Coming Bear Market in Bonds

WHO'S NOT SELLING BONDS?
First, the US Treasury has hundreds of billions of dollars of bonds to sell to fund the trillion dollar deficits Congress is mandating.

Second, the Federal Reserve will be selling the trillions of dollars of securities they have purchased in the recent expansion of the monetary base.

Third, and finally, any investor who owns bonds will be selling to avoid the coming bear market.

Paterson is advising its clients to continue to extend the maturity of liabilities past the 5 year mark, and look at 10 year liabilities, or more.

TACTICS
Continue to shorten the maturity of assets and use money market arbitrage to improve earnings.

Consider borrowing long term deposits.

Use extreme caution on long term lending.

STRATEGY
Warn senior management and the board that a disaster is in the offing.

The flood of money recently added by the Fed will either cause inflation or increases in long term interest rates - or both.

Markets at Major Turning Points

Gold at Major Support










Most of the evidence suggests the bounce will be small, and prices will continue to drop. But, traders don't bet it that way.

Bond Refunding Successful
US Treasury sold $27 billion of notes and bonds following the largest increase in CPI since the Volcker years.

Treasury Note Futures









Treasury Bond Futures









Note that ond prices surged following a successful auction.

Corporate Bond Spreads Falling











Stocks finding Support

NYSE Composite











S&P 500











Russell 2000











SUMMARY
10 years from now this time will be seen as a major turning point in stocks. With inflation banished, and the bull market in bonds ended, only stocks will have the investment potential for the future.

Remember, stock prices rise when interest rates come down and stay down.

Stock Market at Support

Investors will be watching the stock market closely for the next few weeks at prices approach support levels seen twice before in the last 6 months.

NYSE Composite


S&P 500


Russell 2000


Technical traders will be buying the Index here, and selling if the market trades below these levels.

SUMMARY
The usual rule is to buy the market when the situation looks bleakest.

That certainly is the case here.

Credit spreads widen

Credit spreads continue to widen as the Federal Reserve props up the Treasury market while it lowers short-term rates.

First, we review the Fed's recent policy of lowering short-term rates.



In a clear indication of the disaster of the policy of slow-and-steady short-term rate increases since 2004, the Fed has lowered short term-interest rates in a panic.

In the next chart below, we see the effects of the Federal Reserve's policy of pulling down long-term interest rates by purchases in the open market.



While this is occurring, credit spreads for other types of securities continues to widen. The latest casualty in this episode are auction-rate securities. In several recent episodes, auctioned securities have exceeded 15%.

This data carries a clear implication: Lengthen the maturity of liabilities. Had these institutions lengthened liability maturities, as Paterson has repeatedly recommended, they would not be in this situation.

LENGTHENING LIABILITY MATURITIES
When the Fed stops supporting US Treasuries, as it must, and interest rates rise in response to a weaker dollar and rising inflation, the yield curve will steepen and long-term interest rates will soar, adding two-five percent to liability costs: between $20,000 and $50,000 per million per year.

This is a potential increase of 40-100% of liability costs!

DOLLAR DETERIORATION CONTINUES

Paterson finds a continuation of the loss of purchasing power of the dollar, making exports more competitive, imports more expensive, and foreign earnings more valuable to US companies.

The chart below shows the trade-weighted value of the dollar.



Given Fed policy, Paterson sees no reason for this to change and for the dollar to continue to lose value.

TRADING RISK
After the multi-billion dollar loss by a French trader, one would think that trading rules and monitoring would have precluded unauthorized trades. It is not so.

In the recent debacle, a trader in wheat lost more than $100 million. In a bull marktet! Where was the supervision?

Though these problems are not specifically related to interest rates or monetary policy, they are an effect of fluctuating prices.

TACTICAL ASSET AND LIABILITY MANAGEMENT
Increase liability maturities, shorten asset maturities, and work money market spreads for income.

The debacle in the bond market is generating extraordinary returns on high-quality credits which can be funded with matching maturity liabilities. Some clients have experienced a 10% rate of return on select securities over a 6 month horizon.

Credit hedges must be evaluated daily during this time.

Currency hedges must be extended and widened to include currencies with low money growth.

STRATEGY
Though Paterson did not foresee the extent of the credit debacle, we can react to it with prudent actions.

First, the policy of money market arbitrage has proven to be a solid earnings gain.

Second, the policy of eliminating variable rate assets has insulated the portfolio from credit losses.

Finally, the policy of lengthening liability maturities has strenghted the balance sheet with fixed rates.

Senior management must keep the board informed about the deteriorating bond market and be prepared to hedge interest rates, credit risk, and currencies.