Interest rates headed up

Just above this post you see an image of the October 26, 2010 edition of the New York Times. Just above the fold on the left side of the page you will find the heading "Bond Frenzy: Investors bet on inflation". The NYT reports that in the latest auction of 5 year, inflation protected, treasury notes investors paid the treasury 55 basis points per year for the privilege of loaning the treasury money!

According to the Times the auction results tell us that investors fear inflation but I do not agree. If they did ordinary, non-inflation protected note yields would be high. But as you can see from the top chart of weekly 10 year note yields this is not the case. In fact, the yield on 10 year treasury notes is very near historically low levels. A different way to see this is to compare the inflation protected yield with the yield on ordinary 5 year notes. This spread, currently less than 2.00%, is the market's best estimate of likely annual inflation for the next five years. No expectation of inflation there!

But as a contrarian I think the NYT use of the term frenzy to describe bond investors' mass behavior is spot on. In this previous post I observed that mutual fund investors were pouring money into bond market mutual funds and taking it out of stock market mutual funds at a record pace. That hasn't changed during the past couple of months. Nowadays people brag about their bond portfolios like they used to brag about the skyrocketing value of their homes or the pile of money they made on the latest dot.com offering.

Nearly two years ago I predicted that the bull market in bonds and the long drop in yields that began in 1981 was just about over. I haven't changed my mind. And the prospect of further quantitative easing by the Fed just reinforces my view. Bond yields are heading much higher from here.