Are Bonds (Fixed Income) at a Tipping Point? Part Duo

The first of November, my Market Update asked if bonds were at a tipping point because they were not responding as Fed Chairman Bernanke wanted (lower interest rates, lower dollar and increased commodity prices.) I also said that we would know more within the next few months.

Since then, the 10 year Treasury has moved down very slightly or about 20 basis points (0.20). However, the yield curve has steepened (short rates down and long rates higher.) Not what Bernanke wanted (unless he wanted to make the environment for bank profits better.)

The dollar has been rising not falling. But the problem is that other countries are not going to simply sit back and let the U.S. devalue the dollar (to improve exports), so they have responded by devaluing their currency in order to compete. This currency war can’t go on forever, but in the meantime, it is destructive.

Commodity prices are about the same.

It seems that there is no definitive answer yet, but there is a lot of new money going into the banking system and the banks have three choices of what to do with the money:

1.Sit on these new assets and collect the overnight interest rate from the Federal Reserve, or
2.Lend this money out to companies and individuals who want to borrow money. There is not much of this going on because banks are sitting on nearly a trillion dollars of excess assets, (maybe banks don’t want to lend or maybe borrowers don’t want to borrow.) or
3.Buy assets with this money (bonds, stocks, commodities, foreign investments, etc.) Contrary to what many people think, banks do not need to lend money to borrowers to make profits, they can invest the money here and abroad, wherever they can make the most money.

Another thing that seems to be going on here is that we have not seen much inflation (by government statistics) in spite of all the new money that’s been created. The reason many people think is that inflation will not happen until those trillions of dollars in excess assets get turned into trillions of dollars of credit.

So, think about this, if the economy does turn around or people think it has turned around; and suddenly want to use credit, would those trillions of dollars of credit turn into instant inflation? If so, that may not be good for the bond (fixed income) market as investors will want to be paid for the inflation risk.