Bonds have been much talked about of late. Given the sharp rise in interest rates in recent weeks (60+ basis points from the low for the 10yr Note in early May), it’s pretty easy to understand why. The question is one of causality. There are a few potential candidates.
The first is the economy. It is natural when things are improving for interest rates to start working higher. There is more demand for money for spending and investment, which drives yields up. There is also the anticipation of higher inflation, which leads fixed income investors to demand higher yields to compensate for the lost purchasing power. We may not be looking forward to the US economy growing at 5% per year any time soon, but even if it grows in the 2%-3% range, which seems the expectation, high yields than what we’ve seen are easily justified.
The second candidate for the push up in rates by the market is the Federal Reserve. That’s obviously tied in with the economy discussed above in that we would naturally expect the Fed to bias toward higher rates with an improving economy. In this case, though, we have to add in the quantitative easing aspect. The Fed has unemployment as its target and as the chart below shows, that’s been steadily moving lower. As a result, the market is already looking forward to the eventual retraction of all that money printed to purchase Treasury securities and other debt instruments.
A combination of a stronger economy driving higher demand for money and Bernanke & Co. ending Q.E. creates the potential for a rapid upside movement in rates. How fast will depend on how the Fed unwinds. First, there is the step of halting continued purchases of Treasury paper ($85bln/mo). That will reduce demand, which in and of itself would impact yields. Then it becomes a question of whether Treasury securities are sold off or just held to maturity.
Much has been made of the potential losses the Fed could suffer on rising interest rates (like this Bloomberg story). Many market participants make a big deal of this because not only would higher rates mean bigger losses given where all the purchases have been made (low rates meaning relatively high prices), but the act of unwinding the portfolio would likely exacerbate things. As the Fed sells off its Treasuries it would tend to accelerate the rise in rates, and worse its losses.
Here’s the thing, though. The central bank need not sell back its holdings into the market, though. All it needs to do is hold them to maturity to avoid taking any losses (except in the case where Bonds and Notes were purchased for higher than par value, though even there interest income would more than offset the loss of principal). And the Fed need not sell Treasuries to shrink the money supply (selling brings money into the Fed, taking it out of the system). It can do repos to accomplish the same effect.
So with that said, what are the prospects for US rates?
Well, the weekly chart of 10yr yields below tells me that more upside is likely.
The widening of the Bollinger Bands indicated by the turn up in the Band Width Indicator line at the bottom (measuring the relative width of the Bands) says we may just be in the early stages of a trend move. The 2.40% rate area is massively important resistance, however. Notice how it was first a support zone when the market dropped in 2010, then became a topside barrier once broken below in 2011. How the market reacts to making a test of 2.40% will tell us a great deal about its strength or weakness.
Rising US rates, by the way, will only tend to make the USD more attractive to capital inflows.