"Bond on bonds – disaster ahead"

... in which Barcap's Tim Bond forecasts developed market bond yields to double over the next decade. I tend to agree with that forecast, although Tim Bond and I have completely divergent reasons why.

He thinks an aging population will cause a surge in government debt/GDP ratios, which will increase risk premia. I believe that an aging population lowers potential GDP growth and thus, bond yields as well. I believe that inflation is the one main driver of bond yields in developed markets: cf. Japan, with it's government debt/GDP closing in on 200% (this is much higher than anything forecast for Europe and US in the next twenty years).

However, I am much less confident that the current handling of the financial crisis will not bring a spurt of high inflation down the road. It's not yet in the cards, but avoiding that scenario will require extreme toughness from policy makers - something I have trouble believing in.

By the way, as I have argued in many posts in the past six months, I believe in the near term the risks to bond yields are tilted to the downside: in my opinion, there is still more risk on banks balance sheets than on sovereigns balance sheets, and renewed flights to quality cannot be dismissed. For now.

Are Treasury bond yields headed (much) higher?

Theory says the ten-year risk-free bond yield should be equal to nominal GDP growth. With inflation expectations currently at 2.25% or above and consensus GDP growth for 2010 at 2.5% and above, the 10-Y Treasury bond yield could easily rise to 4.75% in the first part of the year, which incidentally, is about the level it averaged during the past half-decade.

However, I am expecting both renewed credit concerns and disappointments regarding GDP growth. This should at least put a cap on bond yields at around 4.75%. Since I am quite pessimistic in assessment of the economy, we should also see at some point a renewed flight to quality (well, quality is becoming less and less appropriate to describe treasuries) which could bring yields back towards 3-3.5%.

To sum up, 2010 could see swings in yields almost as wide as those we have seen in 2009.

To break the 4.75% level, we are going to need to witness "tangible" inflation concerns, and this should not be a problem before 2011 at least.

CR: Effect of Fed buying MBS

From Calculated Risk Blog:

It isn't that Fannie and Freddie "can’t sell to an end buyer", it is that the GSEs [securities] will be selling for a lower price (higher yield) when the Fed completes the MBS purchase program. At that time mortgage rates will probably rise by about 35 bps to 50 bps (relative to the Ten Year) in order to attract other buyers. Alone that isn't all that "scary".

The Fed has issued more than a trillion Federal Reserve Notes (otherwise known as dollars) to buy mortgage backed securities. This is is serious currency debasement for 50 bps! However, I believe the total impact has been bigger: for one, it probably has driven Treasury yields lower than otherwise, so even though the effect on the spread is only 50 bps, the effect on the yield must have been bigger. Second, it has increased liquidity in this market and increased confidence (perception) towards the ability of the GSEs to retain their role in the financial system.

But combined with the growing problems at the FHA, the distortions in the housing market caused by the first-time home buyer tax credit, rising delinquencies, the uncertainty of the modification programs, and likely further house price declines in many bubble states - there are serious problems ahead for the housing market.

Click here for the full post.

TIPS

... or should I say TIIS (Treasury Inflation Indexed Securities), the official name.

Here is an extract from an e-mail discussion I had with MarketWatch's Mark Hulbert, following his post on the subject:

(...) without any adjustment the 5-year TIPS currently embodies a zero inflation rate, and the 10-year carries very small 15 bps implied inflation rate (http://www.bloomberg.com/markets/rates/index.html).

But I don't think that in current market circumstances we should view this as what the bond market expects inflation to be in the future. It is more likely that the same technical factors that have forced down the value of nearly every financial asset in the past few months have been at play here.

Actually when you think of the fact that the Treasury will not take back money from the holder of TIPS if the CPI turns out to be negative, then TIPS are selling at a pretty amazing value here. The risk/reward is simply not symmetric: if the CPI is zero or above you'll make as well or better than in conventional notes, and if the CPI is negative... you won't make less.

Raphael

Well to be precise there are still many risks involved in investing in TIPS even at these prices: there could be more forced sales driving the yields up/prices down, an expanding liquidity risk, or rising real interest rates. But my point is that the risk/reward is extremely favorable.