Treasuries, Oil May Foreshadow Bear Market After Yields Tumble
By Daniel Kruger and Wes Goodman
Dec. 3 (Bloomberg) -- For only the fourth time since Gerald Ford's
presidency, oil is threatening to push the rate of inflation above 10-year
Treasury yields. For bond investors basking in the biggest bull market since
2002, that's bad news.
Yields on 10-year notes fell as low as 3.79 percent last week, within a third
of a percentage point of the consumer price index. Every time inflation has
exceeded what investors get paid to own Treasuries, bonds have plunged. That
happened from August 1973 through August 1975, when Ford addressed the nation
with his ``Whip Inflation Now'' speech, and from January 1979 to October 1980,
the end of Jimmy Carter's term.
``It's like the 70s,'' said Jim Rogers, a former partner of hedge fund
manager George Soros who predicted the start of a commodities rally in 1999.
Rogers said in an interview in Singapore that the rise in oil reminds him of
when climbing fuel costs almost three decades ago caused 10-year yields to
soar.
``We're in a period of a commodity bull market and inflation,'' Rogers said.
``I would not buy government long-term bonds. We'll be going down for years to
come. Commodities are telling you to sell Treasuries. Inflation is
everywhere.'' He holds positions that will benefit if Treasuries fall.
The only other time inflation outpaced yields was in October 2005, when oil
climbed 8 percent in a week in the aftermath of Hurricane Katrina. Treasuries
fell the next two months.
Worsening Inflation
During the 1970s the 10-year note's yield, which moves inversely to its
prices, rose to 12.4 percent by 1981 from 5.89 percent at the end of 1971.
Normally, yields average 3.8 percentage points more than inflation, based on
trading since 1987. Even if the relationship just reverts back to the 2.2-
percentage-point average in the first half of the year, investors in 10-year
notes would lose 0.8 percent.
``The inflation story going forward is going to be very different than what
we've seen in the past,'' said E. Craig Coats Jr., co-head of fixed income at
Keefe, Bruyette & Woods Inc. in New York, who began trading bonds in 1969 at
Salomon Brothers. ``The inflation news is going to be worse.''
The yield on the benchmark 4 1/4 percent note maturing in November 2017
dropped 6 basis points last week at 3.94 percent, according to New York-based
bond broker Cantor Fitzgerald LP. The price of the security rose 15/32, or
$4.69 per $1,000 face amount, to 102 16/32.
`Unsustainable'
Investors have sought Treasuries as a haven from widespread losses in
mortgage markets even as consumer prices climbed 3.5 percent through October,
the most since August 2006. U.S. government debt has returned 9 percent this
year, including reinvested interest and price gains, the most since gaining
11.5 percent in 2002, according to Merrill Lynch & Co. data.
The combination has left the Federal Reserve with the dilemma of either
cutting interest rates next week for a third time since September to prevent
the housing slump from pushing the economy into recession or keeping rates
steady to fight inflation.
``You've got to be thinking inflation is falling by a dramatic amount'' to
buy bonds at their current yields, said Thomas Atteberry, who manages $2.3
billion in fixed income assets at First Pacific Advisors LLC in Los Angeles.
``I'm a little hard pressed to see that with the price for oil and the prices
we're seeing for food. It's unsustainable.''
Oil reached $99.29 a barrel on Nov. 21 and is up 53 percent for the year, and
gold climbed to $845.84, within $5 of its all- time high of $850 an ounce set
in 1980.
`Renewed Turbulence'
The central bank highlighted inflation concerns when it lowered its target
for overnight loans between banks by a quarter point to 4.5 percent on Oct. 31.
``Readings on core inflation have improved modestly this year, but recent
increases in energy and commodity prices, among other factors, may put renewed
upward pressure on inflation,'' the Fed said in its statement.
In emphasizing so-called headline inflation risks, the Fed is including the
impact of rising food and energy prices, which are more volatile than other
items tracked in the index and usually excluded from the central bank's
projections.
Fed Chairman Ben S. Bernanke signaled ``renewed turbulence'' in credit
markets may have shifted risks between growth and inflation during a speech in
Charlotte, North Carolina, on Nov. 29, adding to speculation the central bank
will cut rates again. Financial futures traded on the Chicago Board of Trade
show that there is a 68 percent chance the Fed lower rates at least a quarter
of a percentage point on Dec. 11.
The average price of a barrel of oil was $6.87 in 1974, 77 percent higher
than in 1973, according to the U.S. Energy Information Administration. The
average price of crude tripled from January 1979 to January 1981 to $28.81,
agency data shows.
China, India
Keefe, Bruyette's Coats said his forecast for faster inflation is based on
demand from China, India and other emerging-market economies for oil and other
commodities, demand that wasn't there in the 1970s. Global growth presents
investors with ``a very different scenario'' than earlier periods, he said.
In October 1974, one month after appointing Alan Greenspan as his chief
economic adviser, Ford urged the U.S. to conserve energy and increase
productivity to overcome acceleration in the consumer price index, which
reached 12.1 percent that month. The 10-year Treasury yield ended the month at
7.8 percent.
``I say to you with all sincerity that our inflation, our public enemy number
one, will, unless whipped, destroy our country, our homes, our liberties, our
property, and finally our national pride, as surely as any well-armed wartime
enemy,'' Ford said.
Ford also drew attention to a button on his lapel with the letters WIN for
whip inflation now. ``It bears the single word WIN,'' he said. ``I think that
tells it all.''
Misery Index
The Misery Index, created by the economist Arthur Okun, an adviser to
President Lyndon Johnson, is the sum of the unemployment and inflation rates.
The index peaked in June 1980 during the Carter administration, when the
jobless rate reached 7.6 percent and consumer prices rose 14.4 percent.
Both instances of negative real yields in the 1970s were caused by the
central bank's unwillingness to tackle rising prices by raising rates, said
Lyle Gramley, a Carter economic adviser from 1977 until he was appointed a Fed
governor in 1980.
Carter's appointment of Paul Volcker to head the Fed in 1979 was an
acknowledgment of the severity of the economy's problems, Gramley said in an
interview. ``There wasn't any alternative other than very tough monetary
policy.''
Volcker ended up boosting the central bank's target rate to 20 percent in
1980. Should real yields swing into negative territory it will be a ``unique''
consequence of the flight to quality, Gramley said
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