|If you don't believe in deflationary risk, you've got plenty of company. Few economists actually believe that deflation is imminent, and most point to the explosive growth in the supply of money as one of many reasons why inflation -- rather than deflation -- is the greater economic threat. These observers, who note also the swelling federal deficit and the unwillingness of the current White House administration to make bold efforts to curtail government spending, see a country -- indeed, a world -- virtually awash in money and credit. The effect of such a huge supply of liquidity -- sanctified by Federal Reserve board chairman Alan Greenspan and his commitment to maintain an "accommodative stance" with regard to monetary policy -- is believed to be the harbinger of inflationary pressures, not deflationary risks, in conventional economic wisdom. |
Further, because it is believed that the government will do everything in its power to prevent deflation, many observers decided that this "will to inflate" is so powerful in and of itself that deflation — by which I mean not merely falling prices, but a falloff in the supply of money and credit relative to demand for it — is simply not possible. The Wall Street Journal, in an editorial titled "The Seinfeld Deflation," went so far as to suggest that the Federal Reserve was using the ruse of deflation as a way to continue to provide liquidity to an economy that is, in the opinion of The Wall Street Journal editorial board, recovering, albeit sluggishly.
Intermarket relationships between stocks, bonds, commodities, and the US dollar are among the more helpful ways of understanding if not deflation itself, then certainly deflation's footprints on the financial landscape. Among these asset groups, the effect of deflationary risk on bonds is among the more peculiar and interesting — and pivotal, given the relationship of the bond market to the rest of the economy. Thus, when PIMCO bond guru Bill Gross announced that the "salad days" are over for bond investors, alluding to a secular downturn in bond prices after more than two decades of bull market, it is worth factoring his observation into the matrix of intermarket relationships between bonds, stocks, commodities, and the dollar to determine whether inflationary or deflationary risk is being anticipated by the possibility of a secular decline in bond prices.
Generally speaking, a declining bond market would seem to imply greater inflationary rather than deflationary risk. Inflation erodes invested principal and interest paid, forcing ever-higher interest rates to compensate for the declining value of the currency.
But it is worth noting how we might get there. The fact is, major bond market players have become so wary of deflation — an event that is particularly harmful for lenders, creditors, and many bondholders — that they have encouraged the Fed's reflation campaign, preferring the "devil they know" (inflation) over the "devil they don't" (deflation).
Paul McCulley, Gross' colleague at PIMCO, has been among those "forcefully" encouraging a campaign of inflating the economy — and not just for the United States, but for the world:
. . . It's a G-1 Keynesian world, with the US spending horse pulling the rest-of-the-world mercantile cart of savings, as represented by America's huge capital account surplus. . . . What the world needs, as I argued . . . last fall, is an outbreak of G-3 Keynesian fever, a coalition of the willing running printing presses and fiscal deficits to support domestic demand, rather than to fund domestic demand in America.
What Gross and McCulley, among others, are saying is that the US should risk a world of competitive currency devaluation ("running printing presses and fiscal deficits") rather than continue on the course of overreliance on American spending and a not-so-strong-anymore US dollar (elsewhere, McCulley refers to it as "investment"; critics might refer to it as "borrowing").
This permanent revolution in monetary accommodation, the reflationists argue, may not be what we have come to expect (nay, demand) for our fiscal and monetary authorities over the past few decades of bull markets. But the alternative — a full-blown deflation with credit tightening and the economy contracting as a result of too little (a) spending, (b) investment, (c) borrowing, (d) all of the above — is far worse. In fact, the reflationists are not even convinced that the choice is between "bad" and "worse." Writes McCulley: "In fact, higher inflation will be the definition of Keynesian success."
Putting aside the question of the government's ability to engineer just enough inflation to restore "pricing power" without causing such a sizable shift that inflationary psychology becomes overwhelming, how will reflationary policies affect bonds? Inflationary expectations tend to encourage higher yields as investors demand more in interest to compensate for what they believe will be the reduced value of the cash paid them.
Thus, if we are entering an era of deliberate reflation, stoking the fires of inflationary expectation until they are hot enough to warm the entire house, then one thing that should be evident is a rise in bond yields and a major top in bond prices.
WHEN YIELDS FIND A FLOOR
The recent plunge in yields on the 10-year Treasury note seemed to grab the attention of those who feared that bond prices knew no upward bounds. The money market funds of the nation, went the argument, would be imperiled as rates dropped dangerously low relative to the cost of maintaining these funds. Already the eulogies for those funds that would not be strong enough to withstand the onslaught of record low rates (at least since the mid-1950s) began to be read in the financial press and broadcast on the financial networks as commentators opined that the sacrifice of a few money market funds might be worth the benefits of still-lower long-term rates.
But what a difference a yield bounce makes! Shortly after 10-year yields hit 3.08%, they reversed course sharply and began climbing in what was the biggest drop in prices in the Treasury bond market since 1995. Yields soared from 3.08% in mid-June to 4.25% by the end of July. Reasons for the sudden move abound, ranging from the technical ("bonds were extremely overbought") to the fundamental ("stock yields were increasingly competitive with long bond yields").
However, one of the reasons is undoubtedly in Federal Reserve chairman Alan Greenspan's assessment presented to Congress in June. In his opinion, the "nontraditional methods" of providing greater liquidity to the economy — particularly the notion that the Fed would purchase long-term Treasuries — would not be necessary. Instead, in his learned opinion the Fed funds rate mechanism (one that had been deployed with great frequency during the three-year bear market) remained sufficient in combatting economic underperformance and deflationary risk.
THE FED ATTITUDE
That Greenspan assured investors that the Federal Reserve stance would remain accommodative was a no-brainer. But suggesting that the "nontraditional methods" were now off the table, as mentioned by Fed economist Ben Bernanke in the wake of the October 2002 market stumble, was more than bond investors wanted to hear. One day, the Fed was suggesting it would be the wind beneath the soaring bond market's wings, only to retract it the next day. So with bond prices at historic heights, bond traders and investors did what any smart trader or investor would do: they sold — hard and fast.
Figure 1: Yields on the 10-year Treasury note. Yields appear to have bottomed in the second quarter of 2003.
This selling must be seen not only in the context of the current reflation campaign — one that began, by most accounts, in autumn 2002. The effects of this campaign were understandably blurred and muted at first, due to the buildup — psychologically and physically — for the looming war in Iraq. But note that the Nasdaq responded sharply in October 2002 and did not suffer the March 2003 declines to nearly the same extent that the larger-capitalization Dow Jones industrials and Standard & Poor's 500 did.
While much of this selling was a response to Alan Greenspan's refusal to declare a new "Greenspan put" for the bond market, it was also part of a growing sense that — whether or not stocks are in a new bull market — government bonds from an increasingly free-spending government (arguably necessarily free-spending, per the reflationists) are simply not a worthwhile investment at 3%.
What is ominous from the point of view of the bond market itself is the answer to the qestion: At what yield are 10-year Treasuries a good investment? Unfortunately, the answer, in part, is: how much (a) spending, (b) investment, (c) borrowing, (d) all of the above is the government preparing to do?
THE MOTHER OF ALL TOPS?
The secular bull market in bonds over the past two decades has equaled, if not rivaled, that of stocks. This should not be surprising. One of the tenets of intermarket technical analysis as revealed by John Murphy is that in an environment characterized by the early stages of unwinding inflationary psychology, bond prices will lead stock prices higher.
When it comes down to it, bonds are more key to the operation of a free market economy than are stocks. Bonds are the way that governments do business, the way that people buy homes, and are the primary way that corporations borrow money to grow. Insofar as bonds — and government bonds in particular — represent the stoutest soldiers in capitalism's army, it is fitting that they not only led the charge during the secular bull market's daunting early years in 1981 and 1982. In addition, they are possibly showing themselves to be the last, stalwart warriors to fall in 2003, as the secular bull market in financial assets gives way to the bear.
Figure 2: Prices of government bonds across the yield curve have been in a multidecade bull market. Here are prices on five-year Treasury notes.
Looking at charts of government debt from five-year notes (Figure 2) to 30-year bonds (Figure 3) makes this ascent — and the potential for a sizable decline — all the more clear. If there ever was graphic confirmation of the assessment by PIMCO's Bill Gross that the bond market's "salad days" were over, then that graphic confirmation might look something like these charts of government bonds.
Although they have endured their corrections and setbacks — particularly in the early 1980s and mid-1990s — government bonds have clearly had their run. From a technical perspective, what should be particularly alarming to bond investors is the Nasdaq circa 1999-esque parabolic move to the upside that government bonds have experienced over the past two years. It is this last, nearly vertical move that has pushed interest rates to historically low levels and, perhaps, set the stage for a dramatic reversal as the exuberance of bond market investment turned into the excesses of bond market speculation. The ultimate bull market speculation is the recent, failed bet that the Fed would itself begin buying long Treasuries.
Figure 3: The 30-year bond — the benchmark bond during the bull market of the 1980s and 1990s — has enjoyed 20 years of advancing prices and declining yields.
Does all of this point to a bond bust? Many of those who have written about a bond market bubble have looked to Japan, where deflationary pressures — the end game of winning the effort to "unwind inflationary psychology" — has marked the economy for the past several years. With interest rates hovering above zero, Japanese government bonds (JGBs) have been suspended at the far reaches of a bull market that has been widely acknowledged to be a bubble.
However, with the public's appetite for stocks at historic lows, there was nowhere else for money to go but to bonds. The success of global reflation has been such that Japanese equities have been moving up and Japanese bond prices have finally begun to move down. This is particularly true on the part of the Japanese authorities who have chosen not to reform their economy so much as to devalue the yen. Money manager Marc Faber has gone so far as to call Japanese government bonds the "short of the century" — even if the century is only three and a half years old:
The prime beneficiary of reflation could be Japan. There is a very good chance the 13-year bear market in Japan has bottomed. Government-bond yields are now below 0.6% . . . The Nikkei has a higher yield than the bonds. It's almost a no-brainer to buy Japanese stocks and short Japanese bonds.
With regard to bonds in the United States, Faber is among those who believe that yields of 6% or more two to three years from now should not be unexpected with regard to the 10-year Treasury. On this point, the technicals back him up. If the current trading in the 10-year Treasury yield index ($TNX) continues, then it is easy to see 10-year yields consolidating, roughly, between 4.3% and 3.5%. It is even possible to trace out a head and shoulders bottom that could send the $TNX rocketing toward 5.43% in an initial move over the next year.
A 5.4% yield on a 10-year Treasury might be enough to bring new buyers to the bond market. But what will be important are expectations — in this case, expectations that the trend in rising yields on the 10-year will continue. Will buyers at 5.4% be investors or traders? Did those who chose not to buy at 5.4% not do so because they are waiting for 5.9% or 6.5%?
This is not an unreasonable projection. The head and shoulders formation top in the government long bond; the chart formation that extends from October 2002 to the present is perched upon an even larger head and shoulders top that extends back to 2001 (Figure 4). And what can be said of this three-year head and shoulders top in government long bonds? For one, it too is sitting on a larger, potential head and shoulders top — one that extends back to 1997. There is even a strong argument for an even larger head and shoulders top that extends back to 1993.
Figure 4: Four crucial support levels for the 30-year bond may become necklines for bearish head and shoulders tops if bond buyers' demand for yield increases significantly.
Declines suggested by the various tops in the bond market going back over the last 10 years point toward 30-year yields that are eye-popping by today's standards. Using historical comparisons as a guide, an initial decline in the 30-year bond could see the 30-year yielding in the neighborhood of 6%.
However, a subsequent decline beneath support at 91 could see 30-year yields rise to 1992 levels, around 7.3%. A drop beneath support at the 79 level could see yields as high as 9% (where the 30-year bond was in the summer of 1988). A drop beneath support at 59 would be truly heart-stopping for today's bond investors accustomed to single-digit yields; a coupon of 13% or more could easily accompany a 30-year bond if it fell proportionately below the 59 level, yields not seen on the 30-year bond since the spring of 1984.
TOWARD A BOND BUST?
What is more important than the actual numbers is the trend — in part because it is the expectations about it that will determine what number, what price, what yield. Even if the yield numbers projected here turn out to be off by as much as 100 basis points, if the bond market has peaked, and is in fact reversing in trend, then that trend will bring investors prices and yields that are the opposite to which they have become accustomed. It is also worth remembering that markets that tend to be spectacular on the upside (Nasdaq in the spring of 2000) also tend to be spectacular on the downside (Nasdaq in the fall of 2002).
It would not be surprising if the Japanese scenario — comparisons to which US economists have avoided like the plague — again anticipates the American experience. If reflation is helping snap the deflationary relationship of peaking bonds and plunging stocks in Japan, then it is worth wondering whether reflation will have a similar effect of popping the bond market bubble and providing an enduring boost for stocks.
However, at least as far as the American stock markets are concerned, it is quite possible that US equities will not get off so easily. For one, Nikkei stocks have been truly decimated, down more than 70% from their all-time highs in 1989. Partly as a result, as Marc Faber noted, dividend yields on stocks have risen to a point where they are higher than those of government bonds.
Author Robert Prechter has shown how bull markets in stocks have often occurred when just this phenomenon developed, pointing to the start of bull markets in 1932, 1942, 1974, and 1982 as prime examples (dividend yields were 15.5%, 7.6%, 6.5%, and 7.0%, respectively). Current dividend yield on the Dow Jones industrials is around 2.36%, less than half of what is seen at stock market bottoms historically. With bond yields rising and likely to continue, the Dow Jones dividend yield will have its work cut out for it.
As economist David Malpass notes in an article for National Review, the key to the economy and its mushrooming deficits is government spending — and not just on defense or Social Security or new health care entitlements or any of the other things that are currently ringing the cash registers in Washington, DC. If the economy continues to struggle, bond investors will once again find themselves wondering if those "nontraditional methods" will once again be aimed right between the eyes of the economic malaise. It is likely that continued economic weakness — the recovery that is awake, but not capable of walking more than a few steps down the corridor of the hospital — will mean occasional "buying panics" brought on by rumors that the Fed is determined to step in and keep long-term interest rates low by buying long Treasuries.
A more extreme version of this scenario, such as the one depicted in Martin Weiss' book Crash Profits, which uses a fictional narrative to tell the tale of the boom in the late 1990s as well as to project what might happen during a crash, has the Fed more than buying Treasuries but, in fact, buying corporate bonds as well.
As Weiss illustrates, the effect is very much the proverbial problem of sending good money after bad. Using bond money to fund stock results in a boost to stocks, but that boost cannot last any longer than the accompanying deterioration in bond prices. And as soon as the intervention is over, not only do stock prices return to their lower levels, but they take bond prices with them.
Whether the Fed intervenes by buying Treasuries or more extensively by buying stocks, as the Japanese government has threatened to do, putting stress on the bond market weakens bonds, which will be worse for wear when the intervention is finally called off.
Martin Weiss makes a further point about bond yields based on a comparison of what happened to bonds during the Great Depression. In a subchapter titled "Three Interest Rate Moves," Weiss uses his coming-soon-to-a-future-near-you narrative to describe how the gyrations in bonds during the Depression might point to how bonds might move in a deflationary crisis after a failed government intervention:
In the 1930s, interest rates moved down, up and then down again, in three distinct phases: In Phase 1, all interest rates declined due to deflation and the Federal Reserve's attempt to counter the deflation. In Phase 2, interest rates abruptly turned around and exploded. The 3-month Treasury-bill rate jumped by over sixfoldfrom about a half percent to 3 percent . . .
Weiss goes on to point to similar leaps in the yields of government and corporate bonds of other durations. This phase 2 period was short and sharp, lasting from 1932 to 1933. Interestingly, this period coincides with the bottom in stock prices in the early 1930s. Weiss' phase 3 begins when the interest rate surge of phase 2 peaks out and rates begin to decline again.
However much current movement in the bond market mirrors the movement from the 1930s remains to be seen. But those looking to the sharp rally in bond yields that began in the summer of 2003, and seeing inflationary risk instead of what might still be a predominantly deflationary environment, may want to consider what took place with bonds during capitalism's last global depression and the deflation that brought it on.
Where, then, does this leave bonds — particularly government bonds — and their investors? Paul McCulley and others have encouraged bond investors (and all investors, for that matter) to reduce their expectations to something more compatible with the single-digit investment return world they believe is upon us. It is worth mentioning that Bill Gross, for one, has been trying to prepare investors for this eventuality: his 1997 book, Bill Gross On Investing, speaks of an "era of 6%" and alludes to the fact that investors will, in the words of Depression-era humorist Will Rogers, become "more concerned with the return of their money, than the return on their money."
It is quite possible that events will catch up with Gross' foresight and what might be painful for individual bond buyers watching interest rates climb might become an enjoyable investment pastime for buyers of quality bond funds, particularly those invested in bonds with shorter maturities. Indeed, while enjoying a cruise to Alaska, Gross noted:
In contrast to prior decades, we live in a financial based economy with excessive debt. Accelerating short term interest rates a la 1979-1981 are not possible — must use all means including "ceilings" to keep cost of financing low . . .
And in a list under the heading "Portfolio Management Strategies in this Environment," what strategies stands as number 1?
Highest carry (yield) for lowest acceptable duration.
Even in a world where keeping money may become more important than making money, getting the biggest bang for your investment buck through boom or bust, crescendo or crash remains paramount — even in an "era of 6%." And there is no development forthcoming in the bond market — or any other market, for that matter — that will ever change that.
David Penn may be reached at DPenn@Traders.com.
SUGGESTED READINGFaber, Bruce . "Recovery, Inflation, Or Deflation," Working-Money: May.
Federal Reserve Statistical Release . H15. Selected Historical Interest Rates
Gross, Bill . Bill Gross On Investing, John Wiley & Sons.
_____ . "Happiness Running," Investment Outlook. PIMCO.com: July.
Malpass, David . "Don't Sweat The Deficit," National Review Online. July.
McCulley, Paul [ 2003]. "Promiscuity In The Pursuit Of Virtue," Fed Focus. PIMCO.com: July.
Murphy, John J. . Intermarket Technical Analysis, John Wiley & Sons.
Penn, David . "Gibson's Paradox," Working Money March.
_____ . "The Reflation Trade," Working Money June.
_____ . "Dollars, Debt, Stocks And 'Things,'" Working Money July.
Persaud, Avinash . "The Fed Takes A Dangerous Stance," Financial Times. July.
Prechter, Robert. . Conquer The Crash, John Wiley & Sons.
Rublin, Lauren R. . "Happy Days: Barron's Mid-Year Roundtable," Barron's: June.
"The Seinfeld Deflation" . The Wall Street Journal, Editorial: May 29
Weiss, Martin D. . Crash Profits — Make Money When Stocks Sink And Soar! John Wiley & Sons.
Charts courtesy of TradeStation (TradeStation Technologies)
Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.
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