Sunday, September 4, 2011 0 comments ++[ CLICK TO COMMENT ]++

Follow up to the bond yield scenario during deflationary busts

Given the drastic changes in bond yields of late, I thought I would update the charts I produced a few years ago showing bond yields during three major deflationary busts. It's almost as if we had gone full-circle over the last two years. The present yield (as of end of August, 2011) on the 10 year US Treasury is lower than what it was back in 2008!

You may want to read the original post I wrote to get more details about the following charts and the source of the data (the original post also has a few more charts I didn't update).

American Bond Yields in the 2000's

The following chart shows the bond yield of the 10 year US Treasury, up to the end of August of 2011.

The monthly data I used, which isn't the same as the daily yields, shows a prior low of 2.44% in December of 2008. Just recently, in August, the low was breached and my data shows a 10 year yield of 2.15%. The rally in bonds in the last couple of months have been massive, and is almost half the rally during the financial crisis in 2008.

Quantitative Easing II ended a few months ago so the recent plunge in yields cannot be ascribed to any central bank intervention (at least the US Federal Reserve). So it's interesting that the market is pushing down yields on its own, well after central bank bond-buying ended. I haven't looked at the data so I'm not sure who the big buyers of bonds in the last few months have been but it does go to show that there is heavy interest in US government bonds even with the credit rating downgrade (by one agency only) and a manufactured political crisis (the debt issue is totally blown out of proportion and USA is nowhere near defaulting unless the politicians purposely do it.)

It's not clear what is driving the rally in bonds but if it's for benign reasons (such as retiring Baby Boomers shifting assets to bonds), it should allow the stocks to support a higher P/E. However, if the bond rally is due to deflationary threats, then stocks, and almost all other assets, will likely decline. My guess is that the market is fearing the latter scenario. Deflationary threats, possibly from an economic slowdown or credit bust in Europe, may be on the table.

The following chart of crude oil stocks, crude oil, and S&P 500, shows how the oil market has sold off sharply in the last month.

The sell-off in crude oil may be influenced by political events in Libya, amonst others, but I suspect it is driven more by threats on the economic and credit fronts.

In any case, I am curious to see if the bond yields will drop further or bounce around the current levels. A lot of bond bears thought the 2008 bottom in yields was a multi-decade trough but that obviously hasn't been the case.

Bond Yields during Three Credit Busts

The following chart plots the bond yields during three significant credit busts in the last hundread years: USA in the 1930's; Japan in the 1990's; and USA now. Read my original post for more detail on the scenarios.

In nominal terms, the current 10-year Treasury yield is almost near the bottom of the 1930's bust (ignoring the 1940's when bonds were monetized en masse during World War II). I think a major question is whether it will break below the 2% yield, which may be a psychological level.

Compared to Japan, the US yields are still nowhere near the Japan low of around 1%. My wild guess is that yields won't fall to the 1% level. Such a drop will be very large—50% decline in yield!—and require a huge rally in bonds and I don't see that happening (unless there is a big credit bust similar to what we already saw with the real estate a few years ago.)

Bond Yields during the Three Busts - Normalized

The following chart is a crude attempt by me to normalize the yields over the three periods. The peaks are stacked to the same level on the chart (so the lines for the two US yield datasets are scaled and not actual yields).

My thought here is to see how American bond yields may behave if it followed a path similar to what happened during the Great Depression and Japan of the 1990's and 2000's. My thinking could be flawed so I wouldn't put much faith on this chart. Nevertheless, it does show that the current yields have declined somewhere in between the yield decline during the Great Depression and Japan.

Last Word

It appears that the bond market is entering a bull phase which may lead to a bear market in stocks. One should probably be cautious. Unlike in 2009, I don't think the governments will bail out any banks this time around (some of them are 'too big to save' anyway). I don't anticipate any banking problems in America but you just never know what is going to happen if Euro implodes.

I have been leaning towards deflation so am more bullish on long bonds than most investors but even I find it remarkable that the 10-year US Treasury yield broke below the 2008 level. There isn't any obvious credit problems yet investors are piling into US Treasuries as if they were going out of fashion.

Although the declining bond yields will probably hurt stocks, they will likely help mortgages and corporate borrowing by lowering the cost. So there is some positive, although this is not how you want it to happen.

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