All That Glitters / King Kong Takes on Godzilla

Several reasons underlie the surge in yields on U.S. government bonds.

Quite a drama raged last week, though it slipped under the radar of most pundits. The story began one morning with unusually erratic fluctuation of the rates at which banks lock in interest rates they quote to loan seekers.

"At about 1 P.M., the market seized up. Banks simply stopped setting interest rates," related one American mortgages marketer. "The ones that continued had to ramp up interest rates to clients by 0.75%." Interest rates on "jumbo" mortgages, between $417,000 to $730,000 jumped as high as 8%, the trader added.

Another remarked that it felt like the U.S. Federal Reserve had lost in battle. "As far as liquidity is concerned, we all felt like on the day LTCM collapsed." (That would be Long Term Capital Management, a giant hedge fund run by Nobel laureates that crumbled into dust before the eyes of the disbelieving world markets in the late 1990s, sparking fears of worldwide economic collapse that led to a massive bailout.)

What happened last week? Well, it started in the U.S. government bond market. The Fed announced in March this year that it would be buying government bonds on the market. Prices on 10-year U.S. treasuries rose to levels that reflect a puling yield of only 2.5%, only to fall back.

Last Wednesday the price of 10-year U.S. government bonds fell to a low reflecting a yield of 3.74%. Market players started to sweat. The fear that yields on these notes would continue to rise escalated to panic, which spilled over into the mortgages market, where prices are based on the interest rates the Fed sets and on interest rates in the U.S. government bonds market.

The question on everybody's mind was how Fed chairman Ben Bernanke would react.

Several reasons underlie the surge in yields on U.S. government bonds. The first is fear of inflation and that the dollar will depreciate. Because of the tremendous cash infusions from Washington, coupled with declining tax revenues, the American deficit shot up to $1.85 trillion. That's four times its level last year.

That leads market animals to ponder, who exactly is going to buy all those bonds that the Obama administration will be issuing?

Last week, traders report, the market simply choked on a $100 billion bond offering by the U.S. treasury. It stopped breathing completely when Washington stated that it would be issuing $900 billion more by September. Ed Yardeni, an economist who coined the phrase "the bond market vigilantes" to describe how the bond market punishes spendthrift governments that create inflation by selling bonds, said last week: "Ten trillion dollars over the next 10 years is just an indication that Washington is really out of control and that there is no fiscal discipline whatsoever."

The second reason for the surge in U.S. bond yields is relatively good news coming in from various fronts of the economy and the stock market, and abating uncertainty among investors. During the height of the crisis, oceans of "hot money" parked in U.S. government bonds. Now it's looking for other avenues, riskier ones with higher potential returns.

The third reason is the simplest. U.S. government bonds have become too expensive. Yields of 3.5% over 10 years pale in comparison to the 25-year average of 6.5%.

A lot of economists claim that the main thrust of the Fed during times of crisis is based on the effort to lower long-term interest rates, and through that, the rates on mortgages, which is precisely the core of the financial crisis. Even now, about 12% of America's mortgage borrowers are in arrears or are about to lose their homes. Any increase in interest rates would reduce more homeowners to desperation, exacerbating the crisis even more.

The Fed, they claim, is out of choices. It will have to greatly expand its bond buying.

That's why U.S. treasury secretary Tim Geithner jetted to China last week. The Chinese are among the biggest lenders to America. They already own $770 billion worth of U.S. government bonds and want to hear that the Obama administration will be protecting the value of these bonds, not eroding it through excessive issuance, or encouraging the dollar to depreciate.

But not everybody follows the fearful theory of the bond market. Paul Krugman, also a Nobel laureate, wrote last week in his New York Times column that the problem is still dropping prices, deflation, and that there's no economic evidence or logic to back up the scenario of an inflationary outbreak at this time. Experience, for example in Japan, shows that bond issues and rising government debt, even to the level of 100% of GDP, don't usually create inflation, Krugman explains. The only thing to fear now is the fear of inflation, he concludes.

This is not an American debate. It's relevant to Israeli savers and investors as well. With some exceptions, Israeli bond yields track American bond yields. The reason for the drop in Shahar bond prices last week was the plunge in U.S. government bonds.

Historians are often better at describing reality than economists. Take Prof. Niall Ferguson of Harvard, author of "The Ascent of Money" and host of a BBC television show that's also aired in Israel. Ferguson has the distinction of being one of the few to predict the global economic crisis. Last week he wrote that the crisis has become a battle between King Kong and Godzilla: between the monster of inflation and the monster of deflation.

The battle has all the hallmarks of a monster movie, Ferguson elaborated. It goes on and on, and you don't know who's going to win. All you know is that a lot of ordinary people are going to get trampled underfoot by these unfeeling monsters.

A policy of borrowing more, and vastly so, to solve the crisis of too much borrowing can't support efforts to lower interest rates, he argues. He doesn't purport to know when inflation will break out, he says: but prepare for intense volatility.

Which means, this year will be characterized by sharp movements in the bond market. If you want a conservative parking place for your money, you'd best be doubly careful. Mainly, don't try to make a quick buck by hopping in and out of the bond market.