Monday, February 09, 2009
rising treasury yields
Even a casual market observer like your humble blogger has noticed the dramatic increase in Treasury bond yields from 2.5% on the 30 year bond to over 3.5% in a bit more than a month. (ten-year here via ft) I had assumed that the Fed, at its last FOMC meeting, would shed a bit of light on its December statement, when it said it would use all available means to free up credit markets and was considering buying Treasuries. The latter was particularly credible, since Bernanke has discussed the idea in some of his academic work.
The long bond, which had fallen from its peak (remember lower prices mean higher yields) but stabilized and rallied a bit right before the January Fed meeting. Not only did the announcement fail to clarify how a Treasury program might work, but the language suggested an intent to focus on instruments other than Treasuries. This seems odd, for as long as the benchmark rate continues to rise, trying to control spreads over it can achieve only so much.
Or maybe the truth has dawned on the Fed: the market is bigger than it is. Even so, it had better learn to bluff better, since Treasury investors, discouraged by the latest announcement, are demanding higher yields.
to be honest, the scale of the movement in the treasury market is potentially consquent of a few things. a more cautious view by traders regarding future inflation/repayment credibility is one. traders could be probing for the level at which the fed would be compelled to monetize. it may not be far away.
another is certainly the titanic flood of supply now hitting the treasury market as the government ramps up spending and borrowing. as john jansen has been reporting, the underwriting primary dealers are being overwhelmed with supply and are having to work overtime to place it.
another could be flagging sponsorship -- possibly from foreign central banks, possibly from the domestic community. there certainly has been some unwinding from the fear maximum of november; anecdotal reports from the credit community have indicated diversification of capital flows into high-quality corporate bonds as yields present much larger returns there.
but it is of course a curtailing of capital flows from FCBs that could provide the spark for something more devastating than what we've seen -- perhaps a severe backup in treasury rates. proposals sponsored by the chinese ministry of finance are now circulating in china to devalue the renminbi, reinforcing what i understand to be the opposite side of a power struggle with the central bank, an effort that would see china's authorities permit a greater outflow of capital and seek to perpetuate global flow-of-funds imbalances. this would entail continuing to support the dollar though treasury buying.
but, at the very least, hot money is rapidly exiting china now. china, to maintain its peg, has apparently been selling dollar securities. TIC data covering the period of the rise in treasury bond yields is not in yet, but it will be interesting to see. brad setser has made the very valid point that chinese central bank treasury purchasing might well be being replaced by private-party treasury purchasing, but we'll have to wait and see.
of course there's a great deal of deliberation ongoing about the fate of vendor finance. i have to agree with michael pettis at this point -- global trade will probably deteriorate markedly, having declined already to the degree seen from the peak to the trough of the great depression, and with it the trade volume that puts china in a position to buy lots of treasuries. declining trade flow in combination with capital outflows which require central bank selling of dollars may be helping to drive american yields higher. but for now it remains too early to say.
UPDATE: more from ft, quoting monument securities' stephen lewis.
US policymakers need to take the Treasuries market’s behaviour seriously. Each basis point by which the market yields rise nullifies actions that the US Treasury and Federal Reserve are taking in other policy areas to stimulate the economy. If those actions, through their implications for the budget deficit, are the cause of the rise in yields, the US authorities need to be careful how they proceed.
It is entirely possible that a point might be reached where the loss would exceed the gains. That would set an effective limit to what the US authorities could do to support the economy. Any attempt to reflate the economy beyond that point would be as futile as an attempt to travel faster than the speed of light.
Mr Bernanke and some of his colleagues may believe they can circumvent this constraint by having the Federal Reserve hold down yields in the marketplace. If they initiate a strategy of Fed purchases of Treasuries in such circumstances, they will very likely find plenty of willing sellers. After all, investors will know for sure that, without the Fed’s intervention, yields on Treasuries would be higher, though they will not know how much higher. The Fed’s bid will, therefore, afford investors an opportunity to offload paper at above-market prices.
To keep yields steady, the Fed might well have to increase the scale of its purchases progressively, and eventually wind up holding most of the Treasury debt in issuance. This looks like a route-map to the destruction of financial markets and the establishment of a command economy.
this has some resemblance to 1931, when the treasury market went off the reservation and a severe recession quickly became the great depression. monetization would be very unlikely to provoke a general inflation but could precipitate a hard fall in the dollar and a massive transfer of treasuries to the fed -- one that might well necessitate defending the currency and raising interest rates.
Predictions of rising treasury yields have been the prevalent thinking yet I haven't seen convincing explanations of why this time would be different than the Great Depression or Japan's crisis during which the trend in yields was down. Yes, the crisis is bigger and more global and yes supply will be huge, but then shouldn't the flight to "safety" ultimately be all the larger as private debts implode or are taken onto government balance sheets, leaving more competition for the treasuries that are created to replace the disappearing private assets? I understand that debts that are too big can be considered unpayable by the debtor, but when yields are low enough debt service stays manageable despite contributing to ongoing stagnation (see Japan).
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i'm certainly a deflationist -- what is happening in credit markets will ensure that there is no credit expansion, which is essential for anything like a general inflation.
but i also can't help noticing that we are in a prime position to debauche the currency.
it will soon become established, i suspect, that the fed will prevent the rise of treasury yields over some low level (say 4%). traders will probe for that level. once established, that will open the door for exiting parties -- they know their "worst-price scenario". there are a lot of people out there who might decide to diversify into an infinite bid -- after all, government debt will be made available elsewhere, including that floated by countries who are not clearly positioned to default by devaluation.
that raises the prospect of massive monetization by the fed even as t-bond yields stay low and private credit continues to implode. the effect on the dollar could be awful while still not engendering a concomitant price inflation with excess capacity remaining a tremendous problem.
i suppose what i'm suggesting is that the united states may not necessarily be the beneficiary of a flight to safety but rather a victim.
anyway, color me a history-rhymes type -- this is clearly a depressionary process, but differently in that fiat currencies enhance the possibilities of competitive currency devaluations. if the US has to devalue vis-a-vis the renminbi to avoid absorbing a great deal of the global excess capacity liquidation and to close its current account deficit -- and china is at the same time devaluing its currency while trying to maintain a dollar peg -- the possibility remains for a kind of currency warfare that simply wasn't seen in the 1870s or 1930s.
if our position is roughly analogous to that of britain in the 1930s, then at least britain had as its foreign financier a helpful american government which worked closely with the bank of england. what happens when the foreign financier is china?
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i don't think the united states is in serious trouble by traditional metrics -- its debt as a percentage of GDP is not wildly out of line with others. but by non-traditional measures -- such as treasury debt as a percentage of the global pool of capital, for example -- we're in uncharted territory.
people can obviously criticize where the lines were drawn in the 1930s, but the hoover administration -- activist though it certainly was on the monetary front -- managed to hive off the government from the problems of the economy until 1933. while that certainly aggravated the slump, it also left the government with a solid balance sheet in the aftermath of the deleveraging to help clean up the mess.
this government has instead gone in at least at 3/4 throttle -- blowing out its funding requirements to 10%+ of GDP is impressive. but it's just possible that we will see the inverse experience of the great depression -- whereas the survivors then learned not to fear keynesian spending and budget deficits, we may re-learn (as iceland now has) why folks did fear those things beforehand.
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i commented at clusterstock earlier re: paul kasriel's intimations of a nearby recovery. watch the LEI, yes, but has he forgotten that the "policy mistakes" of 1931 and 1932 were in large part undertaken as defenses of the currency? this was part and parcel to preserving the government balance sheet at that time. he knows that; i can only surmise that he thinks a run on the dollar now unlikely, dismissing the possibility of either china or saudi arabia depegging.
i wouldn't be so sure. here's a paper re: the run on the pound which, finding that british monetary base expansion was relatively responsible and within the bounds of the dollar-gold-pound peg, surmises
the speculative attack against the pound was provoked by something else ... [which] could well have been the financial crises in Austria and Germany that cut the Bank of England off from some of its assets and gave warning that other countries too could be vulnerable. Another telling point that the speculative attack against the pound was a surprise is that prior to summer 1931 there was no mention of a possible exchange rate crisis in important publications such as The Economist and the Federal Reserve Bulletin. Nor did the forward pound move outside of the gold points during 1931 prior to the actual crisis, except briefly in January (Eichengreen, 1992).
in other words, a run on the dollar could come as a complete surprise, and may have come as result of losses taken on the asset side by the BoE -- that is, losses which forced the expansion of the monetary base.
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I've seen others make the "infinite bid" argument you raised, and it usually loses me. Assuming you are referring to the idea that knowing the government will buy longer dated bonds to keep yields low, current holders of treasuries will likely sell everything into the infinite bid, forcing excessive monetization and a collapse of the currency... if that's true, why has the Fed been able to purchase a limited number of MBS/agencies despite announcing buying those? Why was Japan able to perform a limited monetization of its JGB debt and other assets?
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fwiw, note this part of ray dalio's outlook from the other day:
“The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.”
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1. "after all, government debt will be made available elsewhere, including that floated by countries who are not clearly positioned to default by devaluation."
Which countries both fit this criterian and are large enough collectively to support capital flight from the US?
2. "but i also can't help noticing that we are in a prime position to debauche the currency."
You raise both intentional debasement (supposedly good for the US) and devastating runs on the currency (supposedly bad). Is it a given that any run would go either too far or too fast even if a lower currency supposedly helps us?
3. "if the US has to devalue vis-a-vis the renminbi"
Can the US do this alone? I haven't been able to find any real summary of the pegging mechanism (even wikipedia lists 'citation needed' alongside mentioning Chinese monopoly over exchange)
4. "re the fed's infinite bid -- afaik, japan never really experienced the run on the yen that britain and the united states saw in 1931. perhaps that's because the debt is virtually entirely financed domestically."
Okay. So in short the two reasons why US treasuries might not follow the Japan or GD path:
a) Large treasury holding by foreigners who widely expect successful US currency debasement versus other currencies (in other respects, i.e., other than currency risk, foreigners should behave no differently then domestic holders), or
b) Large enough US government deficits ("...3/4 throttle...") relative to Japan to render sovereign debt service infeasible, despite Japan having succeeded so far
Both seem feasible to me but less probable than widespread expectation. With respect to (b), every trillion of new debt equates to an extra roughly 1.2% of the current federal budget at recent treasury rates. While massive, it seems it would take several tens of trillions to make default (versus crowding out and stagnation) a given.
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japan and germany, for starters -- the JGB market is the largest govt bond market in the world, germany third i think. neither, being surplus countries, are likely to devalue by as much as the US.
Is it a given that any run would go either too far or too fast even if a lower currency supposedly helps us?
no -- in fact some devaluation will be considered desirable. where is the tipping point where desirable becomes undesirable? -- or where controlled devaluation becomes something else? remains to be seen, i think. but part of the problem is that devaluation will be encouraged by american authorities early on, in spite of more and more ominous rumblings from chinese officialdom. with our massive financing requirements, even a redistribution of further purchasing could have a very dramatic effect.
Can the US [devalue vis-a-vis the renminbi] alone?
opinions vary but the answer is probably yes. if the US starts to devalue china will at first try to maintain its peg. but this sets up a dynamic by which the US can force-feed dollar claims onto the peg defender like stuffing the gullet of a goose destined for foie gras. "competitive devaluation", then. ultimately the US can break the peg; but at what cost?
So in short the two reasons why US treasuries might not follow the Japan or GD path
the thing is, treasuries might do exactly what they are supposed to -- stay at or below the fed's yield target, beyond which they monetize.
meanwhile the dollar collapses, gold skyrockets, and the US contemplates capital controls to stem capital flight.
in other words, the REAL return of treasuries might be awful, while they remain an excellent NOMINAL store of value. this would be very unlike the japanese situation -- but would have something in common with the british and american situations in the 1930s. it's also obviously why holding rates low by monetization does not ensure infinite ease of debt service. :)
i really appreciate the dialogue, hbl -- thank you.
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But, what if global competitive devaluation leads to stalemate? Simplying for a moment and assuming only China and US (but we could extrapolate to baskets of currencies), if the US prints dollars to buy yuan and China prints yuan to buy dollars, each adding to foreign currency reserves... three scenarios:
1. China holds pure USD balances and US holds pure yuan balances, neither buying foreign-currency assets. Result: mutual sterilization of money supply increases (therefore little change in CPI), plus little change in relative exchange rate.
2. China buys dollar-denominated assets (mostly treasuries) but US is unable or unwilling to buy yuan-denominated assets. (Aside - is that why China can control the peg now -- closed yuan asset market?) Result: Supports US asset values (probably treasuries) with proportionately smaller flow through to US CPI (due to increased supply of dollars in circulation). Effect is mostly currency exchange-rate neutral (or small dollar devaluation as some dollars return to bid in currency markets, unless further offset by China buying dollars). Minimal net impact on China's money supply or domestic inflation given the effective sterlization by the US.
Alternately, if China buys commodities (including gold) instead of treasuries, those assets initially do well instead of sovereign debt, that is until perhaps aritrageurs decide the cashflow of bonds is worth more than commodities with no yield.
Either way, this may be a scenario that reduces US debt burden by raising US inflation due to money supply increases (not currency adjustment). But some US asset class seems likely to benefit disproportionately... perhaps treasuries, perhaps commodities.
3. China buys dollar-denominated assets and US buys yuan-denominated assets. Sort of like mutual quantitative easing! Result: Still mostly currency exchange-rate neutral. Supports domestic asset prices by moving them out of circulation and into CB reserves and increases money supply for each country. This is also where gold and other hard assets might benefit but wouldn't the rate of increase be smaller than the asset price support level provided by central-bank asset purchases (i.e., treasuries or commodities)? Plus money supply inflation may takes years to gain traction in a debt-deflation of this scale (I'm not a believer in the quick-flip-to-hyperinflation theory with debt-to-GDP at these levels).
So in summary I can see your argument playing out via scenario #2 or #3 but with the inflation due to the much slower impacts of monetary expansion rather than huge currency-adjustments.... which would mean support for the prices of CB-favored assets for some years to come.
It's quite likely my thought exercise goes wrong somewhere though :)
Thank you for your thoughtful responses!
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