Thursday, May 5, 2011

Bond Yields Falling

World food prices continue to spiral higher!

Inflation is just around the corner!

Our government is gridlocked !

The Fed's QE2 is ending!

The dollar is plummeting!

And yet yields on Treasury bonds are moving sharply lower - again.

Since peaking earlier this year at 3.75% in early February, 10-year Treasury notes at this writing now stand at 3.18%. Today's rates are also more than 30 basis points lower than a year ago.

Oh, and for the uber-bears on municipals, please note that yields on municipals have been falling even faster than Treasury yields. A dearth in new issue supply, plus an increase in state tax revenues, have returned some luster to municipal bonds.

We had a long discussion about bonds yesterday at our weekly investment policy committee meeting. Most managers are skeptical about bonds. They continue to believe (as they have for the last three years) that bonds are trapped in a "bubble", and rates will rise soon.

As I have been writing for the last couple of years, I don't agree.

I think that we are close to being mired in a Japan-style liquidity trap, and rates are going to surprise investors by staying lower longer than most expect.

The world is awash with liquidity. Credit-worthy corporations may be borrowing, but most are just socking the money away in Treasury bills. The memories of 2008 are still too fresh, when the credit markets were essentially closed.

Most of the surge in M&A activity recently has been done either with cash or in combination with common stock. Leveraged buy-outs have disappeared from Corporate America, at least for now.

Housing prices are poised to take another leg lower. Mortgage credit remains the largest source of borrowing demand in this country, so weak housing activity translates into low demand for mortgage borrowing.

There has been an increase in prepayment activity among homeowners. With interest rates so low, there is little incentive to leave your money in short-maturity bonds yielding less than 1%.

I still think the trend in interest rates is lower, not higher.