Confusion Over Gold and Treasury Yields

The following article from Marketwatch is a perfect example of how confused market participants are about the recent and current action in gold and Treasury yields:

Gold and bonds do not usually go up or down together.

But try telling that to the markets over the last two months.

Since early August, in fact, gold bullion has risen by around 10% and the Treasury’s 10-year yield, which moves inversely with Treasury prices, has fallen by nearly 15%.

These moves are substantial, in other words, and more than just day-to-day noise in the data.

What’s going on?

Consider first why gold is so strong, reaching a new all-time high this week. One explanation is that this has been caused by a weaker U.S. dollar on the foreign exchange markets. This is certainly plausible, since the dollar has been very weak lately.

Another plausible explanation for gold’s strength is that it is discounting higher inflation in coming months and years. And it is indeed hard to imagine that the trillions of dollars that the world’s central banks have injected into the financial system won’t eventually have an impact on the inflation rate.

Credible as these explanations are, however, they are hard to square with strength in U.S. Treasury securities. A weaker dollar, of course, puts more pressure on the Federal Reserve to raise rates, which would in turn cause Treasury prices to fall, not rise. The same outcome would presumably result from higher inflation, too.

We reach a similar impasse when we consider why Treasury prices have been so strong. The standard explanation is that they are discounting a weaker-than-expected economy and/or deflation, which will cause rates to stay low. But those are hardly the preconditions of a gold bull market.

Either way you look at it, then, we come to the same conclusion: Recent trends are unsustainable. Something’s got to give.

Which will it be?

Several factors are pointing to the bond market as being the more vulnerable right now:

  • The stock market has also performed well of late, and equities would not thrive if the economy were weaker than expected or if deflation were a bigger-than-expected threat. So, in essence, the stock market is betting that gold is right and bonds are wrong.
  • Bond market sentiment is at near-record levels of bullishness right now, and (according to contrarians) the consensus is rarely right. ( Read my September 15 column on bond market sentiment.)
  • Sentiment among gold timers is remarkably restrained, if not outright gloomy, suggesting that there is a strong “wall of worry” for a bull market in gold to continue climbing. ( Read my October 6 column on gold market sentiment.)

The bottom line?

Don’t be surprised if the bond market over the next several months is markedly weaker than gold.

All this confusion regarding gold stems from one false pretense: that gold is an inflation hedge. It is not. Gold and Treasury Notes/Bonds are, as opposed to almost all other assets, up from October 07 levels for the exact opposite reason, deflation.

Read what I have written before, for example in Gold, Silver, Treasurys – A Snapshot.

Monetary commodities, such as gold and silver should act well during a deflation. Why? Because during deflation cash is king. And gold is the king of all cash.

Treasury Notes and Bonds are the ultimate deflation investment. Why? Because during deflation cash is king. And Treasury securities are the safest possible claim to cash at interest. Why? Because the government can always (and will) tax and loot the people to the hill to pay off its debts if it needs to.

Read the whole article, look at the predictions I made in there and look where we are today in terms of gold, silver, and Treasury yields. Market data can only be interpreted, understood, and predicted, when you have a sound economic footing to stand on.

I would like to ask the author: What if in addition to falling yields and rising gold prices, the dollar were to start rallying? How confused would he be then?

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Treasury Market – The Alarm Bells Are Ringing

Treasurys have been sending strong signals these days. Today 10 yr Treasury yields dropped to 3.19%, a drop of 11 points on one single day:

treasury-yields-10-01-2009

Note the huge gap on opening today. On September 2nd I noted:

Today’s action in gold was beautifully complemented by corresponding action in Treasury yields which dropped by 8 basis points to close at 3.29%, a recent July low. If it breaks, the way down is more or less open:

10-year-treasury-2009-september-02
Click on image to enlarge.

Now take a look back at the first chart I posted. Notice how that support mark of 3.29% wasn’t even touched for a second today! Buyers leaped past that level and bid up prices so at opening yields were already at around 3.25%.

I am not saying that this necessarily has to mean something, but the likelihood that it expresses a huge demand for safety on any piece of bad news at this point, should not be discarded.

What else was noteworthy on this one day today? Look at the development in the gap between 10yr Treasury (IEF), 20+yr Treasury (TLT) vs. corporate (HYG) bond yields:

treasury-vs-corporate-yields-10-01-2009

See “Corporate Bond Yields – Where to From Here?” for the significance of the above data.

This may all be just a small twitch. But it may also be the mother of all warning signs. Mind the Treasury market in all your investment decisions.

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Corporate Bond Yields – Where to From Here?

Mish points out accurately that corporate bond yield spreads from Treasury yields are a good indicator where stocks are headed:

Keep an Eye on Bonds!

As long as corporate bonds fetch a good bid, which in turn allows companies to raise cash at decreasing costs, the stock market is likely to be reasonably firm. Note that the pullback in junk bonds began 3 days ago on that last red candle.

I am skeptical the rally in bonds can last much longer, but until the corporate bond market starts showing increased signs of stress, equity bears expecting huge pullbacks are likely to be disappointed.

Either way, it will pay to keep one eye on the credit markets to help ascertain long-term equity direction. In August of 2007 the corporate bond market cracked wide open. Although the S&P 500 made a new high in November, the corporate bond market didn’t. It was the mother of all warning calls that most missed.

I prepared a chart that compares Treasury note prices (IEF, blue), corporate bond prices (HYG, red), and the S&P 500 (green), since October 2007:

corporate-bonds-vs-treasury
Click on image to enlarge.

The question is where are corporate yields headed and where are Treasury yields headed. So long as the spreads remain flat or continue to narrow, stocks will probably move sideways or spike up a little more. But as we can see in the chart above, it looks like they are very slowly beginning to widen again. It’s too early though to identify a clear direction at the moment.

News like this certainly won’t bode well for the bond market and will continue to apply downward pressure to corporate bonds, and thus upward pressure on spreads:

The number of U.S. companies that have defaulted on their debt this year rose to 12.2% in August, matching a peak last touched in 1991, Moody’s Investors Service said in a report Wednesday. The default rate is expected to rise to 13.2% in the fourth quarter, then drop to 4.1% a year from now, analysts said. A key part of that forecast is that U.S. unemployment will peak at 10% in 2010, said Moody’s Kenneth Emery. On Friday, the Labor Department said the jobless rate reached 9.7% in August. “If the U.S. unemployment rate were to increase substantially above 10% in the coming year, then default rates would likely be significantly higher than indicated under the model’s baseline scenario,” Emery said.

Here is a nice straight resistance line that corporate bonds are testing right now:

HYG Chart:
corporate-bonds

The downward trend since October 2007 continues to hold up.

Meanwhile, the exact opposite holds true for Treasurys:

IEF Chart:
IEF

… bottom line: keep an eye on corporate vs. Treasury yields.

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Gold, Silver, Treasurys – A Snapshot

Gold & Silver

In December 2008 I called for a bottom in Silver. From then through June it has risen from $10 to almost $16 Dollar per ounce, a 60% gain. Then, on June 7th I advised caution on Silver and recommended to cash in and buy at new lows. Since then it has dropped from near $16 to around $12.50.

Below you can see a summary of my predictions in the chart:

Silver Chart
Click on image to enlarge.

I also said in that post from June 7th that gold should do fine. Gold has remained comparatively stable since then. While silver dropped by about 15%, and the S&P500 by about 6% gold fell by only 4%:

gold-vs-silver-07-10-2009
Click on image to enlarge.

Monetary commodities, such as gold and silver should act well during a deflation. Why? Because during deflation cash is king. And gold is the king of all cash.

The problem with silver is that it acts like a hybrid between a monetary and an industrial commodity. It is hard to discern how many people are invested in it for the wrong reason, namely inflation. (Yes, I am talking to you Peter Schiff :) ) But in cases when it is so obvious, when false inflation fears scream at you, it is pretty easy to figure it out.

Once those are washed out and people are back in reality mode, silver should continue to act well along with gold. Silver may be an attractive addition to portfolios again at this level. But I would advise caution. For the time being gold remains preferable. In fact, gold has outperformed both the market and silver since October 2007.

As far as gold/silver mining stocks are concerend, the ^HUI index continues to hold the line and another upward wave may be due now:

hui-as-of-july-10-20091

Treasurys

Treasury Notes and Bonds are the ultimate deflation investment. Why? Because during deflation cash is king. And Treasury securities are the safest possible claim to cash at interest. Why? Because the government can always (and will) tax and loot the people to the hill to pay off its debts if it needs to.

(Remark: Contrary to what some people tell us, the US government can NOT print money to pay off its debts. True, the Fed can print money to buy NEWLY ISSUED government debt that may or may be used to pay off older debts. But that doesn’t make the debt go away. It merely refinances old debt. It is the exact opposite of printing money to pay off debts which is, for example, what happened in Weimar Germany and in Zimbabwe and precipitated hyperinflation. It is crucial to understand this causality. Again, to those who don’t fully understand this yet, I can only recommend reading my post Inflation & Deflation Revisited.)

Back in November 08 I called for significantly lower Treasury Yields between 2% amd 2.5%. They then fell from 3.09% to just below 2.5% in January 09. I then expected for technical reasons that they will move higher to the upper end of the range which would be around 3.3%. They actually overshot and went as high as 3.99%. I then said that Treasurys are a good call again. Yields have since then fallen to around 3.30%:

10-year-treasury-2009-july-10

Click on image to enlarge.

I think Treasurys will continue to act well. There maybe some upward pushes here and there so long as inflation expectations pop up once in a while, but the mid-term trend remains unchanged: It is likely that yields are headed for new lows.

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10 Year Treasury Yield Drops by 17 Basis Points on Single Day

Yields for 10 year treasury notes dropped by 17 basis points today, ending the day at 3.28%. Today’s auction showed high demand for safety is back and alive.

Below the daily chart:

treasury-yields-july-08-2009
Click on image to enlarge.

So far this is exactly what I have been expecting as I explained in Inflation Fears vs. Reality. Hyperinflationists are unable to explain what is happening and can only watch this trend with confusion.

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