The Bond Market's Locust Cycle - 12/15/09

The investment world as we know it will change with higher interest rates. A changing interest rate cycle will have reverberations in 2010. Consider yourselves forewarned.

Narrator: And the more the Grinch thought of what Christmas would bring, the more the Grinch thought...
The Grinch: I must stop this whole thing! Why, for year after year I've put up with it now. I must stop this Christmas from coming ... but how? I mean ... in what way?

-- How The Grinch Stole Christmas!

The real Grinch will be higher interest rates in 2010, and it now appears inevitable that an interest rate rise will come earlier than next year's Christmas.

There will probably be no more important calculus in 2010 than for investors to determine as to when and how far interest rates will rise.

Thus far, a number of determinants have held down interest rates, a near-zero interest rate instituted by the Fed, a surplus of savings around the world, a banking industry reluctant to fund loan growth (and building up liquidity), low current inflation readings (and future inflation expectations), quantitative easing to buoy growth and a wide manufacturing gap.

But, the threats of a reviving world economy, the structural imbalances and decaying conditions of our state of and local government finances, the unfunded liabilities associated with an aging population and the need to finance our mounting federal deficit will weigh on the bond markets in the months ahead.

While it is always easy seeing the world from a rearview mirror, the difficulty, of course, is in figuring out when the turn will come.

And when that turn comes, the investment world as we know it will change with higher interest rates, starting with the breakdown and risks associated with the carry trade of borrowing low-yielding debt to fund and chase long-dated assets further up on the yield curve (something I briefly discussed in this weekend's Barron's interview). Moreover, the inevitable capital losses in the fixed-income market will no doubt be dramatic, as will the competition of rising yields affect equities to some unknown degree.

This talk of 17-year periods makes me think -- incongruously, I admit -- of 17-year locusts. What could a current brood of these critters, scheduled to take flight in 2016, expect to encounter? I see them entering a world in which the public is less euphoric about stocks than it is now. Naturally, investors will be feeling disappointment -- but only because they started out expecting too much.

-- Warren Buffett, Fortune (1999)

Ten years ago, Warren Buffett used the analogy of a locust cycle to describe the souring outlook for equities in his terrific 1999 article written in Fortune (see above quote). As the Oracle of Omaha wrote, biblical plagues, like locusts, seem to affect the capital markets once every 17 years or so.

While bond investors have feasted on excellent returns for about 17 years, similar to the returns on which stock investors feasted leading into the late 1990s, that era of rising bond prices and lower yields is likely rapidly coming to a close.

As I mentioned in Barron's, since stock valuations have not been stretched over the last decade, equities are clearly less exposed than bonds are. Nevertheless, a changing interest rate cycle will have reverberations in 2010.

Consider yourselves forewarned.