By Nicholas Santiago on March 29th, 2010 1:17pm Eastern Time
Simply put, the Federal Reserve Bank has been masterful since the stock market crash in 2008. They have flooded the market with liquidity by coordinating a global stimulus program. They have kept the Fed funds rate, which is the overnight lending rate to the large major banks at zero percent. Therefore, the bank stocks have done exceptionally well despite the lack of lending that they do. Banks can simply borrow from the Federal Reserve Bank at zero percent and buy United States Treasuries which currently give them a yield around 3.80% – 4.80%, depending on the length of maturity. When you think about it this is a genius plan. Since the March 2009 stock market low, the SPDR Dow Jones Industrial Average ETF (NYSE:DIA) has rallied nearly 45 points. If you convert that to the Dow Jones Industrial Average that is a gain of nearly 4500 points. This is a very impressive rally by all standards.
As it seems, the skies are all clear for the markets and business as usual is taking place. However, there is one problem in the Federal Reserve plan. The problem is yields on the long bonds. The 10 and 30 Year T-Note interest rate must stay low in order for the Federal Reserve Bank and the U.S. Treasury to continue the inflation trade and get the U.S. consumer back to spending. It seems as if the 10 Year T-Note interest rate must stay below 3.90% - and above 3.25%. This range is somewhat of a comfort zone that seems to keep the stock market happy. The administration can modify mortgages at this level and anyone looking to buy up any of the excess inventory of troubled homes can get a low rate. The housing market still seems to be the missing link and a big negative to the Federal Reserve and the U.S. governments plan.
This past week the United States Treasury auctions did not seem to go well. Yields spiked on all long bonds and somewhat spooked the stock indexes last week from their intra-day highs. The Dow Jones Industrial Average reversed an early 120 point rally on Thursday March 25th. The following day the DJIA reversed a 50 point rally as yields traded higher. If you would look at a daily 10 Year T-Note Interest rate chart they would clearly see that the only two stock market corrections came in June 2009 and January 2010. This was when the yields on the 10 year bond moved above 4.00 percent in June 2009 and then traded close to that level in January 2010. When the bond market speaks traders listen.
Could this weak Treasury auction be caused by the Chinese? Recently, Google Inc (NYSE:GOOG) pulled out of China over a censorship technology dispute. There has also been a strong push by many U.S. politicians to get China to float their currency called the Yuan. Currently the Yuan is pegged to the U.S. Dollar. What will happen if China unwinds some of its current U.S. debt holdings? It is said that they are holding over a ½ trillion dollars in U.S. debt. They sure do own a lot of America, therefore, if China starts to sell U.S. debt it could get really ugly very quickly for the U.S. markets. Should this ever take place it would put the Federal Reserve Bank and the U.S. government in a very tough position.
If the yields in the U.S. spike above 4.00 percent, the interest on the U.S. debt could be too much for the United States to handle. The U.S. debt is now in the trillions and growing everyday. This is going to be very interesting as the U.S. Treasury walks a tightrope.
Traders that are looking to trade the yields to the long side or short bond prices can trade the ProShares UltraShort 20+ Year Treasury ETF (NYSE:TBT). This is an ultra fund which means that it is two times short the bond prices. If traders and investors would like to trade bonds prices to the long side they can use the iShares Lehman 20+ Year Treasury Bond ETF (NYSE:TLT).
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