Government bonds are acting up

On May 12th, I mentioned that I believed that mortgage rates and interest rates were going up, so the conventional and normally sound wisdom about never locking in a 5 yr mortgage may not apply this time.

Back in March, I mentioned that I thought that interest rates were heading up.

Last week, mortgage rates went up 20 beeps (basis points) and this week another 40 beeps, 60 beeps total.  Sub 4% 5 yr mortgage rates in Canada are now gonzo... 10 year treasury bonds in the US are near 4%, up 2% from December. 30 year treasury bonds are inching closer to 5%. Mortgage rates in the US are up sharply as well.  And all this despite the Fed buying bonds (at record prices I may add).

This is one of the big stories of the first half of 2009: government interest rates are increasing. I am in the deflation camp. So how do I reconcile my deflation views with my view that the 30 year US treasury bond could go to 7% or 8%?

As Bob Hoye of Institutional Advisors has pointed out repeatedly, in a post-bubble contraction, real interest rates soar, despite falling inflation. Investor risk aversion spreads to long term government rates.

Look at the looming trillions of treasury bond issuances. Who is going to buy up all this debt?

I am not a fan of Keynes, but even he said that governments should run surpluses in good times and deficits in bad times. Instead most G7 (Canada excluded) ran reasonable deficits in great times and are now trying to run enormous deficits in very bad times. There was a "free lunch" for the last few months whereby governments issued trillions in debt to replace the drop off in the private sector demand and tax revenues. That free lunch is ending as the bond market is catching on.

Imagine the impact that soaring interest rates are going to cause on a debt laden economy? If this happens, I am changing the title of my blog from The Great Recession to something with the word Depression in it, because that is where we are heading if interest rates rise to the levels that I suspect that they might.

Corporate bonds have done nicely in recent months as the risk/reflation trade has returned, but the turn in the treasury market could be a warning of problems to come in both the corporate bond market and stock market. Last summer, disasters in the corporate bond market preceded the carnage in the equity markets in the fall of 2008. 

The US dollar may have bottomed last week, and that is also likely to lead to problems in the stock market. Last summer, the US dollar bottomed in mid July, roughly a month before the stock market peaked.

I should caution though, that in the short term, I think that the bond market is going to rally (I have no position in bonds right now) as the bond market is extremely oversold and should rise as corporate bonds, commodities and stocks fall in the coming weeks and months. I have initiated very small short positions (SKF, S&P puts) but I am waiting for further confirmation. I consider these signs to be an alert for trouble ahead.