In normal times, at their most basic level, bond prices follow some very simple laws of financial physics: When interest rates rise, bond prices fall and bond yields rise; when rates fall, bond prices rise, and bond yields drop.
However, bonds could break those laws of financial physics in the New Year - and in a big way. That could inflict some real financial pain on the U.S. recovery, the dollar, the shuddering housing market - and could even ignite a major stock-market reversal.
The U.S. Federal Reserve continues to hold rates on U.S. Treasury securities to artificially low levels - a strategy central bank Chairman Ben S. Bernanke just this week said the Fed intends to adhere to for the foreseeable future.
But yields on U.S. Treasury securities could buck the trend by soaring in the first half of 2010 - even if the central bank holds benchmark interest rates at near-zero levels. Indeed, yields on the benchmark 10-year U.S. Treasury note - now standing at 3.45% - could rise as high as 4.50% within six months. That's based on technical factors and shifting risk-reward evaluations, rather than any change in Fed policy. Bond analysts at Morgan Stanley (NYSE: MS) said that a move of that magnitude could cause the spread between two- and 10-year U.S. Treasuries to widen to as much as 325 basis points (3.25 percentage points).
Rising bond yields are definitely in the cards due to four catalysts, says Money Morning Contributing Editor Martin Hutchinson. An excess supply of bonds is one. An increasing concern about risk is another (Based on Bank of America Corp.'s [NYSE: BAC] Merrill Lynch Treasury Master Index, investors in U.S. government debt lost about 2% in 2009). Inflationary worries are the third. The Fed may even be forced to relent, further fueling this move, Hutchinson said.
"We're seeing a steady rise in the cost of capital because of the excess of supply over demand and increasing concern about risk," Hutchinson said. There's also "the intensifying worry about inflation. Because of the inflation fears, I would expect the Fed to start shifting the yield curve higher by the second half of 2010 - but the process will be a slow one because the CPI (Consumer Price Index) is only drifting up slowly at present."
While the CPI numbers give the Fed some justification for keeping rates low, Hutchinson warns that they can be misleading, noting that consumer prices are potentially far less troubling than the rising real cost of capital. He cites the example of Japan, where stated 30-year government bond rates are up just 17 basis points from last year - but, when the negative inflation rate is factored in, the true adjusted yield on 30-year bonds has risen by about 4.3 percentage points over the past year.
That, he says, is due to the country's huge deficit and worrisome debt levels - two factors that will also spell eventual yield troubles in the U.S. market.
"My best guess is that 10-year Treasury yields will increase by 200 basis points in 2010," Hutchinson predicts. "But the increase will likely be split something like 80/120 over the two halves of the year. If the Fed sticks to its guns and keeps rates low for the near term, inflation will get worse and people will get more worried about both the dollar and Treasury risk, eventually forcing the Fed to hike rates."
This isn't a universal view. In fact, Thomson Reuters Corp. (NYSE: TRI) reported that the current consensus among analysts is that yields on Treasury securities will trade in a tight range well into 2010.
Bernanke's Monday speech to the Economic Club in Washington, which expressed continued caution about the ability of the U.S. economic recovery to sustain itself, sparked a modest rally in bond prices, partially offsetting a Friday sell-off triggered by an unexpected drop in the number of jobs lost in November. However, that gain was quickly reversed by a mediocre investor response to this week's auctions of three- and 10-year Treasury notes and 30-year T-bonds.
While the $40 billion in three-year notes went at a slightly lower rate than forecast (1.223% vs. 1.229%), the government had to pay more to entice enough buyers to unload the $21 billion in 10-year notes (3.448% vs. a predicted 3.421%) and $13 billion in 30-year bonds (3.520% vs. 3.483 projected). Foreign demand was also apparently down as the percentage of bonds going to "indirect bidders," the class that includes foreign central banks, fell to just 40.2% compared to 44.0% at the November auction.
Those results added considerable credence to the Morgan Stanley prediction as they expanded the yield curve between two- and 30-year Treasuries to a 29-year high of 372 basis points, substantially higher than the average spread of 132 points over the past five years and the year-end 2008 gap of 191 basis points.
If the predictions made by Hutchinson and Morgan Stanley play out, the fallout could be substantial, with the overall economy, the U.S. dollar, the American housing market and even the stock market taking major hits.
The only likely beneficiaries could be the banks. If the Fed keeps short-term rates near zero but longer-term yields rise anyway, the banks make big profits because they borrow short and lend long - assuming they will lend at all. They could just keep credit tight, investing their cash in long-term Treasuries and profiting from the growing yield curve.
That kind of credit crunch will stifle recoveries in both the residential and commercial real estate markets - both of which depend on borrowing at long-term fixed rates. In addition, any rise in rates could up the costs on still-outstanding variable-rate mortgages, triggering a new round of defaults and foreclosures, the impact of which would quickly spread through the entire economy.
Because businesses - especially small businesses - already borrow at a large margin over fixed rates, a modest increase in rates probably wouldn't damage that sector much more than it already has been. However, continued tight credit would be a major problem, choking the life out of still more cash-starved small businesses. In fact, though most analysts are fearful of such a move, Money Morning's Hutchinson said the best scenario for business might be for Bernanke to sharply increase short-term rates.
"That would probably HELP small business," he said, "because the banks would be forced to earn their profits by lending their money to those who need it rather just putting it in T-bonds and heading out to the golf course."
Though higher yields are sometimes deemed beneficial for the dollar, they most likely wouldn't help it if Morgan Stanley's scenario plays out. Any increase in longer-term rates would give foreign central banks and other overseas investors capital losses on their U.S. Treasury holdings, which would cause capital inflows to the United States to weaken, pressuring the dollar and reducing demand for U.S. securities.
By contrast, if the Fed were to raise short-term rates it would strengthen the dollar, but they'd have to get to 3.5% to 4.0% for that to happen - and, given Bernanke's stated views, that's unlikely in 2010.
A stronger dollar also carries lots of fiscal baggage with it, weakening exports, worsening the U.S. trade imbalance and spurring more outsourcing of U.S. jobs - all negatives for a recovering economy.
Rising rates could also threaten Wall Street's continuing advance, though the market would probably absorb the adjustments so long as they come at a reasonably gradual pace.
As for individuals, the harm done by increasing rates could be limited unless you're one of those caught in a variable-mortgage trap, in which case the damage could be substantial. Credit-card rates - nearly all of which are now variable - would, of course, go up, but that would be minor in the grand scheme of things. After all, the difference between 21% and 23% really adds minimal cost if you're determined to charge something.
On the investment front, a rise in bond yields would hurt fixed-income investors in the short run because the prices of their bonds would fall, producing capital losses, without any increase in the actual interest payout to offset them. Given that and the uncertainty of the Treasury situation for 2010, the best course for such investors could well be to stick with dividend stocks and foreign-currency-denominated debt securities, adding a little gold and silver to hedge against further weakening of the dollar.