Bonds swamped in fair weather or foul
Come good news or bad, the U.S. treasury market is taking a sell now and wait for inflation later strategy.
Since May 21, Treasuries have been battered, sending the yield on 10-year bonds up by nearly 40 basis points to 3.53 percent, an enormous move in bond market terms.
This is where the real action is, not in speculation about whether credit ratings agencies will cut the U.S. AAA rating in a year or two; by the time they get around to saying what everyone already knows is true, the damage will have been done.
The U.S. is in the process of reflating, really re-leveraging its economy, but this time using the public purse and printing machine to replace private demand.
This may be necessary, it may even work, but what it is without doubt is risky. The Federal Reserve’s massive direct intervention in credit markets will have to be unwound if and when it works, with unforeseeable consequences, and the government’s funding needs are in the meantime intimidating.
Investors in Treasuries rightly fear the risks of inflation and of being left, eventually, holders of what the Fed is selling rather than what it is, at least for now, buying.
Stephen Lewis, of Monument Securities in London believes the surge in prices of things the Fed was buying was by definition short-lived:
“Investors quickly realised that, unless the Fed intended to be a permanent holder of the securities it had bought, or of an equivalent amount of similar securities, the favourable shift in the supply/demand balance would be only temporary,” he wrote in a note to clients.
“Sooner or later, it would give way to an unfavourable shift as the Fed unwound its holdings. More than that, even the cessation, or diminution, of the flow of Fed asset purchases might leave the prices of those assets high and dry…The prospect then would be of a sickening plunge in market prices.”
The irony on Tuesday was that bonds were hit hard even despite a successful auction of $40 billion of 2-year notes, with performance getting worse the further in the future the bonds are due for repayment. But a further series of tests are upcoming, with another $60 billion being sold this week and more to follow as far as they eye can see.
An optimistic gloss on the bond sell off on Tuesday is that better than forecast consumer confidence data had touched off a rally in stocks. Happy days, fill your boots with equities and sell those bonds. A steepening yield curve is supposed to be a sign of a recovery, right?
TREASURIES WEAKEN, OTHER VARIABLES CHANGE
That analysis is tough to reconcile with recent events. Last week, bad news and a fall in the stock market coincided with bonds tumbling. Britain was put on warning by Standard & Poor’s that it could lose its AAA rating, supposedly sparking a read-across of the same implication for the U.S., the jobs numbers looked a bit ropey and, hey presto, bonds and stocks, well really U.S. assets, fell in concert.
Moody’s on Wednesday said the U.S.’s AAA rating was stable, but strangely the rally on the back of this was not forthcoming.
But to understand why bond markets aren’t pleased with the U.S. fiscal situation, you don’t need to read-across from the British model, just read the Congressional Budget Office data.
The CBO predicts nearly $10 trillion of new debt in the decade from 2010, which will leave it at more than 80 percent of GDP. These are just astounding numbers, and while we can’t be sure, the real risk is that the bond market is telling us this is unsustainable, unfinancable over the long term.
The data may well be looking up, and I do think a tepid recovery in the second half of this year is on the cards, but surely not a recovery that is worthy of inspiring a 12 percent plus move in government interest rates in 10 days or so, and not while the Fed is busily doing its best to keep rates artificially low by buying debt directly.
The central scenario is probably a volatile bond market, a jittery one which sees inflation behind every tree but in the end keeps faith with the U.S. and with its ability and resolve to manage the economy.
The tail risk is that the bond market loses faith, and in some combination with a falling dollar begins to not reflect events but dictate them.
It is a small risk, but the bond market could be the story of the summer.
— 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. —