Beware of Bonds As The Economy Improves

by | Oct 9, 2003

A month ago, I wrote about the how the Fed led Wall Street bond traders into a billion-dollar trap, by promising to keep interest rates low virtually forever, and then just weeks later, hinting that it would break the promise. You’d think “once burned, twice shy” — but no, the Fed is making promises again, […]

A month ago, I wrote about the how the Fed led Wall Street bond traders into a billion-dollar trap, by promising to keep interest rates low virtually forever, and then just weeks later, hinting that it would break the promise. You’d think “once burned, twice shy” — but no, the Fed is making promises again, and bond traders are falling for it. This time it’s going to be worse: There’s no way today’s promise can be kept.

First, a quick review. When the Fed sends a signal — through speeches, statements to the press, and in its official written pronouncements — that it intends to hold rates low for an extended period, professional bond traders are given an incentive to put on what the pro’s call “the carry trade.” In this trade, they borrow from the Fed at the promised low rate, and turn around and use the borrowed money to buy long-term Treasury bonds.

They earn the difference between their cost of borrowing and what they can earn on the bonds. Right now that’s about 3% a year, and it’s a profit made entirely on borrowed money, so effectively the return is infinite. The Fed encourages this, because the trader’s buying of long-term bonds moves long-term interest rates lower, and theoretically that’s supposed to stimulate the economy.

This risk is that when rates eventually rise — as someday they must — the prices of the bonds the traders hold will go down. But that’s OK as long as it doesn’t happen too soon, and the trader has a chance to earn that spread long enough to more than make up for the eventual loss. Last spring, when the Fed started sending the signal that maybe rates wouldn’t stay low as long as they’d originally thought, bonds suffered a historic collapse as holders of the carry trade stumbled all over each other to get out. The episode cost Wall Street billions. Thanks, Alan.

Now, to the present. The Fed sees the economy continuing to recover, but is distressed that there isn’t more evidence of job growth. So once again, it’s saying that rates are going to be kept low — for what it calls a “considerable period.” Bonds have been rallying like crazy the last two weeks as traders scrambled back in the carry trade.

But it’s going to end in tears again. Treasurys are an accident waiting to happen — and this time, maybe individual investors will be smart enough to learn from experience and get out early — even though the guys doing the carry trade seem to be gluttons for punishment.

Here’s why it’s all going to go haywire.

First, it’s only a matter of time before job growth starts increasing. Slow job recovery is what’s making the Fed keep rates down, so when that rationale is eliminated, there will be no reason not to raise rates. So the instant that there’s the slightest sign that jobs are on the move, the bond market is going to collapse.

Last Friday’s news — that nonfarm payrolls increased by 57,000 jobs (when they were expected to fall by 25,000), and that the unemployment rate held steady at 6.1% — is just a down payment. Why is job growth inevitable? Corporate profits are surging — and that, sooner or later, leads to jobs. It has to happen: Companies are going to want to reinvest those profits to make more profits. It takes people to do that.

You don’t know about the earnings recovery? Well, wake up! If you exclude the tech sector, trailing 12-month earnings for the S&P 500 are now at an all-time high. Earnings in the tech sector, while off the highs of several years ago, are up 33% in less than a year — and forecasted earnings for tech are being revised upward now at an annualized rate of 65%. No one seems to want to admit it, but this economy is catching fire, and jobs can’t be too far from showing a real turnaround.

The other reason why bonds are at risk is the specter of inflation. Right now the market is so focused on the opposite of inflation — deflation — that when inflation breaks out, it will come as a very ugly surprise. And as every investor knows, when inflation expectations rise, bonds get crushed.

The signs of incipient inflation are actually quite evident, if you’re only willing to look at them honestly. Gold — the most sensitive inflation indicator of all — has been trading with extreme volatility, flirting with decade-long highs. Oil and other commodities have been moving up, too. Even the traditional measures of inflation like the producer price index and the personal consumption expenditure deflator are starting to show alarming growth.

The first source of inflation is the Fed’s obsession with jobs. As the economy recovers, the Fed needs to raise interest rates to track the improving growth rate of the economy — jobs or no jobs. If they don’t, the result will be inflation. So while job growth is inevitable at this point no matter what the Fed does, if it takes too long to materialize we’ll have inflation, too.

And the recent decline of the dollar is playing into inflation risks, too. I complained last week that the Bush administration is risking global economic growth by bullying trading partners like China and Japan into revaluing their currencies — which has the effect of devaluing the dollar. But it’s more than just a matter of growth. When investors get the idea that the US wants a weaker dollar, they’re going to not want to hold dollars — and the world-wide demand for dollars will fall. If the Fed doesn’t reduce the supply of dollars commensurate with the lower demand for dollars, inflation will result as surely as night follows day. Obsessed with job growth, it seems pretty likely that the Fed will make that mistake.

Put it all together, and it’s heads-you-lose and tails-you-lose for bonds. If we get job growth right away, the Fed will raise rates right away — bonds lose. If we don’t get job growth right away, we’ll get inflation — bonds lose.

Are you beginning to see a pattern here? Bonds lose.

Originally published on

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at He is also a contributing writer to

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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