Today I covered my short position in the December contract of 30 year US Treasury bonds futures at $113.89. I initially sold the contract last Thursday for $118.29. This was only a small short term trade to play some lessening of fear after the US and Europe announced they would recapitalize the banking system. Although today’s stock market plunge seems to indicate that the market remains as fearful as last Friday, Treasury bonds have taken the hit that I expected. This may be due to concern about the huge supply of bonds that the US government will have to issue to finance all these bailouts. In any case, for the first time I am sitting almost entirely in cash and awaiting new opportunities. In volatile markets like these, I don’t expect to wait long.
Last Thursday I shorted 30 year US Treasury bonds futures which trade on the Chicago Board of Trade. I sold the December contract for $118.28. This is only a short-term trade based on my belief that the plan for governments around the world to directly recapitalize banks, guarantee interbank lending, and provide a blanket guarantee on all deposits would be enough to prevent a total financial system meltdown and restore confidence in banks.
There are several ways to play this from going long equities to buying Euros. The trade I feel most comfortable with is to bet on rising interest rates on government debt securities which have plummeted due to a flight quality. The 30 year treasury bond looks the most overvalued because the government will have to print a lot of money in the future to pay for all these bailouts. However, other than a short term correction in Treasury bonds I expect its price to remain firm as headline inflation begins to drop dramatically over the next year leading the market to fear deflation. I will probably close out the position at around $112.
The credit markets have come to a standstill as evidenced by the skyrocketing TED spread. This is the difference in rates between three-month LIBOR and three-month T-bills and is a gauge of how fearful banks are to lend to one another.
The reason LIBOR has exploded is that the value of the assets on the balance sheets of banks have been declining leading to widespread worry that they could could be worth less than the value of the liabilities resulting in failure. No bank will lend out funds when it has doubts of being repaid.
This is a very serious problem in our credit dependent economy because it can cause economic activity to come to a virtual standstill. For example, naked capitalism examines how letters of credit are not being honored by banks causing global trade to seize up.
Up to this point government responses have not directly addressed this solvency issue, but have tried to cure the symptoms by lending boatloads of money to provide liquidity. This has been ineffective because banks have been taking these funds and using them to shore up reserves rather than lending them out because they question the survivability of other firms as well as themselves. Thus, the credit markets remain arrested.
The Paulson plan recognized that the capital levels of banks needed to be increased and planned to address this by buying up distressed CDOs and subprime loans for a small fraction of par value. The hope was that this would make the balance sheets of banks more attractive for private sources of capital to invest in. Meanwhile, the government, with its low borrowing costs, would hold the assets to maturity for a profit. But the plan is faulty because it requires a lot of time to implement and the $700 billion allocated to it is insufficient. And there is no guarantee that banks will receive sufficient capital from the private sector.
In the meantime the financial system is melting down which has finally made officials realize that the best way to tackle the problem is to directly inject capital into troubled firms. In addition, they plan to guarantee all interbank lending and provide a blanket guarantee on all bank deposits. This should restore confidence in the banks and credit should start flowing again to where it is needed.
In the long-run these policy decisions could lead to big losses for taxpayers and prevent the economy from correcting its many years of malinvestment in the financial sector. I am opposed to any government interference in markets and would much rather see the entire financial system collapse followed by a return to a true gold standard with no fractional reserve banking. After an initial depression, the economy will grow at its full potential. But no one wants to suffer any near term pain. The result is that the government bailout of banks will lead to a less severe downturn in the economy, but no strong recovery for many years, i.e. we get a softer, but longer depression.
But for the time being the credit markets will begin to function more normally. Businesses and individuals who are low risk borrowers will soon be able to get the funds they need and a complete meltdown in the financial system will be averted. However, we will still have to deal with the fact that banks will restrict loans to only the most creditworthy borrowers and demand for loans will drop off as individuals reduce their debts. Consumer spending is going to disappoint for several years and business investment will be sluggish.
But the panic caused by the turmoil in the credit markets will soon subside and the TED spread should moderate.
The collapse of the subprime mortgage market has caused fixed income investors to demand higher risk premiums from not only all grades of residential mortgage-backed securities, but also commercial mortgage-backed securities, corporate bonds and debt from emerging markets.
Treasury yields, on the other hand, have been declining due to a flight to “quality” creating wider interest rate spreads. However, as the following graph shows, spreads are still low by historical standards:
Source: Bear Stearns
But I am still worried because a record amount of non-government debt is required to create each unit of GDP.
Source: Federal Reserve
Therefore, rising interest rates can induce a monetary contraction that can have a bigger impact on the economy than in the past. This is why the current credit crunch should be closely watched.
Treasuries are on pace for the largest weekly advance in 17 months. The 10-year yield has fallen to 4.6%, the lowest level since March.
I considered buying bonds during the spring as a short-term trade, even though I am bearish in the long-run. My rationale was that the economy was weaker than investors believed and disappointing economic data coupled with the Fed pausing its rate hikes would make bonds attractive. Furthermore, all other assets, including gold, looked overvalued and bonds would be a good place to park some cash until gold corrected.
Since then bonds have significantly rallied as the market realized that the economy is slowing and the Fed is ending its tightening campaign and may even soon cut rates. Gold has also corrected by 19% since its May high. At this point, bonds look a lot more risky to me though I would not be surprised if they continue to rally as the economy enters a recession next year.
My main fear is that foreigners, the largest holders of privately owned government debt, will eventually reduce their holdings causing rates to shoot up. Reading comments like those made recently by a UAE central banker, lead me to believe that its only a matter of time before rates start to increase again.
This is the first in a series of posts, titled ‘The Coming Bear’, that will analyse where the economy is headed. The final post in this series will look at some investment ideas that should do well if the future plays out the way I see it.
Here is a list of the posts in this series:
The first step I usually take when forecasting the level of an indicator or the price of something is to look at a long term chart and try to explain the movements. So lets look at the chart of the 10-year Treasury bond yield which has historically been considered the benchmark for long-term interest rates.
The 10-year has been in a downtrend for the past 25 years declining from over 15% in 1981 to its present level of 5%. What could be factors that affect the rates of the long-bond? While the Fed controls short-term rates, long-term rates are set by demand from investors and supply from the government. Government supply has been steadily increasing during this period due to a growing federal debt that needs to be financed. Since 2000, the rate of growth in the debt has increased due to tax cuts, the war in Iraq, defense against terrorism, and higher government spending on social programs. Debt currently amounts to $8.5 trillion.
Investor demand for bonds is affected mostly by expectations of price inflation and foreign appetite for US securities. Inflation expectations have been declining as people have watched the Consumer Price Index (CPI) fall.
I am no fan of the CPI since it is constructed to understate inflation, but most people still believe the numbers and form expectations based on it. With inflation seemingly well below the levels of the early ’80s, demand for bonds from investors should be much greater today.
The other source of demand for bonds arises from foreign purchases. As the following chart illustrates, this demand has exploded in recent years.
Approximately $5 trillion of the $8.5 trillion in current federal debt is owned by private investors — the rest owned by federal government trust funds and the Federal Reserve. What the above chart means is that foreigners now hold about 50% of the privately owned government debt. In fact, since 2001 foreigners have accounted for the entire increase in privately owned debt and then some.This means that foreigners have been the main players for soaking up additional bond issuance and causing rates to decrease. In particular, China and Japan hold about $1 trillion or 20% the outstanding federal debt. Their intention was to boost exports by keeping their currencies undervalued to the US dollar and using the dollars received through trade to invest in US Treasuries rather than convert it back into their own currencies.
Future Direction of Rates
Now that we have looked at the supply-demand factors that led to decreasing rates over the past two decades, let us analyse what the future holds. The war in Iraq and the threat of terrorism are unlikely to end anytime soon so defense spending is likely to remain elevated. Past tax cuts are unlikely to be reversed and social spending — given the economy’s current weak footing — will continue to increase. Therefore, it is safe to assume that the federal debt will grow at 5% or more over the next 2-3 years.
On the demand side, China and Japan — who have been the biggest buyers recently — will likely decrease the rate of treasury accumulation going forward. Japan has already reduced its US dollar holdings over the past year as it seeks to rebalance its foreign exchange reserves and align the currency mix with that of its trade settlement account, taking into account the increasing importance of the euro. China, too, will do the same for risk management purposes.
Furthermore, Japan — fearing that its growing economy could bring on inflation — has begun raising interest rates which will reduce the amount of funds devoted to the carry-trade. The carry-trade takes place when overseas investors borrow funds in Japan at minuscule rates and buy higher-yielding assets overseas, particularly US Treasuries. No one knows how big of a trade this is, but as it unwinds it will have some negative effect on Treasury demand.
Chinese demand for Treasuries should also fall since they will eventually be forced to take further steps to revalue their currency to appease growing anti-Chinese sentiment in Congress and to slow down their red-hot economy which is growing at over 11%. This will allow China to slow down its rate of Treasury purchases and sell more dollars. And Japan will follow suit since the yen tracks the renminbi for trade-competitiveness reasons. Since China and Japan have been major buyers of Treasuries over the past few years, all that is needed is a small decrease in their rate of buying for yields to shoot up.
How much of an effect will this have on Treasuries? Brad Setser and Nouriel Roubini of Roubini Global Economics estimate that Treasury yields would have risen an additional two percent if it was not for central bank buying.
Now let us look at how future inflation expectations will affect Treasury demand. Price inflation is currently on the uptick growing at 4.8% annually compared to 3.4% for 2005, according to the CPI. But as I said before the CPI has a bias to understate actual inflation which is much higher — just look at the prices increases over the past 12 months of gold, oil and copper which are up 30%, 10% and 49% respectively. M3, a better indicator of inflation, rose at an 8% annual rate in February before data collection was discontinued.
Inflation expectations should increase once foreigners reduce their Treasury purchases and the US dollar depreciates. This will cause the price of commodities and imported goods to increase. Also, as foreigners sell more of their dollars, that money will enter the US economy to be spent rather than be held in the form of Treasuries — this is inflationary.
However, price inflation should be dampened by the recent rise in interest rates — from under 4% in 2003 to 5% now — and its effect on decreasing consumer spending in highly indebted economy. Overall, I expect inflation to stay elevated above the Fed’s “comfort zone” during 2007 and 2008. I don’t think we will see major inflation like the ’70s, but it will be high enough to keep bond investors on the edge of their seats.
My outlook on interest rates is that the supply of Treasuries will continue to increase at the same rate, foreign demand will begin to wane, and inflation will stay around current levels. Therefore, I expect Treasury rates to head higher. For example, I would not be surprised to see the 10-year yield over 6% some time during the next two years. However, over the short-term, rates could fall as it becomes clear that the economy will enter a recession and bond investors believe that inflation will drop.