The bond market has been in a selling mood since 10 May 2007. That selling mood has caused prices to fall. Rates – which always move in opposite direction as prices – have moved up.

Prices on Treasuries are in a freefall again today. Rates on bonds opened higher and have remained at that level in the first couple of hours of trading. The 10-year Treasury is +.084% with the rate at 5.222%.

Prices on U.S. Treasuries are falling today on speculation that rising inflation in the global economy will prompt all central banks to push up interest rates. Further evidence of this came overnight as China’s headline inflation rate touched a two-year high in May. China's central bank has said it wants to keep inflation under 3% in 2007, and inflation has now been at or above that level for three straight months.

The Chinese consumer price index for May was +3.4% in year-to-year analysis, according to data published by the National Bureau of Statistics Tuesday. Most of the gains were due to food prices, and haven't spread to a broad range of consumer goods. What we would call Chinese core-CPI was +1.0%. China’s food prices jumped 8.3% from a year ago.

Even though their core-CPI was low, the headline inflation rate is now higher than the interest rate banks pay on deposits, currently set at 3.06% for one year. That gives Chinese consumers a big incentive to spend or invest that money rather than let it sit in the bank.

Further, and of great Long-Term bearing on US interest rates – is how this will buying will diminish demand for US Treasuries. When demand for any commodity decreases, prices also declines. When bond prices deteriorate as they have, rates go up.

Much of the increase in Sino food prices are something we mentioned months ago in our Mid-Term Outlook. Attention-grabbing increases in prices for pork, for instance, are being caused mostly by supply shortages -- something that changing interest rates would be unlikely to affect, Mr. Zhou said. Grain prices have also been on the rise, but this reflects shifts in global supply and demand that Chinese authorities also have little ability to influence. Grain stockpiles in many countries have fallen to multiyear lows, even as increased production of biofuels such as ethanol has added a new source of demand.

MID-TERM OUTLOOK [12 June 2007]

There may be a few problems for rates for this quarter.

1.) Investor sentiment is now leaning towards higher rates.

A few months back this blogger wrote that the bond market seemed to be looking for any excuse to buy bonds and thus drive rates lower. It appears that that trend has reversed itself. It seems now that the bond market is looking for any reason to sell, and correspondingly raise rates.

31 May 2007 gives one such example. There were six items published that day. Even though most of the economic items came in as expected, three did not. Of the three, two were lower than expected and should have moved rates lower. Instead rates continued their upward trend. Clearly investor sentiment has turned bearish on buying bonds.

On 12 June 2007, U.S. Treasuries declined again as they have for quite some time as investors abandoned wagers that the Federal Reserve will cut interest rates this year.

Options prices on Fed funds futures show traders see a 44 percent chance the Federal Reserve will raise its benchmark interest rate a quarter-point to 5.5 percent by the end of the year. A month ago, there were no expectations of a rate increase and 58 percent odds of a rate cut.

2) The housing bubble has ‘burst’. The question is, will housing continue to decline? Is it flattening? Or, is it on the verge of a rebound? The data over the last few months has been a resounding maybe to all three. IF homeowners start to see a rebound in housing their confidence will increase. As confidence increases, so will spending. Economic growth is moderate now with problematic inflation. Strong growth could renew strong inflation.

On 08 May 2007 the bond market responded to an unscheduled announcement by the National Association of Realtors (NAR). The NAR reduced its sales forecasts for 2007 and 2008, predicting that stricter lending standards would limit home buying. That only makes sense as stricter guidelines reduce the number of buyers able to get a mortgage. Given the already oversupply of houses, verses the very number of buyers we have a buyers market now. Reducing the number of buyers hits the real estate market with a double whammy.

Sales of existing homes will probably fall about 3% this year to 6.29 million from 6.48 million in 2006. Sales of new homes are projected to fall about 18% to 864,000, compared with a 14% drop predicted last month. Housing starts are expected to drop 19% to 1.46 million.

The results in May were mixed. New Home Sales were for April were up, while Existing Home Sales were down. At the same time, the Mortgage Bankers Association Application Index has been moving upward, indicating more people are looking.

When there are signs of housing market weakness it helps the price of bonds. Since it is a sing of a slowing economy it instills safe-haven interest.

3) IF investors continue to be concerned with the FED’s ability to fight inflation. The confusion of the FOMC meeting on 21 March, and the subsequent release of the Minutes on 11 April, caused the bond market to issue a collective HUH?!?! Economists and FED watchers echoed the HUH!?!, and added a wha...?.

There has been one more Fed meeting on 09 May, and it caused rates to move up a bit. The FED action that has impacted rates more dramatically has been comments by FED officials since the last FOMC meeting. FED officials, most often Jeffrey Lacker have spooked the Bond market and pushed rates up in the last few weeks.

4) In February we wrote:

We have one great inflation fear in the mid-term; corn prices. With all the talk of alternate fuel and ethanol, corn futures have nearly doubled. Corn is a staple of many food products that we eat. Increases in corn prices will not just impact corn flakes, but pop/soda, beef, and pig, chicken, candy bars, just about anything we eat.

None other than the Western Hemispheres worse dictators agrees with us. (For once He understands economics.)

An open letter signed by Cuban leader Fidel Castro, titled "More Than 3 Billion People in the World Condemned to Premature Death from Hunger and Thirst," circulated in the media Thursday, 05 April 2007. In his first major statement in months, Castro rejects the use of crops for biofuel production. …he is concerned that President Bush and the US Auto Makers enthusiasm for flexfuel vehicles will have disastrous environmental and food-price consequences for developing countries.

Castro and his ally, Venezuelan President Hugo Chavez, probably are concerned that the Brazilian-U.S. ethanol initiative, launched during Bush's recent Latin American tour, threatens Venezuela's influence in Central American and Caribbean countries through its subsidized oil Petrocaribe initiative.

Even the best estimates of corn based fuel say that it will never replace the need for fossil fuels. At best it can only reduce the demand some. It would be much better for us to reduce our demand on foreign oil and decrease the price at the pump by; 1.) Drilling where we know that there is oil, 2.) Build refineries, 3.) Eat food as food.

Steve Boxmeyer [612] 799 – 6858
steve@LendWithIntegrity.com