I don't know if you've ever prowled around an old deserted house. I did when I was a kid. The floors would shake with each step. Patches of dry rot threatened to give way and send you plunging into the basement. If you put your weight against a beam, the whole house would sway. Exciting -- and dangerous.
Unfortunately, that's also a pretty good description of today's bond market. The unstable foundation is built on overseas cash flows and currency manipulation by foreign central banks. Dry rot threatens the whole system of credit ratings. And some of the banks propping up the market for credit derivatives shake at the slightest touch.
The professionals in this market -- the traders, the underwriters and the more sophisticated investment banks -- know exactly how shaky the whole edifice has become. They're determined not to be the last out the door.
The result? It doesn't take much to turn a market decline into a rout. That's exactly what happened in the four weeks that ended June 12. In that period, yields on the 10-year U.S. Treasury bond soared from 4.7% to 5.25%. Prices on this "safe" bond plunged 10.5%.
And while bond prices have stabilized for the moment, nothing fundamental has changed about the nature of this market. We could get another replay of this kind of panicky drop at any time during the remainder of 2007.
Cash? What a novel ideaWhat should you do if you've got money in the bond market? Ever hear of something called "cash"? With the 10-year Treasury bond yielding a tad less than 5.25% and banks paying a top rate of 5.25% to 5.45% on a 12-month federally insured certificate of deposit, I frankly don't see any reason to take on the risk in bonds right now. (You can find a list of high-yielding CDs on this site.) Let bond prices recover a bit from the recent panic and then move. (I'll give you my thinking on what this all means for the stock market in my next column.)
It hasn't mattered much that this bond market was rotten through 2006 and into 2007, because bond market trends were still supportive. But now the fundamentals have turned, which is putting pressure on all the shakiest parts of the bond market structure.
Those now negative fundamentals include:
- Interest-rate increases from all of the world's major central banks -- except, so far, for the U.S. Federal Reserve.
- Rising food and energy inflation around the world -- almost 7% in the first quarter of 2007 in the United States.
- The end of the "Wal-Mart inflation bonus" as China, India, Vietnam, etc. shift from exporting deflation to exporting inflation.
- A shift away from the dollar by overseas central banks.
All these are long-term trends, you'll note. They've been in place for months, quarters and, in some cases, years without having much negative effect on the bond market, despite the jeremiads preached by financial market bears. So why did the market panic now?