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Friday, 4 February 2011

Bonds and the Age of Irrational Exuberance

It's been quite a ride for equity investors over the last fifteen years. I'd date the start of the current bubble era from Alan Greenspan's 'irrational exuberance' speech in December 1996, though the origins lay further back to the famous 'Greenspan Put' that was first applied after the 1987 crash, and amounted to a commitment that the Fed would strongly apply the economic accelerator after a decline, but would never apply the economic brakes in an expansion. Greenspan justified this unbalanced policy with the observation that asset bubbles were difficult to identify, so the Fed would confine policy response to picking up the pieces after bubbles burst, and with that lazy and populist abdication of any Fed responsibility for economic stability the current era of successive asset bubbles was born.

The results of these policy so far can be clearly seen on the Nasdaq 20 year chart, where I've marked in the point at which Greenspan warned of irrational exuberance in the stock market, and then famously did nothing to restrain that exuberance:
One thing that has enabled this era of bubbles, though in part it may have been a result of the Greenspan Put as well, is the very long bull market in bonds from 1980 until, depending on how you look at it, either November 2008 or to the present day. In practical terms though, the high in November 2008 is likely to have been the bull market high, and what we are waiting for is confirmation that the bear market in bonds has started since. Why's that important? Simple, the asset bubbles have been built on a huge increase in debt, and debt is very interest-rate sensitive. More directly the current asset bubble is built on government debt, and that is particularly interest rate sensitive when there is a lot of it. The following chart taken from Clusterstock Chart of the Day shows why that is and you can see the full article here. :
Now this chart above is showing the ratio of interest payable to government revenue under a range of scenarios for interest rates, of which the most pessimistic assumption is that interest rates (long term bond yields) rise 2%. That's not actually particularly pessimistic and illustrates the extreme difficulty the US is likely to have holding on to a AAA rating for US treasuries in the next few years. When you consider that at the start of this long bull market in bonds long term interest rates were close to 10% higher than they are now, you can see that if interest rates start to rise sharply, then the US might start to seriously risk default.

The reason this is becoming a major issue is because the US government deficits are now so large that they are creating a ocean of debt, and if the target of all this spending is achieved, by engendering self-sustaining economic growth, then that growth is likely to increase debt servicing costs to a level that becomes, at best, extremely painful. This is akin to sitting in a pool of gasoline trying to light a match, and  while the US is nowhere near as advanced in this process as Japan, the US is on the same path, with a pool of debt gasoline that is growing fast as the next chart illustrates, also from Chart of the Day, and you can see the full article here:
So where are long dated treasuries now? They're right on the cusp of confirming that we are now in a bear market for bonds, and that interest rates are on a sustained upward path. I have a twenty six year old declining channel for 30yr treasury yields, and we're right at the top of that channel. The yields chart is of course the inverse or mirror image of the bonds chart, so when yields rise, bonds fall, and vice-versa. Once we close a month above it, or break it with any conviction, the end of the three decade long bull market in bonds is confirmed, and the end is in sight for current Fed policies that depend on low interest rates. I'd add that the MA guys are looking at the 100 month SMA and that has already been broken as you can see on the chart:
Shorter term the 30yr T-bill yields are in a two year triangle that broke the resistance trendline today:
So the bond market is standing in front of death's door, but obviously bonds could still bounce from here, and so that door might not open for a while. That's the reason I was very interested to notice on Wednesday that there is a strong bearish pattern on the  30yr T-bill chart that was (64% probability) likely to take bonds through this strong support level. It broke downwards yesterday and is now halfway to target:
I'm hoping this breaks downwards hard and shatters support with conviction. A bear market in bonds will be the beginning of the end for the Bernanke Put, formerly the Greenspan Put, and once that is dead, the economy can have the necessary correction to eliminate these wild economic imbalances that have built up over the last three decades, before current policies have increased those imbalances to a much more disastrous level. Greenspan, Bernanke et al can then take their rightful place in history as dangerous fools who have brought the world economy to the brink of disaster, and in thirty years students of economics will chuckle at the stupidity that led us to this point. Until the next time it happens of course. :-)

That said, this is only the beginning of the end, not the end, and we may be in for some wild rides yet, particularly if the US dollar follows bonds in breaking major support. On long treasuries I'm looking for a monthly close above the channel to confirm the bear market in bonds.

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