Bond markets give stress test thumbs down
The most revealing verdict on the results of the U.S. banking stress test was delivered not by shareholders but by the vigilantes of the bond market, who shunned an auction of 30-year government debt.
This makes sense: if the U.S. is letting banks off too lightly it will be taxpayers and the people who lend the U.S. money who will have to pick up the bill.
The stress test, which showed that 10 large banks will need to raise about $75 billion in capital, was greeted with euphoria by bank shareholders, despite being heavily leaked.
That’s no surprise, the stress test is useful not so much as a set of forecasts about the economy or bank losses, those being arguably too optimistic, but as a signal from government to capital about the rules of the game. It matters not because it is true but because of who is saying it.
Think of it as a term sheet in which the U.S. seeks junior minority investors to take some of its exposure to its banking system. The message is we will give you enough rope to try to earn your way out of your hole; if it works the rewards will be huge.
The U.S. has already said that none of the 19 banks would be allowed to fail, and if the past year has taught us anything it is that banks are creatures of government, the corollary being that that government has to pick up the pieces if banks fail.
So how do we interpret the very poor debt auction, or the fact that 30-year bonds ended the day yielding about 25 basis points more than in the beginning, a very large move when yields are only a bit over 4.3 percent?
It’s possible that this is a green shoots story, that bond market investors are looking for a healthy pick up in growth and inflation, but I doubt it.
More likely is that it is a combination of unease about budget indiscipline, about the amount of debt the U.S. will have to sell and about the bills that will come due if the stress test gets an F from reality.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–