Why Bonds Are Tanking

Yesterday's sell-off on the long-end of the Treasury yield-curve continues, with the 30-Year off nearly another point today.

Unfortunately, this sell-off has been accompanied by headlines pinning the blame on the tax cut deal that was negotiated between the President and Republicans in Congress.  Specifically, the stories behind these headlines tend to state that this tax cut deal will increase the Federal budget deficit, therefore making Treasury Bonds less attractive.

It won't.

Just as the 2003 Tax Cuts resulted in a sharp increase in Federal receipts from personal income taxes, especially from the wealthy, this current tax cut deal is going to pave the way for a new recovery in Form 1040 receipts as well.  Unfortunately, we won't see the data for 2011 and 2012 Federal tax receipts for another five years.  That is the downside to tax policy analysis; it can take years to see the cumulative effect of taxation on people's behavior.

The real reason that bonds are tanking now has to do with the prospects for economic growth and corporate profitability going forward.  With the uncertainty of tax policy behind us, and an abandonment of a really bad, anti-growth agenda in the form of letting those 2003 Tax Cuts expire, businesses and entrepreneurs will focus more on being productive.  The effects of this phenomenon should start showing up in the GDP numbers by the 2nd half of 2011.

How does that affect bonds?  Bonds, as a financial investment, must compete with every other asset category.  When economic growth and corporate profitability is anemic, bonds become more attractive.  However, with the prospect of renewed economic growth over the next two years, common stocks become more attractive as an asset category.  That relative attractiveness draws capital away from the bond market.

For most of three years now, the 30-year Treasury Bond has traded with yields in the low 4s%.  This is great if you're a new homebuyer with decent credit, as it's afforded home owners the ability to finance, and refinance, fixed rate mortgages at the lowest rates seen in generations.  But this is not good news if you need the economy to grow at a faster pace.  And collectively, we need that growth if we're to ever address the coming demographic nightmare known as Social Security and Medicare.

SPGlobal currently estimates that corporate profitability will grow by 15% over the coming year.  I now suspect that actual growth will exceed their estimate.  It'll be great news for stocks.

But it's not going to be a fun ride for bonds.