The Big Bond Squeeze

The sales of existing homes just plunged 11.2% while new home sales nosedived 22%. So, I don’t have to warn you about housing anymore … the carnage is all over your local newspaper.

Instead, I’d like to dig a little deeper into the bond market, which I think is sending us an important signal.

The whole thing reminds me of one of my favorite science fiction movies, The Matrix. In case you haven’t seen it, the main character, Neo, is trying to figure out why the world seems so “off” to him. To get an answer, he seeks out a man named Morpheus, who tells him,

“You’re here because you know something. What you know you can’t explain, but you feel it. You’ve felt it your entire life – that there’s something wrong with the world. You don’t know what it is, but it’s there, like a splinter in your mind, driving you mad.”

Like Neo, I’ve had a haunting feeling lately: That out-of-whack interest rates are indicative of a much deeper problem …

Curves in All the
Wrong Places

When you buy a bond, you’re just lending someone else money and hoping to get paid back your principal plus interest.
And as a lender, you face two big risks:

Default risk – the possibility that the borrower won’t be able to pay you back. In the case of Treasury bonds, default risk isn’t really an issue: It would take economic Armageddon for Uncle Sam to default on his debt.

Inflation risk – the possibility that inflation and interest rates will rise while your loan is outstanding. If they do, it could leave you earning just 5% even though interest rates have risen to 6%, 7%, or beyond.

Now, inflation risk is very real no matter what kind of bond you’re holding. And the risk increases the farther out in time you go.

This is why 10- and 30-year Treasuries usually pay higher rates than two- or five-year Treasuries.

And any Treasury bond almost always carries a higher rate than the federal funds rate, which is what banks charge each other for overnight loans. Reason: the Fed funds rate is pretty much the shortest-term loan out there.

If you plot all these rates out on a chart, you get what’s known as the yield curve. Normally, it looks like this:

This is what it looked like one year ago. But right now, as I said, interest rates are out of whack.

Earlier this year, 10-year yields fell below 2-year yields. That was the first critical change.

Now, even the Fed funds rate (5.25%) is higher than rates on all other Treasury bills, notes, and bonds …

This is not a science fiction story … it’s very real. What does it mean?

Big Bond Market
Traders Expect the
Economy to Slow

If you have the choice of giving your borrower a six-month loan at 5.25% or a two-year loan at 5%, which would you choose? You might say the answer is easy: Go with the higher rate, a 5.25% loan.

But what if you thought rates were going to fall to 4% over the next two years? Wouldn’t you rather “lock in” your rate at 5% for two years? Absolutely! Otherwise, you’d have to keep offering six-month loans at lower and lower rates.

Based on that logic, we can take the current interest rate situation and infer that the bond market expects lower rates in the future. Their reasoning: A cooling economy will drive rates lower.

Could the bond market be wrong? Sure. You could easily get a slower economy and rising inflation at the same time.

And there are lots of fundamental reasons to expect global inflation pressures to remain high. You’ve read about them in Money and Markets for a long time – strong growth overseas, high oil prices, easy money policies, and more.

Still, the current yield curve is definitely a “splinter in my mind.” Reason: The last time it looked something like this was in 2000, when the stock market crashed and the economy slumped into recession.

A few years ago, the Federal Reserve published a yield curve study. The conclusion was that you can use the difference between three-month Treasury yields and 10-year Treasury yields to estimate the probability of a recession within the next four quarters. I’ll run you through two examples …

Last August, 10-year notes yielded 70 basis points more than three-month bills. Indicated recession risk? About one-in-ten.

Now, 10-year notes are yielding 29 basis points less than three-month bills. That’s the deepest inversion in more than five years. Chance of a recession? About one-in-three.

In plain English, the odds of an economic downturn have tripled in the last year! The Wall Street experts call it the “inverted yield curve.” I prefer to call it the Big Bond Squeeze.

You may feel like ignoring the squeeze. But just ask anyone who shrugged off the bond market’s warning back in 2000 if they’d like to wind back the clock. I bet they’d answer with a resounding “Yes!”

What You Can
Do About It

Conventional wisdom on Wall Street is that we’ll get a gentle slowdown that reduces inflation without crushing the economy and cratering corporate earnings.

I don’t think you should count on that. In fact, I can’t help wondering if it’s the summer of 2000 all over again – only with housing, not tech stocks, as the catalyst for a major slump. How might you protect yourself?

First, stay away from higher-risk bonds. That includes junk bonds and subprime mortgage-backed securities. If the economy slumps toward recession, you’re going to see defaults rise quickly. That will really hurt the value of bonds that have lots of credit risk.

Second, keep a big chunk of your money in the safest investments. That would include short-term Treasuries and Treasury only money funds. If you feel like taking on a bit more interest rate risk, consider six-month Treasury bills or even 2-year Treasury notes.

But I wouldn’t go farther out on the yield curve than that. Ten-year and 30-year Treasuries just don’t offer enough return, in my book, to compensate for longer-term inflation risk.

Third, cull the losers in your stock portfolio. I warned several months ago that housing stocks would crater. Now they have done just that. I said construction suppliers would tank … that also happened.

Now, I’m worried about high-risk lenders and even select diversified banks. Some are alreay falling in value. For others, the verdict is still out. But it’s safe to say that risk is rising fast. Take a good look at what’s in your portfolio before it’s too late.

Until next time,

Mike

About MONEY AND MARKETS

MONEY AND MARKETS (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, and Tony Sagami. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Amber Dakar, Monica Lewman-Garcia, Wendy Montes de Oca, Kristen Adams, Jennifer Moran, Red Morgan, and Julie Trudeau.

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