During the recent market tumult, bond yields have once again dropped sharply to very low levels, as seen by the yield on the 10-Year Treasury.  A couple of charts illustrate this.  First, a weekly long-term chart from 1962 as seen in Doug Short’s August 12 blog post titled “Treasury Yields in Perspective“, with 10-Year Treasury Yields shown in blue:

(click on chart to enlarge image)

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Next, a 3-year daily chart of the 10-Year Treasury Yield:

(click on chart to enlarge image)(chart courtesy of StockCharts.com)

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While this Bond Bubble may have a little more “upside” left to it, I am of the belief that attempting to derive gains from bonds at this point is akin to “picking up pennies in front of a steamroller” – i.e. there is little to be gained, and much to be lost.

While the Bond Bubble continues, its risks to investors, financial markets and the economy in general has in no way diminished.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1194.20 as this post is written

The bond market is believed by many to be an asset bubble.  I agree with this assessment, and have written a few posts on the subject.  I discussed when it may “burst” and other considerations in an October 4 post.

The chart below shows the 10-Year Treasury Yield from the mid-90′s on a monthly LOG basis.  As one can see, the yield has been less than 4% since the latter part of 2008:

(click on image to enlarge charts)(charts courtesy of StockCharts.com)

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The next chart shows a one-year daily chart with the 50- and 200-day MAs (Moving Averages).   At 2.55%, the rate is just at the 50-day moving average (shown in blue) and considerably below the 200-day MA shown in red.  From this view, it appears as if there may be some mild upward pressure on rates:

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When one takes a slightly different view, by using a 13 and 34 day EMA (Exponential Moving Average) and adds the MACD indicator, however, it appears as if there may be considerably more upward pressure:

A pivotal question at this point is what impact will additional QE (Quantitative Easing) measures have on lowering rates.  As I have previously commented, “One question that looms large is whether any rate-suppression effect that additional QE may have is already “priced into” the market, as additional large doses of QE has been widely expected for a while now.”

Now onto Part IV, the stock market…

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A Special Note concerning our economic situation is found here

SPX at 1185.62 as this post is written

As I have previously written, I believe that there is a bond bubble encompassing the entire bond market.  While for many reasons one might not expect the bond market to become a bubble, nonetheless such a bubble has occurred and it is now simply enormous.  This bond market bubble stands out from other bubbles in history in both size and duration.

As one can see in the chart below, from Doug Short’s site on 10-4-10, the 10-Year Treasury Yield (blue line) has been on decline since the early ’80s:

click on chart to enlarge image

This decline in bond yields has been exceedingly munificent to the economy in many different ways.  As well, the bond bubble has been very beneficial to a range of asset classes.   On the above chart, one can see the performance of the S&P500 in green during this period of falling interest rates.

Of course, if one believes the bond market is a bubble, then a pivotal question becomes when will the bubble “pop?”  This question is difficult to answer, as there is a complex interaction between various factors fueling this bubble.

One important factor is that of additional Quantitative Easing (QE).  Many believe that such efforts will further depress interest rates.  Various estimates seem to generally support the idea that $2 Trillion of additional QE would depress 10-Year Treasury rates (currently at 2.48%) by approximately 100 basis points.  While I believe that such an effect may be possible, it is likely such an impact is overstated.

For many reasons, it is tempting to conclude that the bond bubble will last for years.  In fact, I am not aware of anyone who is predicting its imminent demise, i.e. “popping.”  However, I believe, from an “all things considered” basis, that the “popping” of the bond market will happen in the short-term (i.e. likely within 6 months, and possibly even yet in 2010).  I make this judgment based upon many different factors.  Such a bursting of the bond bubble will have immense ramifications on many levels; I have already discussed the threat of rising interest rates in an April 6 post.

Another critical issue with regard to the bond bubble is the following:  If one believes that there is a bond bubble that is serving to unduly depress interest rates, what might be the “natural” interest rate – i.e. one that may endure after the bond bubble pops?  I may discuss this, as well as further define the timing of the bond market “top”, in future posts…

A Special Note concerning our economic situation is found here

SPX at 1137.03 as this post is written

chart courtesy of StockCharts.com

There is very little general expectation for a significant rise in interest rates.  In fact, the average economist forecast (as seen for the March 2010 Wall Street Journal Economist Survey) for the 10-Year Treasury Yield for December 31, 2010 is 4.24%.

I believe that there is high potential for interest rates to rise faster than expected, and the economic implications of such, should it happen, can hardly be understated.

Falling interest rates over the last 20 years have been an “enabler” of much of our current day economy.  These falling interest rates are seen in the 20-year monthly chart shown below:

chart courtesy of StockCharts.com

Of course, a significant rise in interest rates would have adverse effects on many different economic areas, and would likely serve to impair and/or derail any hopes of an economic recovery.  Some areas that would be impacted by rising interest rates would include: real estate, all facets of lending, the bond market, corporate profitability, etc.  The list is virtually endless.

Furthermore, consumer spending would likely be impaired, as would the government’s ability to rather cheaply (and easily) fund the outsized deficits and debts.  As well, the government’s ability to “stimulate” the economy through deficit spending could largely be impeded.

I’ve previous mentioned (in a December 2nd post) that I believe that U.S. Treasuries are in a “bubble.”  While some have expressed the same view, it doesn’t appear as if there is recognition of the perilousness of such a condition.

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SPX at 1187.44 as this post is written

http://abcnews.go.com/ThisWeek/week-transcript-treasury-secretary-timothy-geithner/story?id=9758951

I could make a lot of comments regarding this interview.

However, I would like to focus on this one exchange:

TAPPER: The Congress just voted to raise the debt ceiling to more than $14 trillion dollars. Moody’s, the bond rater, just said, quote, “unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture for the next decade will at some point put pressure on the triple-A government bond rating.

Is the United States going to lose its triple-A government bond rating? And what happens when the credit markets are no longer willing to buy U.S. debt?

GEITHNER: Absolutely not. And that will never happen to this country. And again, if you step back and look at what has happened throughout this crisis, when people were most worried about the stability of the world, they still found safety in Treasuries and the dollar. You’re still seeing that every time. People are reminded again about the many challenges you see around the world.

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my comments:

First, I don’t think any country can ever flatly deny the possibility of a credit downgrade.  As well, as I have previously commented, sovereign deficit and debt levels are coming under increased scrutiny.

Second, as far as the U.S. Dollar and Treasuries purportedly acting as “safe havens” during the crisis, and the inferences Geithner draws from this :

Although the U.S. Dollar and Treasuries increased in price during the height of the financial tumult, I don’t agree with the idea that this price increase can be viewed as an (implied) affirmation of our financial standing.  Many different factors played into the price increases of the U.S. Dollar and U.S. Treasuries during that period.  As such, I do not come to the same conclusion as does Treasury Secretary Geithner.

As well, I don’t believe that drawing inferences off of past price action is necessarily a strong predictor of the future, especially on an “all things considered” basis going forward.

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SPX at 1062.90 as this post is written

“Members noted the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an unanchoring of inflation expectations. While members currently saw the likelihood of such effects as relatively low, they would remain alert to these risks.”

from the book Meltdown, p8, by Thomas E. Woods, Jr.:

“The Fed’s policy of intervening in the economy to push interest rates lower than the market would have set them was the single greatest contributor to the crisis that continues to unfold before us.  Making cheap credit available for the asking does encourage excessive leverage, speculation, and indebtedness.” 

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As one can see from the above two quotes, there is a considerable difference in philosophies regarding the probability of prolonged low interest rates in creating asset bubbles.  The top quote is from the November 3 Federal Open Market Committee Minutes, while the quote below it from Tom Woods Jr. and seems to offer a concise view of the Austrian philosophy on the low interest rate matter.

The issue of whether the ultra-low interest rate environment that has been put in place has fomented asset bubbles is a critical one.  For background on this matter, the November 30 BusinessWeek had a story titled “Is the Fed Creating New Bubbles?” and can be found at this link:

http://www.businessweek.com/magazine/content/09_48/b4157022781639.htm

My opinion on the matter is that there are currently multiple bubbles that have formed across various asset classes.  They are of various sizes and “vintages.”  Asset bubbles that burst can of course cause tremendous economic damage.  Perhaps the best example of this is “bursting” of the housing bubble.

Some bubbles are harder to spot than others.  Bubbles, almost by definition, include irrational behavior, and therefore can be hard to predict both in their formation as well as their ultimate size.  There are many factors that can come into play in order to cause bubbles.

I have addressed my thoughts as to whether Gold is in a bubble in a November 20 post.   Another question, that is critical  to both investors and the economy, is whether U.S. Treasury securities, especially the 10 Year, is in a bubble.   I believe the answer to this is “yes.”  The reasoning for my opinion is rather lengthy and complex; however, the previous post (from November 30) represents some of my thought on the issue.

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SPX at 1112.28 as this post is written