Wednesday, March 23, 2011
Interest rates have been trending lower.
Since peaking near 4.8% in early February, the yield on the 30-year Treasury bond has fallen to 4.4%. It's the lowest yield of 2011… And a lot of bond buyers think interest rates are headed even lower.
They argue the disaster in Japan will curtail economic activity, thereby reducing the demand for money and keeping interest rates low. They believe the Fed will embark on a third quantitative easing (QE) program when the current scheme expires in June. They think the government has the power to control long-term interest rates and will be able to keep them at artificially low levels.
Those poor, stupid fools.
The problem with the Treasury bond market is supply and demand. Reckless government spending ensures an ever-increasing supply of bonds in the market. But fewer folks are willing to buy these things… So demand is drying up.
China isn't buying our bonds like it used to. Japan will be using its surplus cash to fund rebuilding efforts. It won't be buying our bonds either. Our own government has been trying to take up the slack in demand by buying the bonds itself through the quantitative easing programs. QE2 ends in a few months, and while talk of QE3 is making the rounds, politically it'll be a difficult pill to swallow. Besides, interest rates are higher now than they were when QE2 kicked off. So even if we get more QE programs, it's doubtful they'll have the desired impact.
The only folks who will be buying U.S. Treasurys will be the "flight to safety" crowd. Indeed, the recent downtick in interest rates coincides with the swoon in the stock market. Nervous investors jumped out of stocks and parked their money in government-backed bonds.
If the stock market falls further, bonds could rally a bit more and interest rates have more room to fall. But that's a temporary affect with no lasting impact. Interest rates will adjust to the longer-term forces of supply and demand. And that adjustment may happen sooner than most people think.
Take a look at this chart of the 30-year Treasury yield…
We last looked at this chart back in mid-December after rates had put on a tremendous three-month run. While I was bearish on bonds and bullish on interest rates at the time, I suggested rates had risen too far, too fast. Investor sentiment toward bonds had turned too bearish. And perhaps it was time for rates to correct a bit lower. I suggested anyone looking to short the bond market would be better off waiting for rates to fall back down to 4.3% or even 4.1% before doing so.
As you can see from the chart, rates are close to hitting that initial 4.3% target (43 on the chart) – which means it's just about time to step on board the short side of the bond market again. If the stock market correction that kicked off a couple weeks ago makes another move to the downside, bond prices will rise and interest rates will fall as investors jettison their stocks and rush to the perceived safety of the U.S. Treasury bond market.
We don't have the perfect setup for shorting the bond market just yet, but we're close. If 30-year yields drop to 4.3%, it'll be time to start nibbling on a short trade. At 4.1%, be ready to gulp it down.
Best regards and good trading,
"Two weeks ago, nobody cared that interest rates were rising," Jeff wrote back in December. "Two months ago, the entire world seemed convinced the Fed could push long-term interest rates even lower. But we thought differently." Learn more here: How to Trade the Spike in Interest Rates.