Bonds, US Dollar and Gold

It has been some time since we last discussed the bond market in some detail. But bonds are an integral part of the market. World wide it is estimated that there are $33 trillion of bonds outstanding. The US market represents just over half of that at around $17.1 trillion at the end of 2001. Canada's bond market by comparison stood around $515 billion at the same time. By comparison the estimated global market capitalization of stock markets is around $20.5 trillion. The NYSE is the largest at roughly $8.5 trillion (all figures US$). It is estimated alone that the global stock markets have lost over $6 trillion of value since 2000. One last comparison is with the Global Derivatives market that has an estimated size of $100 trillion.

Another way of looking at the size of the Bond market is daily trading volumes. It is estimated that the average daily trading volume of US Treasury Securities alone is around $360 billion per day. By comparison the US Equity markets trade only around $50 billion per day. Both of these pale in comparison to the Foreign Exchange market that averages $1.5 trillion in transactions every day.

Bonds are debt securities. There are many different issuers of bonds including governments (Federal, Provincial, State or Municipality), government agencies, corporations both private and public, mortgage and asset backed securities, and foreign government bonds. Bonds are often called notes for terms of 5 years and under. Securities issued for terms of one year or under are called money market and include treasury bills, commercial paper, certificates of deposit (CD's), banker's acceptances (BA's) and repurchase agreements.

Unlike the stock market there is no central exchange where bonds or money market instruments are traded. They are traded instead in a huge over the counter market amongst investment dealers, banks, insurance companies, trust companies, pension funds, mutual fund dealers, corporations, governments and government agencies, central banks, and individuals.

Bonds pay an interest rate known as the coupon and at maturity the bond pays the principal. Interest is paid normally semi-annually. Interest rates move inversely to bond prices. Bonds trading over 100 are said to be trading at a premium and bonds under 100 are said to be trading at a discount. When bonds trade in the over the counter market dealers always quote in prices not yields. Bond prices are subject to fluctuations. Factors affecting bond prices are changes in the supply and demand, changes in credit conditions, central bank policy and operations, government fiscal policy, exchange rates, economic conditions, changes in the rate of inflation and market psychology.

Unlike stocks, bonds are rated by Rating Agencies. Standard & Poor's and Moody's are the best known and most influential credit rating agencies (here in Canada it is Dominion Bond Rating Services (DBRS)). The best credit bonds are rated AAA or Aaa. Both the Government of Canada and the US Government bonds are rated AAA/Aaa. Everyone else falls behind. Other ratings are AA, A, BBB, BB, B, CCC, CC, and C. Anything BB and under is speculative and anything CCC and under is junk bonds. C rated bonds are bonds in default with recovery unlikely.

With federal government bonds the highest rated, all others trade at spreads over governments. In periods of financial stress these credit spreads widen even further. As the market became more leveraged in the late 1990's and as defaults and company collapses became endemic in 2002 credit spreads widened considerably. This has made borrowing more expensive for corporations and other entities including provincial governments. As a result we have seen some slowing in borrowing particularly for corporations as money has become more expensive and volatility has increased.

Bond prices peaked (yields bottomed) in September 2002. Since then we have seen steady rising bond prices responding to a perceived improvement in economic conditions, rising government deficits (the US has fallen back into budgetary deficits to finance the War on Terror and Homeland Security), the perception that the Fed has little room to move rates lower and a falling US Dollar.

Contrary to perception the Central Banks do not influence bond prices except as what might be done as to ongoing market operations. The Fed and the Bank of Canada set monetary policy and influence monetary policy through the discount rate and the bank rate. This has its biggest influence at the short end of the market and not in the bond market. Yields tend to rise the further one goes out along the yield curve (normal) although there are periods when short rates are higher (inverted).

Bond prices have been shown to move in a cyclical fashion. The long term Kondratieff cycle has shown that interest rates tend to fall or stay low in the spring, fall and winter of the Kondratieff cycle but rise in the summer (inflationary) part of the cycle. Not unexpected then bonds last major low in prices was in 1981 when interest rates peaked at over 20% at the end of the Kondratieff summer. Since then significant lows in bond prices (high in yields) have been noted in 1984, 1987, 1990, 1994, 1997 and 2000. The longest cycle was 1990-1994 that lasted about 4.2 years while the shortest was 1994-1997 that lasted 2.4 years. On average the bond cycle from trough to trough was roughly 3 years.

That tells us that the next major bond cycle trough should occur any where from June 2002 to March 2004 with the average pointing to January 2003. We did have a cyclical low in March 2002, which would be very early by past measurements. Bonds have recently turned down sharply in price coming off of record high prices (low yields) in the US. Canadian bond prices have also fallen although they never saw the record highs in prices seen in the US as Canada/US bond spreads rose. Our weekly chart of US Treasury Bond futures shows that an attempted rally back to the highs has failed. This signals to us that a new bear market in bonds is getting under way.

Bonds are generally positively correlated to the stock market and the US dollar. There are of course leads and lags in these inter-related markets. The Kondratieff Cycle probably provides the best summary as to the cycles stocks, bonds and gold. We summarize as follows:

The US Dollar has not been part of the Kondratieff cycle. But we can make the following observations. During the spring of the Kondratieff cycle the US Dollar was generally strong. During the summer when both bonds and gold prices were rising, the US Dollar was falling. During the autumn of the Kondratieff Cycle the US Dollar had been generally stable to rising. Notable periods of US Dollar weakness such 1989-1990 and 1993-1994 saw bond prices falling and gold prices rising along with stock market weakness.

The US Dollar is once again exhibiting weakness. Foreigners hold roughly one-third of outstanding US Treasury Securities. Foreigners also have substantial holdings in US Corporate bonds and the stock market. Notable holders of US Treasury securities are the Japanese and Saudi Arabia. The Japanese have been and continue to be in a position to sell substantial holdings of US Treasuries to raise funds to finance their bankrupt banking system. The Saudi's have threatened to sell US Treasuries for Euros or gold if the US invades Iraq. The US with insufficient savings would not be able to purchase the bonds and this would in turn put downward pressure on bond prices and on the US Dollar.

The US Dollar has already been demonstrating substantial weakness. Our weekly chart shows what appears to be a massive triple top. While triple tops are rare they can prove quite devastating if correct. The triple top suggests we should fall to at least 100 and possibly lower. The US Dollar index is trading under its 13-week, 40 week and 4 year moving average. A recent breakdown from a bear flag has confirmed at least a target of 100.

Bond prices, as noted, have failed recently their record highs. Bond prices should continue to move lower as the US dollar moves lower. This is consistent with past observations. Bonds have fallen below its 13-week moving average but remains above its 40-week moving average. A rising up trend line and the 4 year moving average are lower at around 100^00.

If the US Dollar is falling, and bond prices are falling, gold prices should rise. Gold has been trading in a narrowing range over the past few months with lows of $298 and highs of $330. The more recent range is between $310 and $325. Gold should break out to the upside of what appears as a bullish symmetrical triangle. Gold has been holding above its 40 week moving average and is well above its 4-year moving average. A breakout over $325/$330 would be confirmation of an upside move to at least $360. Only a breakdown under $310 would negate this scenario. We do not expect this to happen.

Bonds are an important integral part of portfolios. It has been suggested that bonds make up at least 25%-40% of a portfolio depending upon conditions. The coming rise in bond yields will not be friendly to those who are holders of bonds. When, however, the current cycle trough in bonds plays itself out it should afford investors an opportunity to lengthen bond maturities at very attractive prices.

Note: Chart produced using Omega TradeStation or SuperCharts. Chart data supplied by Dial Data.

Charts and technical commentary by David Chapman of Union Securities Ltd. 69 Yonge Street, Suite 600, Toronto, Ontario, M5E 1K3 (416) 604-0533, (416) 604-0557 (fax) 1-888-298-7405 (toll free) email [email protected]