Rising Bond Yields Indicate Market Fearing Inflation

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Just when it looked like global bond vigilantes had woken up from a long slumber last week, the stock market struck back. Stocks on Wall Street rallied Friday, with the Dow finishing up 157 points. But the Friday rally doesn’t obscure the fact that something important happened in global markets last week. Let’s take a closer week at what happened last week and why it matters.

The yield on 10-year U.S. Treasury bond acted a bit like a Chinese stock last week and skyrocketed. Treasury yields finished the week at 5.25%–their highest level since May of 2002. In bond market circles, this sort of action passes for a panic. But what does it mean?

Bond prices fall—and yields rise—when markets fear inflation. The low unemployment numbers in the States last week suggested to the market that the U.S. Fed will not be lowering rates this year. In also suggests that the Fed is right to fear inflation. And for that reason, bonds are selling off.

You might think stocks would rally when bonds sell off. But traditional inter-market relationships between asset classes are all out of whack these days. And on closer inspection, it’s easy to see why the S&P and the ASX both fell late in the week.

Low-interest rates have fueled the stock market boom. Long-term global rates average just above 4%, nearly 3% lower than the last peak in the rate cycle. Money is still cheap, relatively speaking.

Companies are able to borrow cheaply and buy back their own shares, magically improving earnings per share. More importantly, low rates have enabled the merger and acquisition boom. With the cost of money low, a lot of deals get done that might not get done at higher interest rates.

At least that’s what you’d think. We may soon find out. If the cost of long-term financing goes up, and the price of “risk free” government bonds keeps falling, might riskier assets be sold too? And if that’s the case, is the boom in global equities in jeopardy because of rising bond yields? Will rising rates kill the buyout boom?

We’ll find out a little more this week. It’s really a contest between two explanations for what’s going on in the market. The one explanation is that the whole planet is over-heating—and not in the physical sense but the economic sense. Higher rates mean a cooling of activity and a correction in stock prices. Locally, this explanation calls for hike in rates from the Reserve Bank and a few month’s of consolidation in the share market (especially financial shares.)

The other explanation is a little more complex, and therefore probably suspect. But we’ll go ahead with it anyway. This explanation is that the bonds of sovereign nations—despite having the reputation for being risk free—are a dying asset class. There are two primary reasons for this.

At some point high bond yields would be enough to attract large money flows, you’d think. Unless, that is, there really is a huge threat of global inflation. If that’s the case, then sovereign government bonds again become “certificates of confiscation,” a place where cash goes to suffer incremental declines in its value (or not so incremental, depending on the pace of inflation.)

It this kind of market, stocks of resource-rich economies or commodities themselves are better long-term investments than the sovereign bonds of mature Western economies. Emerging market stocks are backed by real economic growth. And resources are backed by the real economic demand from the developing world.

That free market maven himself, Vladimir Putin, put it this way in a weekend speech in St. Petersburg, “If 50 years ago, the G8 countries accounted for 60% of the world’s GDP, the current situation is vice versa—about 60% of world GDP is produced beyond their borders.” G8 nations still make up a large portion of global GDP. But what Putin is saying is that these nations will not be the engine of global growth for the next 50 years. That job lies with China, India, and a whole slew of other countries.

If that story is correct, then the best investment strategy is…what? One clear trend is the emergence of sovereign wealth funds. These government-formed mega-funds are designed to channel foreign currency reserves and oil profits into productive investment. Does anyone really know what that means?

Not yet. But it probably means a shift away from sovereign government bonds and into more tangible assets, especially energy and resource projects that can secure the material needs of newly-industrializing economies. These funds are seeking real assets more than yield.

The downside to this concentration of huge investment war chests (currently around US$5 trillion globally) is that it’s hard to find a place for all that money and still earn a good yield, or buy a quality asset. If not into the highly-liquid and deep U.S. Treasury market, where is a sovereign wealth fund manager going to park $500 billion these days? Not even major infrastructure projects are large enough to absorb the kind of huge dollar amounts we are talking about.

That sets the stage for the rest of 2007. We were half joking when we suggested that Western Australia sell a long-term license to China for mineral projects. WA is obviously doing just fine without any special deals. In fact, the value of stocks listed in Wan has topped $150 billion for the first time, according to a wire service story. Keith Jones, the managing partner of Deloitte Perth, says an index of WA-listed stocks has increased by 45% in the last twelve months, compared to 23% for the All Ords.

One thing seems pretty certain for the rest of the year. The Big Dig under way out West will find plenty of money and is backed by plenty of demand. That means for punters and long-term investors alike, there is no better place to invest these days than Australian resource stocks.

Granted, there’s a lot to choose from. But being in the right asset class sure is a good place to start. Rather than sorting out what the mega-funds will do with trillions of dollars, the best investment strategy is to concentrate at the micro-end, in junior resource exploration companies.

Dan Denning
The Daily Reckoning Australia 

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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