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A Favorite Indicator

01/25/2011

Has anybody noticed the difference in interest rates between 30-year and 2-year Treasury bonds? It has reached a new high of 4% or 400 basis points. This is an all-time record!

One reason might be that the Chinese have stopped buying 30-year bonds. (The longer the term of a bond, the more volatile the market value of the bond.) They needed to cut back their holdings of our bonds and wisely cut back on the most volatile. With reduced demand for those bonds, the price dropped, which increases the interest rate required to sell them.

Another reason for the reduced demand for long-term bonds is that some investors legitimately question whether the United States will survive another 30 years.

The more bullish investors point to the fact that a “steep yield curve” or big difference between short-term and long-term rates is a reliable indicator of an improving economy. The logic is that buyers of bonds know demand for bonds in the future will rise, causing rates to rise and the value of bonds purchased now to fall. This suggests stocks will rise in value more than bonds.

I think the bond market is telling us that inflation is inevitable. Knowing rates are going to rise due to out-of-control government spending, i.e., entitlements, the buyers of longer term bonds demand higher rates to protect themselves from the corrosive power of inflation.

Frankly, I don’t understand why anybody would buy a long-term bond when interest rates are almost certain to rise. Besides, many stocks pay much higher dividend rates than bonds.

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