Wednesday, June 13, 2007

The Sale of the Century

Interest rates on bonds are not rising because of inflation. They are rising because the people are selling into a scared market. As rates rise smart money comes into the equation. There seems to be a complete disconnect between the media and the bond market.

The media thinks that when the Fed raises interest rates, bond rates go up. Forget that idea. Bond rates go up when there is lack of buyers.

The Fed raises and lowers the discount rate, but it means very little. At one time we were the major player. Time has changed all of that. This is now a global market, and as a global market, the U.S. is just a small frog in a big pond. Bernanke is pushing on a string, the market is too big.

We might have the most regulated fair market in the world, but that doesn’t bring in the big bucks. It’s the other markets that are hawking their wares for our retirement dollars. Of course, most of what they do in foreign markets would be illegal in ours anyway.

So the 10 year rate is jumping up a bit. The real question to ask is, “What’s happening to the 30 year bond at 4.5%. If interest rates hit 9% this bond has had a 50% haircut. Someone yesterday suggested that it could hit 7% this year.

So if it does go to 9% aren’t you happy that your mutual fund locked you in at 4.5%?

So let’s see, if you bought a 100K 30 year bond at 4.5% and wanted to sell it to raise cash, you would get 50K in cash in a 9% market. But if you were the buyer, you get 9% on your 50k and 100K when the bond matures or when rates return to 4.5%. It kind of makes a stock trader look like a small time piker.


Anonymous said...

I have to disagree. Why isn't the stock market also being sold off to raise cash? Most bonds are owned by foreigners. They're swimming in cash. I think it has more to do with the "quality" (or lack there of)of US bonds. It's also in the interest of therse countries to keep the US dollar strong - since they hold so many of them. With New Zealand and other countries recently raising their rates, US bonds are not as attractive.

Jim in San Marcos said...

There are several issues here. The bond market is 10 times the size of the stock market. In an up market, there are more buyers than sellers so if you are raising cash, it's not noticed.

In the bond market, if you bought a 100k bond at 4.5% and the current interest rate is 5.5%, list price on your bond is about 82k. Thats an 18k loss.

Lastly, I am suggesting that interest rates are rising because people are reluctant to lock in at low rates if rates are rising.

Governments raise rates because of the spread between their rate and the real rate. So if the present Fed funds rate is 5.25% and street money is demanding 5.75%, you can borrow from the Fed and loan to the street and make a half point. The Fed in response raises rates to kill the spread.

This is an extreme oversimplification of what is happening, but it boils in down into simple terms. The imbalance is real as is the spread, the way it's taken advantage of is a lot more complicated.