Extraordinary Doings in the Bond Market (Negative Interest Rates signals deflation)

To go along with the piece I wrote earlier today, the bond market appears to have picked up on the theme of deflation. The 30-year US Treasury bond rocketed upward in price to more than 118 and a half by today’s market close, and much of the move came late in the day.

This price corresponds to an interest-rate of 3.49% for the long bond. Just this morning, it was trading to yield over 3.90%. For the bond to drop over 40 basis points of yield in a single day is simply unheard of.

If this pricing holds up (and bond yields have been exceptionally volatile for many months now), it indicates at the very least that there is now an expectation that inflation will be non-existent for years into the future.

There’s an arcane interest rate called a “swap spread.” It’s a way of pricing plain vanilla interest-rate swaps (the kind where you receive a fixed rate of interest for some period of time on a nominal amount of money, and in return you pay a floating rate, perhaps 6-month LIBOR).

You can think of a swap as roughly equivalent to purchasing a fixed-income security with short-term borrowed money. So it’s useful to compare the fixed swap rate on any given day with the US Treasury rate, at the corresponding point on the yield curve.

And that gives you an interest rate measured in basis points that is generally taken to indicate the credit risk of a typical AA-rated bank. (Since such banks are often the ones who pay on swaps.)

The 30-year swap spread (meaning, the difference in the interest rate on a 30-year swap and a 30-year Treasury bond) has been running slightly below zero for several days now. The swap, in other words, is priced as if it were more valuable than the bond.

This is senseless (and in fact has long been considered mathematically impossible) because a swap has credit risk and a Treasury bond doesn’t. Can you imagine borrowing money, and having the lender pay you interest instead of the other way around? And besides, wouldn’t you guess that someone will always find a way to arbitrage away a negative interest rate?

Negative interest rates are very occasionally seen in overnight repo, depending on the collateral, in times of severe stress. But not in swap.

Today, however, the 30-year spread got even more negative. In fact, it plunged all the way to NEGATIVE 60 basis points, according to some reports. This is almost as surprising as a shattered window pane jumping back together by itself.

The only way this can be possible, that I can imagine anyway, is if large numbers of investors are being forced to liquidate positions, for some reason. It’s known that fixed-income professionals use all kinds of arcane mathematical strategies to trade the shape of the yield curve. Something must be happening to make a lot of those trades go bad all at once. And something must be forcing lots of people to get liquid at once, even if they have to take extraordinary mispricings to do it.

And that tells me that we’re witnessing a temporary, short-lived effect. But it’s like a major volcanic eruption, or a nine-magnitude earthquake. It won’t last for a very long time, but it will produce a completely unpredictable amount of lasting damage. We’re likely to see wild swings in all markets, in both directions, over the next few days and weeks until this washes out.

Gary K weighs in:

On The Ledge Again!
http://www.garyk.com/
By Gary Kaltbaum | TradingMarkets.com

Gary Kaltbaum is an investment adviser with over 18 years experience, and a Fox News Channel Business Contributor. Gary is the author of The Investors Edge. Mr. Kaltbaum is also the host of the nationally syndicated radio show “Investors Edge” on over 50 radio stations. Gary is also editor and publisher of “Gary Kaltbaum’s Trendwatch”... a weekly and monthly technical analysis research report for the institutional investor.

Before I get into the technicals, a few things to ponder:

Why is GE having to raise more capital? Is GE just another company who has lied about the condition they are in?

Is CITI next? As you know, I have been calling for single digits in CITI for months. Man...did I get flak for that one! Not anymore. The problem for CITI is not what I think - but as always - what the market thinks. The market forced FNM, FRE, AIG, LEH, BSC and the rest’s hand. CITI is acting like the rest of the cadavers. I think there is a decent chance CITI is next. I cannot believe I am saying that. Prince Alwaleed cannot be a happy man.

Yesterday’s nonsense on Capital Hill is symbolic of corporate culture run amok. How these imbeciles can fly on private planes to ask for money is beyond reason. I must also say I get sick to my stomach every time I see Bob Nardelli...who walked into Home Depot, took out about $250 million...left the company’s culture in shambles...and immediately gets a job running Chrysler.

The credit markets are locked up, do not believe the pundits that are saying credit markets are thawing. All one has to do is see the plunge in U.S. Treasury rates. The latest move was set off by the bumbling, mumbling, stumbling and pitiful fool named Paulson, who publicly announced he changed his mind. This TARP vote will go down in history as one of the stupidest yes votes in history, and I am proud I was against it vociferously. (I think that is a word!)

It continues to amaze me how easily so many fell for this crap when it was proposed by one of the people who caused all these problems. Again, Paulson lobbied this same Congress years ago to raise the leverage for companies like Goldman Sachs...and of course, Paulson ran Goldman Sachs. This was an easy puzzle to put together. Paulson actually argued that “the financial markets are much more stable today than before the TARP”. Who is he trying to kid? ABX and CMBX spreads are predicting a not so nice outcome. I gather this man is counting down the days when he can get out of this job.

Every major index (except the DOW) has broken into new bear market low ground. The DOW always holds best during these drops as money parks itself into megacap companies that pervade the DOW. The only good news here is that the thousands of bottom callers will finally be shut up. The bad news is that the internals are horrid...and buying continues to be anemic into the massive supply of stock that keeps hitting the market. In fact, in the past two days, the internals have been as bad as I have ever seen.

I am not one to give targets but I am one that knows if a market is ready to turn or not. So far, not. There is underlying support down at the last bear market lows at 7200 DOW and 768 S&P. It amazes me, I actually have to mention these levels. This recent ridiculous whipsawing we have been seeing has now only led to another leg down. We may get some waterfall action here because of the break but not sure. I remain in 100% cash and I remain up in this bear market for the ages.

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Generally and theoretically the bond market moves in an opposite direction to the stock market. Fear drives money out of stocks and into the bond market for safety not return. As the price of a bond goes UP the interest rate it pays goes DOWN. This gives a self-correcting mechanism to the investment market as lower interest rates produces more investment everything else equal. So lower interest rates are “bad” in that they are the symptoms of reduced economic activity.

Your second question is more complex but can be approached by realizing that deflation makes Cash more valuable since prices have falled. It hurts savers though because interest rates fall as well. If you have invested in real assets their prices stagnate or fall hence their rate of return drops. If you had invested in Treasuries then you profit since their prices have increased as does the principal you invested in purchasing them.

The solution to deflation is also a cause of deflation. You want to spend money more slowly since it is becoming more valuable but spending money more slowly means economic growth slows which becomes a self fulfilling prophecy.

Hence, there will be a massive push for even more federal spending as a means of keeping income growth from falling rapidly.

Economics is not called “the dismal science” for nothing.

Inflation (or more properly “DEFLATION of the value of money”) Takes a good while to work into the system. The inflationary times of the 1970s actually took over 5 years to ramp up after years of goosing the money supply. The first “shock” came with the arab oil embargo in 1973, but we had been running a guns and butter economy since 1966.

That is the good part. The bad part is that once inflation gets imbedded in the general flow of the economy, it is extremely difficult to get out.

The fed is absolutely terrified of the deflationary implosion they have seen in Japan for the last 20 years. So much so that they are committed to do the same dumbass stuff the BOJ did and hope that the results will be better.

Three quarters of our problem has been federal reserve policy of goosing money supply. The other fourth comes when they try to “address” the problems they create.

The federal reserve is stupid, corrupt, incompetent, and horribly destructive. They have pissed away over 96% of the value of the dollar in less than 100 years simply by being allowed to ratchet up the money supply far in excess above the rate of growth our economy has experienced. The curve has been practically asymptotic for the last 27 years or so.

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