I have discussed bonds and interest rates over the past year, but it is so important you understand what is happening. It is vital to your investments. For those of you who completely understand, please bear with me but it won’t hurt to reiterate and take a refresher course.
Additionally, our newsletter subscribers have doubled in the past month or so they may not have heard this before. It is about interest rates, the direction of interest rates, and their effects on your investments.
The long term direction of interest rates is up, no question about it. We may get a short term downward spike temporarily if we got a major event in the Middle East, a sovereign default, stock market correction, or some other global scare. But the long term downward trend from 1981 was over in October of last year.
Since that time, the interest rate yield curve steepened significantly. The yield curve is the relationship between short term rates and long term rates and implies how much risk and inflation investors perceive going forward.
For instance, if investors do not perceive a lot of risk or inflation, long term rates will not be much higher than short term rates. If, however, they perceive a lot of risk or inflation, long term rates should be significantly higher than short term rates. So, the steeper the slope from bottom left to top right with Time on the X axis and Yield or Rates on the Y axis, the more the perceived risk and/or coming inflation.
Do you know what the yield curve is telling us right now? I will tell you. It has become the steepest yield curve in HISTORY, and it has done so in just 3 months (see the Treasury Yield Curve Graph below, especially how steep it is from 6 months to 10 years). This means investors believe there is an extremely elevated level of risk and/or inflation now and on the horizon.
US Treasury Yld Curve 2/14/2011
You can see this in the downward pressure on bond prices over the past few months, especially sovereign or government bonds. Remember your economics class in college talking about supply and demand. Well now we have sovereign or government bond supply, lots of it.
President Obama just announced today that our National Debt was 14 trillion dollars and equal to our GDP. He also said our deficit this year would be 1.65 trillion and that our national debt would soon be over 15 1/2 trillion. This means we have a 100% debt to GDP ratio and getting worse FAST!
This is not sustainable and all it takes is China or Japan to refuse to buy our debt, our interest rates would spike even worse, and we are DONE. By the way, Japan is in worse shape than we are and their debt to GPD is 200%, and their economy is slowing. Japan is already done, it is just a matter of time. How much they eventually devalue their currency is speculation.
Europe is in bad shape too. Italy just had an auction today. Yields were higher and the Italy did not raise all the capital they attempted to at reasonable rates, but the media tried to put a positive spin on the auction.
One example is the Wall Street Journal. They had an article with the title “Italian Auction Bodes Well for Portugal” and stated “Italy sold $7.01 billion of government debt today, nearly the maximum amount it had intended, confirming investor demand. Yields were somewhat higher than previously, but the result still offered hope for Portugal and Spain, which will sell government debt later this week.”
The WSJ is attempting to put a positive spin on this auction, but it was not fully subscribed at the rates Italy wanted. Portugal & Spain have their auctions later this week, and Portugal reported today that their growth slowing – not good.
The whole point is we are having mountains of new, sovereign debt (supply) coming to market quickly and investor (demand) can afford to be choosy. When you have more supply than demand, the price goes down. This mean that interest rates will rise as they already have, and bond prices will go down further.
What does this mean for you as an investor? It means you need to be very careful with any bonds, especially longer term bonds and sovereign bonds. Going forward I would only hold high grade corporate mid and short term bonds.
This is the coming debt collision Dan Cofall and I have been talking about ever since the first bailouts of 2008. It is here and the effects are already being felt with the rising rates.
For further clarification or help in deciding what you should do specifically, feel free to contact me.
