Carry on with wayward bond?

Larry Kudlow
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Posted: Mar 11, 2004 12:00 AM

Bond investors beware.

It is extremely rare for 10-year Treasury bond yields and commodity prices to move in opposite directions. Yet that's exactly what's happening now. Commodities are soaring, while bond rates are sinking. If history and economic logic are useful guides, this can't last much longer. Something's got to give.

So, either commodity prices are going to tank big-time, or bond rates are going up a lot. As bonds look significantly overvalued right now, rising interest rates are the most plausible outcome.

If you are among the pessimists who believe the U.S. recovery is going to sink, or that the China boom is on the verge of collapse, then buy bonds. But if you stand with the optimists and expect a world economic recovery, then it's time to take profits off the table in the bond market.

Over the next 12 to 18 months, the 10-year Treasury rate will surely move toward 5 percent, signifying a considerable sell-off from today's 3.7 percent. But there are scarier implications in the current disparity between commodities and bonds. If commodity prices and the 10-year rate peak together, then we're talking about an 8.5 percent Treasury rate. Undoubtedly the truth will land somewhere in between. Either way, selling -- not buying -- into this bond rally makes a lot of sense.

But what's going on behind the bond rush?

Inside the markets themselves, a number of large investors, especially hedge funds, are selling stocks and buying bonds. After a big stock market rally, a stock market correction makes a lot of sense. But barreling into bonds during a correction certainly does not.

Economist Victor Canto makes a good case that the current bond rally is a function of the "carry trade." This is where the purchase of a long bond -- in this case the 10-year bond, which holds a higher yield than a short-term maturity -- is financed by taking out a short-term loan, allowing the investor to keep the difference in rates between the two maturities.

For the foreseeable future, Alan Greenspan has virtually guaranteed a 1 percent fed funds rate anchor to Treasury yields. Unless and until either jobs or inflation (or both) shoot higher, the 1 percent funds peg will continue. So, traders are borrowing at 1 percent in order to capture a 3.7 percent yield on the 10-year Treasury. The "carry" on this is a handsome 270 basis points profit. Nice work for little risk, especially during a stock market correction where the risk quotient is considerably higher.

The fact that this carry-trade spread has come down from 3.5 percent last August has not deterred this trade, especially after a weak jobs number last week and continued expectations that core inflation will remain very low.

However, in order for this bond scenario to continue, the U.S. economy would need to slump to much slower growth rates than nearly everyone expects. The latest economic survey from Bloomberg News anticipates 4.6 percent real gross domestic product for 2004. That's not consistent with a Treasury yield below 4 percent.

One of the outstanding features of the bullish case for the economy is the rapid and strong profits recovery that is driving business capital-goods investment. Measuring income-tax profits from the National Income and Product Accounts, business profits have increased to a record 10 percent of GDP.

More is coming. Prescient stock market analyst Elaine Garzarelli is reporting on the unusually positive profits outlook stemming from record productivity. Not only are outsized productivity gains holding down unit labor costs, they are in fact keeping productivity-adjusted wages in negative territory. So the profits spread, or difference, between unit prices and unit costs is now wider than at any time in over 20 years.

Classical economists like the late Benjamin Anderson argue that profits are the heart of the business situation. Rising profits drive business expansion, while falling profits induce business contraction. Surely, the country is in an expansionary phase today, and there is no reason to believe this will change for quite some time. Investment returns and real interest rates can be expected to rise.

There's no telling how far bond-market carry-trade speculation will lift bond prices higher and yields lower in the near term. But there's more wisdom in a strategy of buying growth-sensitive stocks at attractively lower prices resulting from the equity correction. When you add in lower tax rates on stock dividends, bonds are simply not the place to be.