chance in hell of coming to fruition.

Why are bond investors selling long bonds and demanding a higher yield? 

Part of the reason is likely the growing specter of the dreaded “I” word, I-N-F-L-A-T-I-O-N. 

Inflation is DEFINED as a growth in money supply that causes an increase in the general price level of goods and services.  Webster’s exhaustive dictionary, believe it or not, does not define inflation as a rise in the CPI, as the perma-bulls seem to think.  The dictionary says inflation is “a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency.”  An increase in the volume of money, eh?  Our last graph looks at the breathtaking growth of M3, the broad US money supply, since January 2000.

This graph also uses weekly data direct from the United States Federal Reserve.  The black line below represents M3 in billions of dollars, and is slaved to the right axis.  The left axis shows the ANNUALIZED weekly growth rate of M3 for each week in the graph.  Green columns represent increases, red columns the rare decreases.  The bold yellow line is the 5-week moving average annualized weekly growth rate in M3.

As the black line shows, M3 has exploded at a mind-boggling rate over the last 16 months.  From January 2000 to April 2001 (the latest available aggregate monetary data at this writing), M3 grew 13%, twice as fast as the US economy over this whole time period.  From January 2001 to March 2001, M3 rocketed 3.8% while the US economy saw a much smaller 1.3% gain.  A money supply growing three times faster than the US economy is a tremendously inflationary omen, no doubt.

The two white arrows above mark massive spikes in the 5-week moving average of annualized weekly M3 growth around 20%, a phenomenally high rate.  With Greenspan figuratively “running the printing presses” like there is no tomorrow, is it any wonder that the bond market is beginning to see the prospect of huge general price inflation in the US economy as more cheaper dollars compete for relatively fewer scarce goods and services?  Is it surprising that bond traders are selling off long bonds and driving up the yields as they try to avoid the inflationary tsunami Greenspan is spawning?

As we mentioned in opening, bond market players are professionals and NOT rookies.  Unlike the equity investing masses of Americans, bond traders do NOT care what drivel bubblevision happens to be spouting and they are usually not deceived by the constant bullish hype.  Bond players are serious operators who manage vast amounts of capital and they take their duty of preserving and enhancing the capital under their control very seriously.  If the big bond players believe Greenspan’s attempt to shore-up the NASDAQ and flood the US economy with liquidity is inflationary, odds are they will be proven correct.

Unfortunately, the perpetually bullish cheerleader analysts are happily focusing on the lagging Consumer Price Index and Producer Price Index and excitedly proclaiming, “Look!  Inflation is dead!  We told you so!”  The highly intelligent and motivated bond market players, however, fully realize that a necessary precursor to inflation is a sustained ramp of broad money supplies that far outpaces economic growth.  Where there is smoke, there is fire, and the bond market players are apparently looking beyond recent heavily hedonized and highly suspect CPI numbers and realizing that the fires of inflation have been stoked by Greenspan’s careless ballooning of the US money supply.

Although early, by all initial appearances it appears the long bond has launched a devastating revolt against Greenspan’s and the equity perma-bulls’ desperate fantasies of re-inflating a collapsing equity bubble for the first time in history.  Like James Bond in Fleming’s espionage masterpieces, global bond markets march to the beat of their own drummer and they are virtually impossible to tame.  Maybe the bond markets are unilaterally vetoing Greenspan’s frantic monetary policy.

The bond markets are far beyond important in the global financial marketplace, and we believe all prudent investors and speculators should be carefully monitoring the long bond yield to see if the bond traders are going to tow the party line and play Greenspan’s game or if they are calling Greenspan’s macro inflationary bluff.

If the bond markets choose NOT to play along with Greenspan’s last-ditch inflationary gambit, the New Era mythology, the US consumer, and the US equity markets are approaching a world of hurt.

Adam Hamilton, CPA     May 18, 2001     Subscribe