Thursday, May 28, 2009
The key question is how to interpret it:
(1) Is this simply an unwinding of the unsustainable “bubble” that had emerged in US Treasuries during the flight from risk, that is now gradually deflating as risk aversion ebbs. If so, the movement should be fairly limited and could be interpreted as part of the “normalisation” of financial conditions.
(2) Is it the start of a flight away from Treasuries as fears about inflation and record issuance and debt levels trigger a fundamental reassessment — in which case the move could be much larger and far more destabilising.
no one yet knows, but this from john jansen (via nemo at self-evident) did not calm.
Why is the market crashing and why is the curve so steep?
We are drowning under the weight of near term supply for sure but I guess I think something else is afoot here.
Look at the breakeven spread on the 10 year TIPS bond. That spread is currently 185 basis points. I do not believe that we have been that wide since the advent of the financial crisis in 2007. I think that investors are uttering a gigantic and collective nyet regarding the implementation of monetary policy and fiscal policy in the US. That is why the curve is steepening so dramatically.
Foreign central banks continue to intervene, buying dollars and selling their local currencies. The names most mentioned in that endeavor are Russia and Brazil. Sources tell me that the fruits of the intervention are parked in 2 year notes and 3 year notes. There is a dearth of central bank interest in the longer maturities.
Some cite the very strong 2 year note auction today as a sign of the market’s health. I think not. The issue is propped up by the prospect of a very low funds rate for an extened period of time. The carry and ride down the curve profits are seductive.
Central banks bought over 54 percent of the issue. I would submit that while that is great for the 2 year note it is a less than festive sign for the 5 year note and the 7 year note which will auction over the balance of this week, The money in the 2 year note is money that will not be invested in the 5 year note and the 7 year note. The treasury should organize a posse to search for marginal dollars for the 5 year and 7 year. If one wishes to observe bond market panic I think it would develop quickly if the 5 year note or the 7 year note auctioned with long tails as we observed in the Bond auction earlier in May.
A long tail in a bond auction with its attendant risk is one thing. If that were to occur in a shorter maturity in would be a sign that investors are in full retreat from longer dated US assets.
Maybe the final climactic event is upon us. Maybe the final bubble to burst is the US Treasury market and maybe we are on the verge of a financial Krakatoa which will realign financial markets.
Whatever the case it feels like the calm before the storm and we are about to embark on another interesting expedition.
as earlier, where some see signs of economic recovery in a steep yield curve, under these exigent circumstances of titanic pace of treasury debt issuance -- well in excess of what can be financed by the combined flows of the capital account surplus, increased household savings and reduced capital investment -- that light at the end of the tunnel may very well be the headlamp of an oncoming train. i'm left to reconsider the potential implications of my earlier observation:
alternatively, they can force the capital markets for corporate bonds and equities to vomit out the requisite funding with an end to the short squeeze and a return of the fear trade. but it seems altogether too reasonable to say that the treasury's funding demands in support of wealth transfers and balance sheet expansion are getting far ahead of the kind of cash flow funding that can be provided by household and corporate deleveraging and saving. the result has been rising rates on the long end that -- with apologies to caroline baum -- may or may not be indicative of a positive yield curve signal.
there's some wondering around the market about ben bernanke and whether we might see a dollop of his quantitative easing elixir here. but one again has to question the wisdom of such a sign of official panic and ask, "what if QE doesn't bring the yields in?" -- a particularly salient quesiton in light of karl denninger's thesis from earlier this year that QE would end with the fed becoming a dump for overpriced treasuries. an announcement of further treasury purchases by the fed into the teeth of this could be seen as one of the highest stakes ever gambled by any american civil servant.
UPDATE: brad setser with more on the inadequacy of foreign demand, particularly post-trade-collapse, to meet this kind of issuance schedule.
Looking at the 12m change actually understates the swing in central bank demand. In the first quarter of 09, the outstanding stock of longer-term Treasuries rose by $278 billion. Central banks – according to the Treasury data – only bought $25 billion of longer-term Treasuries (all in March, and likely mostly short-term notes). China only bought $15 billion (all in March). Over that time period, central banks bought $85 billion in short-term Treasury bills, including $32 billion from China.
Since the first quarter, the scale of long-term issuance has only increased. Central banks aren’t just buying bills anymore, but they still prefer the shorter-maturities.
UPDATE: some more context from john mauldin.
I think the bond market is looking a few years down the road and saying that $1-trillion deficits are simply not capable of being financed. And if the debt is monetized, then inflation is going to become a very serious issue.
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The banks, that’s who. They are the ones with the cash — over $1 trillion on the balance sheet, which is not only a record but more than triple what was considered a normal level in the past. At the same time, even with private sector borrowing on the decline, the commercial banks have not added anything — nada — to their cache of Treasury securities this year. But, it’s one thing to have the curve at 170bps as it was four months ago and the huge 275bps spread the market is offering today. The banks have never before had so much cash to be put to work in the most attractive carry trade in Treasuries in recorded history.
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