Or is it "torpedos"? I read the deceptively titled story copied at bottom, "Federal Reserve Puzzled by Yield Curve Steepening", and I just had to make a comment at this late hour.
The topic of the story, by a reporter appropriately named Alistair Bull, is that this last week there was a fast rise in the yield of long-term government bonds last week. Boy, if that doesn't sound dull, I don't know what does, but hang in there. I say "appropriately", because the story rambles back and forth on the various possible cause or causes of the rise in bond yields without reaching any useful conclusion -- was the cause an improving economy, or a worsening one? The article concludes,
Fed officials also believe that some better-than-expected economic data recently has encouraged investors to believe there is less need for the safe-haven of government bonds and more risk of inflation. ..."Obviously, there is a lot of supply of debt. Another way to interpret the steepening of the yield curve is ... confidence in the economy going forward."
And if you believe any of that, you are smoking something a lot stronger than dope.
First, for the bond neophyte (like me), what is a bond? Debt. Here's a helpful link: http://www.investopedia.com/university/bonds/default.asp
...a bond is nothing more than a loan for which you are the lender. The organization that sells a bond is known as the issuer. You can think of a bond as an IOU given by a borrower (the issuer) to a lender (the investor).
There's corporate and municipal bonds, but the biggest seller of bonds is Uncle Sam, in the form of long-term Treasury "bonds" (security with a maturity of more than 10 years), Treasury "notes" (maturity between one and 10 years). Short-term T-bills (maturity of less than one year) technically aren't a bond.
The point of bonds is that they have well-defined returns in the form of annual or semi-annual interest payments until a date in the future when the original bond value must be paid in full (sort of like a balloon payment on a mortgage):
The issuer of a bond must pay the investor something extra for the privilege of using his or her money. This "extra" comes in the form of interest payments, which are made at a predetermined rate and schedule. The interest rate is often referred to as the coupon. The date on which the issuer has to repay the amount borrowed (known as face value) is called the maturity date. Bonds are known as fixed-income securities because you know the exact amount of cash you'll get back if you hold the security until maturity.
If you're wondering about the difference between bonds and stock,
Bonds are debt, whereas stocks are equity. This is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is that you have a higher claim on assets than shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a shareholder.
Unless you're a bondholder for GM or Chrysler, for whom Obama has launched a boarding party and run up the Jolly Roger. But in theory, the value of bonds is guaranteed (almost) at rates of return with lower risk than stocks.
Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market.
The risk isn't zero however -- corporations can go bankrupt (aka, GM) and so can municipalities (aka, California). When that happens, those "guaranteed rates of return" aren't so guaranteed anymore. The "coupon" payments stop, and the value of the bond falls.
What does it mean for the value of a bond to fall? Because bonds are long-term debt over years, they can be bought and sold on the open market. (You could hold an IOU and sell it to a friend, right?) Maybe you bought a 10 year bond and got tired of holding it, and prefer some other investment, for whatever reason. So you sell it, like a stock, to someone else.
But what are they willing to pay? If the bond issuer is healthy or reliable, there's only so many coupon payments left to receive. The bond value will be somewhat lower. But of course, not zero because of that coming balloon payment, when the bond must be paid off in full.
For example, say you buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years. This means you'll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you'll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you'll get your $1,000 back.
Various things can make that $1000 bond (in this example) worth more or less than $1000 when you try to sell it on the open market, and that can cause bond yields (your "return on investment") to be positive or negative. This gets into that news story below.
Remember: bond "yield" is in relation to the current bond price on the open market (once issued) plus those fixed coupon payments plus the final maturity payment. Those don't change, ever. But if the bond price falls to $950 on the market, "yield" improves -- you're getting a deal on the bond cause no one wants it. This can occur if the stock market is booming. Who wants a low yield "safe" bond (let's say, averaging 5% a year return over 10 years) when you can make 20% a year in stocks? So bond prices must fall as investors rush to the better returns of stocks, and bond yields rise to restore equilibrium in the supply and demand for bonds -- when the yields are high enough, someone will still prefer bonds to stocks.
Ah, but what if the stock market sucks? I can't imagine that ever happening, but just try. Everybody who is terrified of losses and uncertainty in stocks might find bonds *very* attractive lifeboats. Guaranteed interest payments, low chance of default.
But what if there's more people than there are seats in the raft? It's obvious: people bid up the price of lifeboats rather than go down with the Titanic. Bond prices increase, and they can even increase enough to make yields go negative. Such is the price of safety. When bond yields fall that much people are paying for the insurance value. (http://www.investopedia.com/university/bonds/bonds3.asp)
When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.
The article summarizes bond features nicely:
When price goes up, yield goes down, and vice versa. When interest rates rise, the price of bonds in the market falls, and vice versa. Bills, notes and bonds are all fixed-income securities classified by maturity. Government bonds are the safest bonds, followed by municipal bonds, and then corporate bonds. Bonds are not risk free. It's always possible - especially in the case of corporate bonds - for the borrower to default on the debt payments. High-risk/high-yield bonds are known as junk bonds.
You may note that Michael Milken made all his money on so-called "junk bonds", a market he almost entirely created, and which may make him more responsible than anyone else for the business boom of the 80's. At least, till the government, goaded by envious goons at places like Goldman Sachs, decided to shut him down. Another story.
That summary of points gets directly to my point. When bond prices fall and yields rise, people either have better investments to pursue, such as stocks, or people simply don't want bonds because the risks are too high. The news story states that bond yields have been rising a lot this last week. There's some positive spin for you. "Yields are rising". What Bull doesn't say (though certainly the saavy investor knows this) is that this means that bond prices had to be falling last week to make yields rise.
Now, among the two explanations for falling bond prices -- rising stocks, or rising bond risk -- which makes sense? Take a look at the Dow for the last week:
Sorry, I don't see a great rush to the next Bull market, Alistair. So as Sherlock Holmes used to say, when you've eliminated all other possibilities, whatever remains, however improbable, just must be the explanation: clearly, the market is bailing on United States Treasury bonds because the risk has gone way up.
What would cause the risk on Treasuries to increase sharply? Two things: 1. Default, and 2. Inflation.
Now, even if the U.S. loses their triple-AAA credit rating, they aren't going to default on Treasuries anytime in the near future. They dun have to. Hell, they run the printing presses. As Mr. Thompson told John Galt in Atlas Shrugged,
Mr. T: "I can offer you anything you can ask. Just name it."
J.G.: "You name it."
Mr. T: "Well, you talked a lot about wealth. If it's money that you want-- you couldn't make in three lifetimes what I can hand over to you in a minute, this minute, cash on the barrel. Want a billion dollars--a cool, neat billion dollars?"
J.G.: "Which I'll have to produce, for you to give me?"
Mr. T: "No, I mean straight out of the public treasury, in fresh, new bills... or... or even in gold, if you prefer."
That's the way they think. Not enough tax income coming in, Gomer? Just print off another trillion or three. It's only money. An' let's have some more of that D.C. Moonshine, while yer at it.
As I said in a previous post, the Fed's have at least doubled the amount of money in circulation by now. A trillion here, a trillion there, and pretty soon you're talking some real money. If you've got a pile of goods (the entire gross domestic product of the United States) represented by a pile of dollar bills (the entire money in circulation for the United States), and then you double the amount of bills in circulation, you'd kinda think the price of those goods should double, all things being equal. There's other effects, of course, like if the economy collapses so fast that demand falls faster than supply, prices can stay constant or even fall, but in that scenario, your income is falling so much faster you're starving. As Galt said, "A is A" -- there's no escaping reality, and you've *effectively* had severe inflation -- your standard of living falls in any scenario of the government printing money out of thin air.
Leave out the nuances. If you suddenly pump a few trillion of green ooze into the economic bloodstream, it's guaranteed to increase blood pressure and prices, but it takes a little time for the transfusion to filter into the prices everywhere. But it will. Give it time. My own wild guess is something like 10% this year, 20% next year, 25% the year after, and 25% the the year after that. 1.1 x 1.2 x 1.25 x 1.25 = 2.06. Assuming Obummer and Geithner don't keep mucking around with things. But you know where I stand on that one.
Here's something else to buttress that point: Look at the price of gold:
Now you know where the inflation's going to come from, why demand for bonds is falling, why bond yields are rising, and why there ain't no gold lining in the lead balloon of this sucker's market. I'm no expert on bonds, and I'm sure to get some corrections on my understanding from general quarters out there, but damn the torpedoes, I'm putting my money on another stock collapse before too long. This ship's going down to Davy Jones' locker.
Federal Reserve puzzled by yield curve steepening
WASHINGTON (Reuters) - The Federal Reserve is studying significant moves in the U.S. government bond market last week that could have big implications for the central bank's strategy to combat the country's recession.
But the Fed is not really sure what is driving the sharp rise in long-dated bond yields, and especially a widening gap between short and long term yields.
Do rising U.S. Treasury yields and a steepening yield curve suggest an economic recovery is more certain, meaning less need for safe haven government bonds and a healthy demand for credit? If so, there might be less need for the Fed to expand the money supply by buying more U.S. Treasuries.
Or does the steepening yield curve mean investors are worried about the deterioration in the U.S. fiscal outlook, or the potential for a collapse in the U.S. dollar as the Fed floods the world with newly minted currency as part of its quantitative easing program. This might be an argument to augment to step up asset purchases.
Another possibility is that China, the largest foreign holder of U.S. Treasury debt, has decided to refocus its portfolio by leaning more heavily on shorter-term maturities.
With officials still grappling to divine the factors steepening the yield curve, a speedy decision on whether to ramp up the Treasury debt purchase program or the related plan to snap up mortgage-related debt seems unlikely.
"I'm in wait-and-see mode," said one Fed official who spoke on the condition of anonymity. "We laid out the asset purchase plan and we're following it. That is going to have some affect on various interest rates, but together with a hundred other things. So I don't think we should be chasing a long-term interest rate," the official said.
An important clue could come on when Fed Chairman Ben Bernanke testifies about the economy to U.S. lawmakers on Wednesday morning.
After lowering short term interest rates to near zero in 2008, the Federal Reserve said at its March meeting that it would buy up to $300 billion in longer-term Treasury securities over six months as part of its efforts to increase the money supply and ease the credit crunch of the past two years. So far, the Fed has bought $130.5 billion or about 44 percent of that $300 billion.
The Fed also has a goal of buying up to $1.25 trillion of mortgage backed securities (MBS) and $200 billion of debt issued by agencies like Fannie Mae and Freddie Mac. The Fed purchases of agency MBS total $507.075 billion so far in 2009.
But last week the benchmark 10-year U.S. Treasury bond yield jumped to a six month high around 3.75 pct, while the spread between 2-year and 10-year bond yields widened to a record 2.75 percentage points.
Economists at Barclays Capital in New York have argued that the Fed should announce plans to increase its planned purchases of longer-dated Treasuries to $1 trillion from $300 billion to drive yields back down, lower home mortgage rates again, and support the embryonic economic recovery.
They warn the Fed cannot afford to hold fire until its next scheduled policy meeting on June 23-24.
But the Fed is not so sure, and officials note that corporate bond spreads have narrowed over U.S. Treasuries, and that although mortgage rates have risen, they are still low.
An obvious culprit for the move in bond yields is the country's record fiscal deficit, which will generate a massive amount of new government issuance.
The U.S. Treasury must sell a record net $2 trillion in new debt in 2009 to fund a $1.8 trillion projected fiscal deficit, resulting from falling tax revenues, an economic stimulus package and sundry bank bailouts.
Investors began to worry this could erode the United States' cherished triple-A sovereign credit rating when Standard and Poors's on May 21 revised its outlook for Britain's triple-A status to negative from stable, blaming higher government debt.
The International Monetary Fund estimates that gross U.S. debt will reach 97.5 percent of the country's GDP in 2010, versus 72.7 percent of GDP for the United Kingdom.
But other Fed insiders said they have a problem blaming the steepening of the yield curve just on the extra supply of new Treasury debt.
While there has been a sharp deterioration in the U.S. fiscal outlook, this has been evident for months and the dramatic steepening of the curve only occurred this week.
Fed officials also believe that some better-than-expected economic data recently has encouraged investors to believe there is less need for the safe-haven of government bonds and more risk of inflation.
Dallas Federal Reserve Bank President Richard Fisher said on Thursday that the yield curve often steepens after a period of flatness heralding an economic recovery, but in this case is it likely a combination of factors.
"Obviously, there is a lot of supply of debt. Another way to interpret the steepening of the yield curve is ... confidence in the economy going forward," he told reporters in Washington after delivering a speech.
(Reporting by Alister Bull)
(Additional reporting by John Parry and Lynn Adler in New York, and Ros Krasny in Chicago; editing by Carol Bishopric)