Sorry for the long delay in producing a new “musings”. Unusually, I did not have much to say.
As I have written in the past, the bond market is vastly larger than the stock market, and the rates on bonds have huge implications for the rest of the economy, and finance in general. As rates have now reached the zero-bound, unusual things are likely to occur. That could explain recent unusual spikes in interest rates. It could also explain the sudden appetite for riskier assets, like stocks.
Most of you know that a bond is a loan that can be traded. The terms are generally fixed for the term of the loan, and the price paid determines the future yield, since the payments in the future are already known. The US Government is a huge borrower, and the seeming certainty of future repayment makes US Treasury bonds the pinnacle for safety. This is still true despite our recent downgrade to AA from Standard and Poors. Surely you are aware that the market for interest rates has been manipulated by the Federal Reserve (and other forces), in order to produce a desired outcome. We know this because the Fed has said so. Primarily, the Government is interested in forcing the hand of investors.
When risk assets are shunned as they were in 2008, the influx of money into Treasuries distorted the market for short term bonds. Investors were huddled in one-year maturities like cattle hiding from rain inside the drip-line of a tree. You could see that manifest in two-year maturities paying three times the yield of a one-year, with nary a taker. Mr. Bernanke is successfully moving all us cows down the chute; hopefully without the same fate.
Quantitative easings (QE) of various ilks have been in the system for the past several years. Another iteration has been “Operation Twist” in which the Treasury issued new short term bonds, and used that money to buy long term bonds in the open market. This was designed to lower the yields of long term bonds, by driving up the price. You are correct to assume this is unsustainable, and can be dangerous. While we are using farm terms, be careful not to lean on a fence post that can suddenly give way. The government normally only intervenes in short term interest rate manipulation at the credit window, known as the discount rate. This is the rate that banks pay to borrow from the Fed. The Fed has no real mechanism to alter long term rates other than open market activity, and the market (buyers and sellers) is normally free to determine what a fair rate should be. Since rates are determined by the free flow of money between buyers and sellers, the equilibrium level is normally a consensus of all currently known information. Bureaucratic intervention is subject to whimsical reversal of course, and this could leave vacuum pockets in the bond market. There are some telltale signs that the market for bonds is under stress: