The economy seems to be recovering, but at a slow pace. The stock and bond markets, however, are charging ahead. For example, the stock market closed on Friday at its high for 2009–the Dow is up nearly 50% from its March low.
So why are the stock and bond markets so strong?
One of the main reasons these markets are going strong is the huge amount of liquidity injected into the economy by the central banks of many countries–including the Federal Reserve in the U.S. These central banks put money into the banking system through a variety of government programs such as buying Treasury bonds and mortgages. With the banks investing these large sums of money rather than lending it, the stock and bond markets are the beneficiaries of this excess investing.
Lesson: Liquidity can drive investment markets without strong economic growth.
by Bull Bear Times on August 31, 2009
in Bonds
First a few basics about U.S. Treasury securities (you can also check an earlier post for links)–
- U.S. Treasury securities are investments in the debt of the U.S. economy.
- U.S. Treasury securities have been considered the safest securities in the world for investing.
- These securities are backed by the U.S. government, and no Treasury bill, note or bond has ever defaulted.
- U.S. Treasury securities are the ultimate safe investment; therefore, their yields tend to be lower than riskier corporate bonds.
There are several types of U.S. Treasury securities. A few include:
- Treasury bills, or T-bills, have short maturities (52 weeks or less) and thus are less affected by moves in interest rates.
- Treasury notes, or T-notes, are issued in terms of 2, 3, 5, 7, and 10 years, and pay interest every six months until they mature. When a note matures, you are paid its face value.
- U.S. Treasury bonds are issued in terms of 30 years and pay interest every six months until they mature. When a Treasury bond matures, you are paid its face value.
You can hold a U.S. Treasury security until it matures OR you can sell it prior to its maturity date.
- If you sell U.S. Treasury securities early, you can have a gain or loss depending on whether interest rates have risen or fallen since you bought the security.
- If interest rates have moved higher, the Treasury security price will fall.
- If interest rates have moved lower, the Treasury security price will rise.
Interest rates fluctuate with a growing or declining economy:
- In a growing economy, interest rates usually rise as many companies need additional funds to expand their business.
- As the yield (or interest rate) on a U.S. Treasury security goes up, the price of the security goes down.
- Many believe we are rebounding toward a growing economy. The stock market is reflecting economic growth ahead. Thus, we should expect a rise in interest rates to soon follow. But that is not what we see reflected in the U.S. Treasury bond yields.
Over the last few months, yields on long-term U.S. Treasury bonds have been going down. A growing economy and falling long-term interest rates do not usually go together.
There are two possible explanations for what lies ahead. Either, in the months ahead, we should see long-term interest rates move higher OR in the months ahead, we will realize that we are not in an economic recovery a second recession–called a “W” shaped recovery– will begin to emerge.
Lesson: Strong economies typically are associated with lower Treasury bond prices with rising yields. Today we are not seeing this traditional relationship. Anticipate a change in one of the following-either the economy and the stock market will fall OR interest rates will rise with Treasury bond prices falling.
