We have been in the midst of a showdown (Chicken or Who blinks first) between the bond traders and the Chairman of the Federal Reserve, Mr. Bernanke. The battle has been over the yield on the ten year T Bond. The traders think it should be over 4% and the Chairman wants it as low as it can be to try and save the housing market and in turn the economy. As I said in the last posting , watch two things - housing and employment for the recovery. I think these are the two things that are most important to the Fed. They watched the yield on the 10-year bond stretch for 4% and they saw mortgage rates spike. The spike in mortgage interest rates dropped a lot of buyers out of the market so mortgage applications fell rapidly.
For the last month interest rates outside of short-term, less than a year, have been rising. The bond traders are concerned about the impact on inflation as a result of all the money the Fed is putting in circulation. Because they were concerned about future inflation they demanded higher interest rates to compensate for the potential of inflation down the road. As news came out indicating the recovery might not get fully underway till 2011 and that recovery might be very anemic, the concerns about inflation were replaced by concerns about deflation.
The world and the United States are awash in excess capacity. When you have so much excess capacity, it is very hard to increase prices. Because of this excess, prices are still coming down and my current thinking is that prices will continue to fall for the balance of this year. For the first time in many generations, Americans are becoming savers and price sensitive. When we had oil prices at $4 a gallon we said the demand destruction drove down the price of gas and in turn the price of crude oil. The recent run to $70 a barrel for crude oil and the commensurate increase in the price of gas will create demand destruction, but at a much lower price level. The run up in crude oil was an anticipation of an economic recovery around the world. Today that recovery seem less certain and less likely to be robust. Watch the price of crude oil for it may well fall below $50.
With a decline in crude you will see renewed strength in the dollar against all major currencies. A strengthened dollar will increase the demand for US Government bills, notes and bonds. We are already seeing that shift just slightly with the significant amount of buyers in the Treasury auctions this week. The yield on the 10-year bonds was 3.50% on June 29, 2009. If we see a decline in oil to $50 a barrel, I would expect to see the yield on the 10-year bond close to 3%. So who blinked first? I think the bond traders forgot one very important fundamental, never fight the Fed. If you try and fight the Fed you will almost always lose and may not be able to come back again and play the game.