Whither Yields? Wither the Economy?

Something very strange is happening in the Bond markets. Last night this interfered with my sleep cycle and, in turn, it made me sufficiently irritable to sit down and focus with a bit more intensity than normal.

In short, my bleary eyed unconscious has been screaming at me. "Wazzup?!!"

Let's take this one easy step at a time.

The long dated yields have "gapped up" on the charts; showing a breakaway gap followed by runaway gap. This is quadruple attention demanding, because:

• The bond markets are supposedly populated by serious, staid, quietly spoken pin stripers who are not typically given to the kind of emotionally anxious behaviour that gives rise to a chart gap.
• The gaps on the long dated yield charts were not dimensionally trivial.
• A breakaway gap followed by a runaway gap have measuring implications regarding further minimum movement in the same direction.
• The charts gapped in the "wrong direction."

Huh? Waddayamean "wrong direction"?

What I mean is that the market as a whole seemed to be taken by surprise because an analysis of the last fifteen years yield DIFFERENTIALS shows that if anything, either the short dated yields should have gapped up, or the long dated yields should have continued lower. As young Bill Tremblespike's character put it in Hamlet: "Something is rotten in the State of Denmark"

Which is why, instead of my morning exercises, I sat myself down and analysed the yields. I grabbed a monthly chart going back to 1987 of each of the 3-month Bill yields and the 30-year Bond yields, and checked out (manually) the intra year highs for each instrument (Left Hand Table) and the intra year lows for each instrument (Right Hand Table).

This little exercise gave rise to some fascinating insights.

• The DIFFERENCE between the yields on 3 month instruments and 30 year instruments seems to flex between 0% and 4%. In both the intra year highs and the lows
• The LARGEST difference occurred in 1992, when the lowest yield on the 30-Year Bond was 4.5% higher than the lowest yield in the 3 month Bills. (THIS SETS AN IMPORTANT OUTER BOUNDARY OF NORMALITY)
• The SMALLEST difference occurred in 2001 when an inversion occurred, and the highest 3 month yield was around 0.25% higher than the highest 30 year yield.
• In 2002, the differential of 4% in the highs seemed to indicate that we may have been approaching a boundary of normality, and that - for the yield differential to start narrowing, either short dated yields should rise, or long dated yields should keep falling. 

So, given that long dated yields gapped "up", this was counter-intuitive; and it may well be that many of the "comfortable" speculators (hustlers) who have now started to trespass on the turf of the quietly spoken pin stripers were caught in a squeeze.

As an aside, in discussing this with a savvy friend, he opined that this state of affairs could well have been facilitated by the Internet; and I think he may have hit a bull's eye with that one. On reflection, his prescient observation might just have honed in on the Achilles Heel of the entire financial system that was previously "controllable" by the Central Bank centric Establishment.

(As an aside, it struck me as mighty strange at the time that the financial authorities should decide to discontinue the 30-year Bond as a financial instrument given that the yield on this instrument provides the ultimate benchmark for risk/reward assessment for the entire financial system. Perhaps this decision was taken to deliberately cause an obfuscation of the "facts" that are so readily available via the internet)

OK, lets review:

• Step 1 was to identify from the charts that the yields have further upside potential, and the measuring gap implications show a minimum final destination of around 5.25% on the 30 year bond, with a possible move (as shown by the falling wedge) to around 5.4%
• Step 2 was to identify that a 4.5% differential is within the bounds of normality; and so the long yield "could" rise to as high as 6.25% without causing any breakdown of logic - or dislocation in the markets.
• Step 3 will be to determine why. What in Hades is going on? Are we facing a squeeze of speculative positions of the river boat gamblers, or is there some fundamental change occurring out of left field?

If the former, then we should soon see a reversal of the secondary spike and a resumption of the Primary trend with long yields eventually bottoming at any level that shows a yield differential of between 0.5% and 1.5% of the low in the 30-day yield. (Which is why some analysts are looking for a bottom of 3% in the long bond yield; and even this level is higher than is logically defensible)

If the latter (structural change) then it is conceivable that the Primary Bear Market in equities will extend to the Bond Markets, and an enormous amount of financial damage may be wrought before the Primary Bear Trend exhausts itself.

We could "reach" for a few possible answers:

• The market is shifting its view from an anticipation of deflation to one that anticipates inflation. (not yet reflected by the gold price)
• Rates need to rise to protect the dollar and the flow of capital into the USA (very plausible, but approaching the end of its life cycle)
• Rates need to rise at the long end to ensure that Lending Institutions remain solvent, and the financial industry as a whole does not implode when the bad debts start to impact. (Most reasonable at face value).

Well, if I knew the answer to this little conundrum then I guess I would be able to look in the mirror in awe that I should know someone of such towering intellectual genius. The fact is that no one on this little blue planet can know the answer, but I have a gut feel that my friend's view on the Internet may be right. I think the world has changed, and I think we need to adapt our thinking accordingly.

The very fact that someone who is as busy as I currently am on a day-to-day basis - in a field of endeavour that is quite far removed from the Markets - can actually research this article and think about its contents as a "mild" diversion provides hard evidence that Professional Investment Managers cannot continue to rely on shallow investment tenets, regardless of how well accepted or "brilliantly conceived' they may be. For example, to embrace the concept that you can use a computer model to "trade" profitably on any market is evidence of a very low level of understanding of the ultimate complexities of financial markets (as even the geniuses behind LTCM found out).

Because of the Internet, we may now have entered a brave new world where only a truly deep level of understanding will enable one to make sense of what is happening.

And let there be crystal clarity on one point. The writer of this article is not possessed of that understanding. I have rubbed shoulders with a sufficient number of mega wealthy individuals to understand that the really successful investors are possessed of an instinct that cannot be learned. You either got it or you ain't, and most people, by definition, ain't got it. Even the mega successful don't really understand why they just "know" the answers - which is why, even they tend to make mega mistakes and zig when they should have zagged - often at the worst possible time.

For this reason, I am leaning towards the view that the savage up-move in yields may be primarily related to a squeezing out of the riverboat gamblers, but there are three "straws in the wind" that are making me very nervous that we could ALSO be facing a structural increase in interest rates at the long end:

• I don't trust the decision to discontinue the 30 year bond. That decision smacks of dishonesty, and leads me to suspect that the financial system may be close to running out of control.
• The US deficit grew again last month, and the elastic can stretch only so far before it finally snaps.
• If the banks are faced with a decision where it's their lives or that of their customers, there is no contest, the customers will lose. Regardless of the economic consequences, if the banks are faced with a decision of having to raise their margins to survive, they will do it.

Yes, it is "nice" to know that gold offers the ultimate safety valve, but let's stop a minute and think about it. There are possibly 500,000 people who regularly visit this GOLD-EAGLE.com site. These represent the people who believe that the gold price is entering/has entered a Primary Bull Market, with $400/oz being at the low end of expectations and $3,000/oz being at the high end.

In light of the complexities that I have alluded to above, can it really be that easy to "make a killing" in a market (gold shares) whose total size is equivalent in value to around sixty days deficit in US foreign trade? Even a child will understand from reading the story of Cinderella that you cannot fit a size 500 foot into a size 5 shoe.

C'mon guys. Let's have a reality check here. What we absolutely HAVE TO DO is apply our minds to fixing the economy. There is no alternative to this outcome that justifies any application of mental bandwidth.