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The Weekly Peak - December 10, 2010

The Weekly Peak - December 10, 2010

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Published by: derailedcapitalism.com on Dec 10, 2010
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12/17/2010

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 Abigail F. Doolittle | abigail@peaktheories.com
 
December 10, 2010
The Weekly Peak 
The Bond Bust Has Begun
There’s no question that the last thirty years have been very good to the bond market.In fact, the chart above may even paint the picture of what could be called the Great Bond Bull Market with price moving inverse to yield.While I have been writing for months about thinking the “bond bash” is coming to an end, I think we may have seen the true beginning of that endthis week with the 10-Year Treasury yield spiking almost 40 bps higher in just three days to an intra-day high of 3.33% from 2.95%.And what might have been the impetus to bring about this potential end to the bull market in bonds?Interestingly, the most obvious possibility is also all but impossible and perhaps the reason why many seem to be surprised by the 95 bps or almost
1.0% move up in the 10-Year
on an intraday basis in
less than two months
.This “impossible” possibility is the Federal Reserve raising rates. While Fed Chairman Ben Bernanke said he could raise rates very quickly if need bein a recent interview, such a raise would be in response to any possible inflation down the road that might stem from QE2 or a need to slow theeconomy.Today’s concern is quite the opposite or possible disinflation, even deflation, as shown by paltry CPI figures while equally unimpressive GDPnumbers point to an already slow economy. Putting aside the fact that raising rates today would throw the economy back into a recession, it issomething that clearly did not happen this week or in any recent time, and thus can be eliminated as the harbinger of the bond bubble’s end.Rather, I think it makes it sense to take a look at the following factors.-
 
Stronger prospects for the economy,-
 
Budget deficit or fiscal worries,-
 
Inflation expectations/risk, and,-
 
Loss of confidence in the Fed, its monetary policy and QE2.This week, we’ve seen the perfect storm of these four factors coming to play and there have been two sources to bring this confluence about.First, the tax compromise between President Obama and congressional Republicans has been viewed by many as a “second stimulus” for the U.S.economy with many economists viewing the extension of the Bush-era tax cuts and payroll tax cut as a reason to raise their 2011 GDP forecasts. Inturn, such economic growth could have the potential to bring about a rise in prices or inflation. Simultaneous, however, this tax deal has causedconcerns around its effect on the U.S. budget deficit with some economists pointing to the possibility that the tax breaks could bring the deficitclose to 10% of GDP next year.So with Obama’s deal-making, three of those four factors occurred that could bring about an overall decline in the bond market.
 
1357911131517
Jan-78 Jan-82 Jan-86 Jan-90 Jan-94 Jan-98 Jan-02 Jan-06 Jan-10
10-Year U.S. Treasury Yield % (Monthly Thru 11/10)
 
Peak Theories Research LLC
The Weekly Peak
2
 
December 10, 2010
Please see important disclosure statements at the end of this document.
www.peaktheories.com
 
The first – economic growth – is likely to drive investors toward equities and out of bonds since stocks should perform better than bonds during atime of economic expansion.The second – unsustainable fiscal policy – is likely to drive investors toward precious metals and other physical and transferrable stores of intrinsicvalue and out of bonds that will suffer from such policy.The third –
inflation
– is related to that unsustainable fiscal policy and will be the
most powerful force
of these three, in my view, to
driveinvestors out of bonds
since rising rates will cause the value of bonds to decline while curbing the value of interest received.The second source to bring about two of the aforementioned factors, in my view, was Fed Chairman Ben Bernanke’s recent
60 Minutes
interview.For in that interview, Mr. Bernanke hinted at the idea that the Fed’s current round of quantitative easing to help stimulate the economy could bealtered – as in expanded – as needed.In the past, this communication may have been received by bond investors with cheer since the possibility would exist for a steady stream of thegovernment’s support for the Treasury market. In fact, this may have been the initial reaction out of investors with the 10-year’s yield dropping to2.95% on Monday from 3.03% on Friday but with this yield as high as 3.33% on Wednesday, investors seemed to have gotten sick from thepotential for an ongoing QE Drip. Sick because Mr. Bernanke committed to nothing specific about such bond purchases while intimating that theFed could be a constant inflationary force on the markets for some time to come.Mr. Bernanke may be “100% confident” that he and his team could tame inflation quickly by raising rates but that view does not seem to be sharedby ixed income investors and perhaps the early bond vigilantes.While most of the analysis I have read has attached this week’s spike in yield to growth expectations for the economy, this would seem moreplausible if stocks had rallied significantly.
If investors really thought the tax deal was going to juice the economy
,
it would be showing up in the equity markets and not the dollar
.And perhaps it will show up in the equity markets over time and I tend to think it has been over recent months – last week in particular perhaps –and will continue to slowly, but if the particulars related to the tax compromise were likely to bring such growth to the economy in 2011, it seemsto me it would have deserved at least a 1% rally after the fact and especially in light of the steep decline seen in Treasurys.It is for this reason that I think much of this week’s sell-off has more to do with investors signaling to the Fed that as a collective the fixed incomemarkets will not tolerate the Fed Chairman’s continued puppeteering especially when his proposed actions could bring about inflation that cannotbe tamed overnight. Put otherwise, I think
this week’s decline in Treasurys signals some loss of confidence in Ben Bernanke’s Federal Reserve
.Putting aside any early action out of the bond vigilantes, however, and returning to the idea that increased economic expectations might support abust in the bond markets, I think we’re looking at a slow dynamic rather than a dramatic sell-off of bonds as was seen earlier this week.Rather, I believe investors will assess – cautiously – that the economic recovery is, in fact, underway and creep from the safety of bonds for thehigher returns offered by other investment classes such as equities and commodities.And while this unwind is likely to be slow, it’s very much underway as the previous charts of an investment grade bond ETF show us.
 
Peak Theories Research LLC
The Weekly Peak
3
 
December 10, 2010
Please see important disclosure statements at the end of this document.
www.peaktheories.com
 
The 6-month chart to the left is weak considering that LQD appears to be in somewhat of a near-term downward arc and while there’s support atvarious levels, the longer-term chart points to the real support being around $100 or more than 7% lower than current levels.In addition, as I discussed last week, the
S&P 500 earnings yield
of about 6.5% suggests that
bonds are expensive
with the 10-year yield at 3.23%.
The Fed Model
points to the idea that equilibrium between the two markets is found when the S&P earnings yield is close to that of the 10-yearyield and, if correct, and it should be noted that it may not be but this non-Fed endorsed methodology does seem to point to meaningfulrelationships over longer periods of time, seems to point to
the idea that yields are likely to increase as will the S&P 500
.And so it is this inflation expectation/risk and perhaps an increasingly less tolerant stance toward the Fed’s until now artful maneuvering of marketsto create movement that is the most likely driver of the end of the Great Bond Bull Market, in my view,After all, the 10-year’s rise in yield has been telegraphing this message to us for two months now in the chart below of 
the roundtrip QE2 trade
.It may have been more difficult to believe its message a few weeks ago but now with the fixed income markets mimicking its message seeminglyacross the board, investors may want to consider taking a seat by reducing exposure to bonds before this market’s music ends entirely.
Sam’s Stash, Gold, and the S&P
I think we have the topic of 
Treasurys
mainly covered for today, but I will reiterate what I have been writing for many, many weeks now or the factthat I thought the 10-year would move back above 3.0% and would likely hit 3.25% and even 3.5%.Clearly the first two levels have been hit and I still think we see the 10-year at 3.5% and perhaps even closer to 4% for in the chart below, it ispossible to make out the natural target-like “pull” of that level.As I indicated above, I think it is wise to consider reducing exposure to the fixed income markets and Treasurys are very much included in thisassessment.

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