BOND YIELDS CONTINUE TO REBOUND -- RISING INFLATIONARY TRENDS IN ASIA COULD BE SIGNALLING A MAJOR SHIFT TO HIGHER INTEREST RATES
BOND YIELDS ARE CLIMBING ... A few weeks ago I suggested that bond yields could be bottoming. Chart 1 shows that could still be the case. After forming a potential "double bottom" during January and March, the 10-Year T-Note yield is now testing its February high. It's also nearing a test of its 200-day moving average. Needless to say, a close over both of those chart barriers would suggest that bond yields have bottomed. Chart 2 shows the 30-Year T-Bond Yield (TYX) forming a more convincing bottom. Considering where that rebound is starting from, we could be forming an important low in long-term rates.
Chart 1
Chart 2
LONG BOND IN MAJOR SUPPORT ... I find Chart 3 particularly interesting. It shows the 30-Year T-Bond Yield (TYX) bouncing off chart support formed during 2003 and 2005. That makes this a logical spot for bond yields to start bouncing again. I suspect one of the factors making that happen is the build-up in inflationary pressures all over the globe. So far, bond yields have stayed historically low in the face of surging commodity prices. That's been somewhat unusual since rising commodities have, in the past, produced higher bond yields. Here are some thoughts on that subject. The five-year bull market in commodities started with a collapse in the U.S. Dollar several years ago. A huge part of the commodity buying came from big emerging markets and China in particular. China, in turn, became the low-cost producer for the rest of the world. While Chinese imports were pulling commodities higher, cheap Chinese exports were keeping the prices of finished goods from rising. The huge cash reserves built up in China from big trade imbalances were reinvested in U.S. Treasuries which also helped keep U.S. rates down. At least that's been the story up until now. So what's changed?
Chart 3
RISING CHINESE INFLATION AND RISING YUAN ... In order to keep its exports cheap, China has kept its currency (the yuan) artificially low. Since 2005, it has allowed to yuan to rise moderately but it's still way undervalued. What's changed is a big jump in Chinese inflation (mainly food). One way the Chinese can combat that is to let the yuan rise more quickly. That would help restrain Chinese inflation, but would increase the cost of their exports. A stronger yuan against the dollar would boost the cost of Chinese imports to the U.S. That means higher inflation here. Since the Chinese wouldn't have to buy so many U.S. Treasuries to keep the yuan from rising, rates here could start to rise accordingly. I'm not completely sure what the ripple effect of rising rates would have on other markets. Over the short-run, an upside breakout in bond yields could push the dollar higher and cause some profit-taking in commodities. Some money coming out of bonds might find its way back into stocks. The short-term benefit to stocks, however, could lead to some long-term problems.
Chart 4
LOW INFLATION ERA COULD BE ENDING ... Since 1998 when global deflationary concerns coming from Asia (mainly Japan) pushed bond yields to historic lows, bond yields and stocks became positively correlated. In other words, bond yields and stock prices have tended to rise and fall together. That's been the case over the past few years as well. If we're entering a more inflationary era, the trend for interest rates could be turning up. In a more inflationary environment (which we haven't seen since the 1970s), bond yields and stock prices may revert back to their more historical relationship of trending in opposite directions. If that happens, a big jump in bond yields may wind up hurting the stock market instead of helping it. The Fed will try to prevent that from happening. While the Fed controls short-term rates, however, inflationary expectations drive bond yields. Just as latest deflationary era in 1998 started in Asia, it may be ending there as well.
Chart 5
