This week in The Institutional Risk Analyst, “Will Devaluation and Default be the Themes for 2011?,” we feature a comment on the likelihood that sovereign defaults and devaluation will be the themes of 2010 in both Europe and the EU.
Despite the best efforts by the Federal Open Market Committee to provide liquidity to the entire world, the retreat of the bond market over the past few weeks proves that even Ben Bernanke cannot keep the bond market at bay forever. As I said at the meeting of Professional Risk Managers International Association in New York last night, risk professionals need to question the data and metrics they see on the computer screens more than ever before.
October was arguably the best month in the global bond markets in recent memory; we can call the first week in that month was the peak. A good bit of money was taken off the table by savvy investors who realized that the markets have just barely regained the levels seen a year before. But for those investors who now cling to the side of the proverbial capsized sailboat, the past month and more has seen bond prices move down in what one veteran hedge fund manager calls the worst month he’s ever seen.
Take a look at the chart for the iShares S&P National AMT-Free Muni Bd (MUB), which illustrates the climb of the municipal bond market in the U.S. buoyed by the subsidized “Buy America” bond program and the Fed’s quantitative easing, or “QE”, program to keep interest rates artificially low. The chart shows very directly how these markets were supported by the Fed during the most aggressive phases of the emergency liquidity operation, but now these same markets are reverting to the mean.
In an earlier post on Reuters.com — “Bernanke conundrum is Obama’s problem” — I looked at the way in which the Fed was understating the degree of risk in the global markets via QE. Essentially, the U.S. central bank is not only forcing down interest rates, but also visible measures of risk, such as the VIX, that are widely used to price and manage market risk. With the market for U.S. Treasury bonds moving nearly a point in yield, and spreads on junk and muni bonds moving at several times this rate, funds and financial institutions have been hit hard. As David Kotok of Cumberland Advisers said to me earlier this week, the impact of the sudden, sharp movement in U.S. interest rates has been “global.”
As Martin Wolf suggested in the Financial Times yesterday, the Fed is probably not unhappy with the move in rates since it marks a normalization of the Treasury yield curve after two years of heavy manipulation. The trouble is that the duration of the bond market, including several trillion dollars worth of mortgage backed securities, has been increasing by leaps and bounds over the past several years. Thus the volatility of the overall market has increased, amplifying market risk for investors many fold.
For many banks and fixed income investors in dollar assets, the relatively sudden move in U.S. interest rates has wiped out the gains of October and then some, showing that whatever the good intentions of Fed policy makers, the U.S. central bank is now a major source of market volatility. Banks, ETFs and REITs have all been hit with sharp movements in the market value of bonds, causing many to scramble to meet margin calls.
With the QE effort seemingly tailing off at just the time when credit concerns are mounting regarding states in the EU and the U.S., the upcoming year could be a time of rising volatility in the markets. But this increase in the visible market risk is also coming at a time when credit concerns are growing.
One senior U.S. official told me this week that the International Monetary Fund may eventually be called upon to manage a combination of debt haircuts and fiscal reforms for states like Ireland, Spain and Portugal, but that the U.S. states may be in the same boat. “Think of IMF-style conditionality for U.S. states like California, Illinois and New York, imposed by Washington at the behest of its foreign creditors,” the veteran financial observer predicted.
As we wrote this week in The IRA: “One of the things about a free society is that when a problem grows to a certain size, the political force behind the good of the many becomes irresistible and the good of the few or the one can often be overlooked.
As new political tendencies join governments in Ireland and the U.S. in January 2011, we look for macro economic and financial factors to start driving events that will be very unpleasant in some ways for creditors and consumers. Just remember that sovereign states like Ireland, California and New York don’t file bankruptcy, they merely default a la Iceland and Argentina. Or to quote Reuters.com blogger James Pethokoukis’s headline, “Secret GOP plan: Push states to declare bankruptcy and smash unions.”