Wednesday, May 30, 2012

10-Year Yield Hits New Low

The yield on 10-year U.S. treasuries has hit a new low, at least for the last 60 years.  The yield dropped as low as 1.62% earlier today.  The 30-year rate is also down, although not at record low levels yet.

This is interesting for a lot of reasons.  First, the 10-year rate is highly correlated with mortgage rates.  This means that mortgage rates are now at or near an all-time low.  It doesn't seem to be doing much for the housing market, but maybe on the margin it will encourage a few more buyers.  Anyway, if you can lock in a 30-year fixed rate for under 4% right now, that really is the bargain of the century.

The next interesting thing about the super low rate is the bond market's defiance of the bond bears.  There are a lot people, libertarians included, who have been predicting higher rates for quite some time.  I remember when Harry Browne was talking about the permanent portfolio about 7 years ago and there were people challenging him on the bond portion of it, saying that rates couldn't possibly go any lower.  Yet bonds have been one of the best investments of the last 30 years.  While gold has done better in the last 10 years, bonds have been more consistent since the 1980's.  I'm not saying that it will remain that way, but just that the bond market has proven a lot of people wrong, at least in timing.

Another interesting thing about the low rates is that it is allowing the Fed to stop its quantitative easing (money creation).  Since QE2 ended about 11 months ago, the Fed has been tight.  It can remain tight with low yields.  That means the U.S. Congress can continue to rack up huge debts without relying on the Fed to buy the debt.

So when will rates finally go up significantly?

I think the answer depends on price inflation.  And price inflation will depend on several factors including the general health of the economy, bank lending, and Fed policy.  If price inflation remains relatively low, then I don't see interest rates going up.  If rates start to tick up and there is relatively low price inflation, then the Fed can step in and buy.

The only scenario I can see where the Fed would refuse to buy more government debt in the face of rising interest rates is if price inflation is also high.  If there is price inflation of 2 or 3 percent like we have now (at least according to government statistics), then the Fed has no problem creating new money out of thin air.

On the other hand, if we had a scenario where interest rates were rising significantly and we had price inflation of 10 or more percent, then the Fed would have difficulty stepping in and lowering rates, out of fear of triggering massive inflation or even hyperinflation.

Until we see a significant rise in price inflation, I don't expect a significant rise in rates on U.S. government debt.  There will probably be a good time to short the bond market, but we are not there yet.

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