This week, something very ominous has happened - on the secondary market for US Treasury debt. The yields on ten-year Treasury paper jumped 18 basis points to 4.27%, their worst weekly performance in NINE YEARS. Since February 9, these ten-year yields have jumped 29 basis points from 3.98% to their 4.27% level on February 18. That's a BIG turnaround, which does not bode well for the future of US financial markets.
We have pointed out many times in this commentary that the number ONE impetus for a REAL and long-lasting precious metals (Gold and Silver) bull market is RISING interest rates right along the yield curve. Rising short-term rates alone won't do it, the Fed controls these. But when the rate rises are coming along the whole length of the yield curve from short to long term, the "safety" is off on the precious metals markets and the trigger is getting very sensitive indeed.
As a stark illustration of this process, consider, not the $US Gold price, but the $US Silver price. On February 9, when the Treasury ten-year yield fell 5 basis points to close at 3.98%, its lowest level since April 2004, Silver closed at $US 6.59 (and Gold at $US 412.90). By February 18, Silver had shot up to $US 7.41 - a rise of $US 0.82 or 12.4% in only seven trading days. Gold, as it usually does, lagged. It closed at $US 427.10, up $US 14.20 or only 3.4% over the same seven days.
Of course, the silver correction of December/January was much steeper than the Gold correction, and nobody has been threatening to sell Silver to "forgive" third world debt lately, so the bigger Silver bounce could be expected. As of February 18, Silver was still 9.9% below its 52-week high in $US terms while Gold was only 6.3% below its equivalent high.
Last week, in his Credit Bubble Bulletin, Doug Noland made the following statement:
"I would assert that the Fed’s warnings of higher rates and the market’s rational reaction (large-scale hedging and bearish speculating) assured either a self-reinforcing downward spiral in bond prices (spike in rates) or an unfolding major 'squeeze,' derivative unwind and destabilizing drop in rates. We are witnessing the latter."
Mr Noland was undoubtedly right in his explanation of the phenomenon which has seen longer term Treasury rates FALLING throughout the period since June 2004 when the Fed began the rate RAISING regime which has seen the funds rate increase from 1.00% to 2.50% - so far. We track the "spread" between two and ten-year Treasury yields. On June 30, 2004, the day that the FOMC announced the first 0.25% rate rise in the current series, that spread was 179 basis points (2.68% vs 4.47%). Last Monday, February 14, the spread had fallen to its low so far - 72 basis points (3.36% vs 4.08%). By February 18, the spread had an abrupt turnaround and was up to 85 basis points.
The "squeeze derivative unwind" which Mr Noland mentioned was undoubtedly a major factor (if not THE major factor) in the drop in long-term rates since June last year. We are now seeing the first signs that this unwinding is, if not coming to an end, at least slowing markedly. More signs include the latest figures on foreign Central Bank buying of Treasury debt which show that such buying is actually contracting. And then there is the January US PPI announced on February 18, with the "headline" rate at 0.3% but the "core" (excluding food and energy) rate at a six-year high of 0.8%. That rate over a year would come to 9.6%. The combination of an exhaustion of derivative hedges and a dawning realisation of the frightening level of monetary inflation presently being unleashed in the US makes an abrupt UPTURN in yields right along the curve in Treasuries a DISTINCT possibility.
How distinct a possibility? Well, both foreign and domestic US government debt buyers have thus far been able to ignore the fantastic blow-out of government deficits which have been a feature of the 21st century so far. We don't know what was discussed behind closed doors at the recent G-7 meeting in London, but it's a safe bet that this issue was high on the unspoken agenda. Take a look at the table below
How do we get the "projection" for the end of fiscal 2005? In the simplest way possible. We divide the debt increase so far in fiscal 2005 with the days elapsed in fiscal 2005 (140 days up to and including Feb. 17) and multiply the result by 365. Yes, we know that this is not "seasoned" in any way and does not take into account such things as the tax grab of April 15. Nonetheless, you can see that the "progress" on Treasury debt so far is "big", to say the least.
How big? Well, by way of comparison, here are the increases in the Treasury's funded "debt to the penny", rounded off to the nearest $US Billion, over the past five years - along with the increase in Bush's first term compared to Clinton's second term:
Please note the increase during Clinton's second term, during which the Treasury reported budget "surpluses" in 1998, 1999, and 2000. Please note also that the increase in Bush's first term was almost FOUR TIMES the size of the increase in Clinton's second term. And the debt increases in the single years of 2003 and 2004 both exceeded what the entire Clinton second term managed to pile up. Finally, consider the fact that between the end of Fiscal 2000 and the present, Treasury debt "to the penny" has increased by just over TWO TRILLION DOLLARS - which represents an increase in TOTAL (since 1789) debt of 35.5% in less than four and a half years.
Can you say "unsustainable"?
If the "hedges" on the gargantuan porfolios of US Treasury debt, both foreign and domestic, are now starting to be unwound, then the "captive buyers" of US Treasuries are starting to dwindle. If they continue to dwindle, the pressure on Treasury paper of ALL maturities will increase, as will the rates on said paper. As these rates increase, so will the fear of accelerating price inflation and the attendant pressure on the US Dollar. At some point in this process, Gold will accelerate upwards against the US Dollar. At a further point, as more and more people realise the extent to which the global financial system relies on US Dollars as "reserves", Gold will accelerate upwards against ALL paper currencies (and there ain't no other kind). At that point, if and when it happens, the REAL long-term Gold bull market will be on for young and old.
In the 1930s, cash was indeed king. But this is not the 1930s. When FDR took office, the US had no unfunded liabilities at all and funded liabilities of less than $US 20 Billion. Now, US funded liabilities are nearing $US 8,000 Billion and have increased by more than one-third since September 2000. And as for the unfunded liabilities, well those are five to seven times the size of the funded ones.
Watch the "progress" of Treasury yields closely, both the absolute yields and the spread between short and long-term yields. These are the "writing on the wall" for the US Dollar. And if the hedges on these Treasury holdings ARE being unwound, or if they are even starting to be unwound, we are in for wild times indeed.
