1.) Inflation expectations are perhaps the biggest determinant of direction. Because bonds have a fixed rate of return, anything that lowers that rate lowers demand. Rising inflation takes away more of the money investors get from fixed income payments, so a period of rising inflation should lower the bid for bonds.
2.) Flight to safety: whenever things get really crazy, investors flock to bonds as a safe haven bid. This simply means that bonds have a specific payment investors can continually expect to receive from their interest rates. This is attractive when the overall environment is a bit nuts.
On the 7-10 year chart, notice the following:
-- Prices rose through mid-April. That was the result of the rally that started at the end of last summer. This rally was the classic "flight to safety" bid. As the financial markets dropped, investors flocked to the safety of the Treasury market.
-- Prices fell starting in mid-March. This was a reaction to the Fed's move to back-up the JP Morgan/Bear Stearns deal. This move sparked a rally in the stock market which means bonds would probably sell-off (which they did).
-- However bonds have risen since mid-June. The question is why? There are several reasons. First, it's become more and more obvious the Federal Reserve won't be raising interest rates anytime soon. This makes the current run of Treasuries more attractive because investors know that bonds with a higher coupon won't be coming down the pike. There is also the increase in overall volatility which makes the safe haven of bonds more attractive. However, what I find interesting is this is happening in a period of higher inflationary pressures. Theoretically, higher inflation should take the bid away from Treasuries. Instead we are seeing an increase in Treasury prices. I'm guessing there are two inter-related reasons for this. First, traders are expecting inflation to come down. The Fed has continually stated they see lower inflation ahead. In addition, yesterday we saw big drops in commodity prices adding fuel to the lower inflation fire. Secondly, the stock markets have been extremely volatile. This makes the fixed return of the bond markets very attractive.
1 comment:
A good explanation. I hold a fair amount of IEF, and its price behavior is not easily understood by me.
It seems to me that I change my mind among three possibilities for future action:
1. Runaway inflation
2. Stagflation
3. Deflation of the 1930's sort
I can understand #1, and see how #2 could occur. What I can't visualize is how the current situation turns into #3.
#3, if my understanding of deflation from the 30's is correct, is a downward spiral of asset values, wages, business activity and credit availability. We have some of that occuring now, lead by credit availability and stock and housing prices. Business activity could be next, and more unemployment could (but hasn't yet) could lead to falling wages in excess of that which has already occured from job outsourcing from global competition.
In deflation, I don't understand however what happens to bond prices (and the interest rates and retreat to safety that drives them). Which is another way of saying I don't know what happens to interest rates in a full-blown depression. If savings/earnings fall, then credit should be costly. On the other hand, if other assets are devaluing, then demand for 'safe' investments should increase (since even after a crash, there's still lots of money looking for a return but few than can afford to borrow it).
Bottom Line, and being as gloomy as the situation seems to demand, what will happen to treasury prices and yields in major deflation?
[note: I'm not a financial sophisticate, but just a person scared sh*tless].
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