Thursday, June 14, 2007

Interest Rates

After hitting a new 12-month high, long rates eased off yesterday and equity markets immediately breathed a sigh of relief. But the question still remains: why are long rates going up all of a sudden?
  • Negative carry: bond dealer inventory is typically financed with short-term repos. With the yield curve inverted, carry was negative, i.e. it cost more to finance the bonds on the trading books than they paid in interest. Until recently the negative carry was more than made up from capital gains, since credit spreads kept narrowing. But this has now come to an end (see the ABX, CMBC, CDX indexes), so holding positions becomes unprofitable. As they say on the trading desks: "the spread will eat you alive".
  • There is huge borrowing demand from M&A activity. In the first four months of 2007 there have been more such deals announced (in dollar terms) than in all of 2006.
  • Adjustable mortgages are being reset in record amounts (see June 9 post for chart), also creating demand for longer-term money.
  • There are reports of slowing foreign demand for US bonds. Since the main recycler of US consumer debt is China, the current economic slowdown in the US could mean there are less exports, less dollars to recycle and thus fewer bond purchases.
The 10-year yield chart below is about a month old (now at 5.22%), but it is useful for a long-term perspective, particularly when we consider that such historically low rates are happening at a time when total debt/GDP is breaking all-time record highs.


Note: I will not be posting for a few days due to phone line technical reasons. See you soon.

4 comments:

Alex Zeissig said...

hellasious,

I think the movement of the 10 year treasury rate since 2003 is revealing when looked at in the context of the overall long term downward trend. Unlike past upswings since 1980, since 2003 the 10 year rates upward movement has been a long, protracted trudge.

Nor is this phenomena limited to the US. It is being experienced across the developed world. Japan reached the end game a long time ago. It looks to me as if 10 year rates in the US are preparing to break down completely in a final deflationary collapse.

As evidenced by the historically low spreads across a wide swathe of risky assets, one can only conclude there is simply too much capital chasing an ever diminishing supply of profit making opportunities.

Any thoughts?

kicker said...

As evidenced by the historically low spreads across a wide swathe of risky assets, one can only conclude there is simply too much capital chasing an ever diminishing supply of profit making opportunities.

The Federal Reserve has created the problem by attempting to take volatility out of the market. Heaven forbid the Federal Reserve ever raise rates more than a quarter point without "telegraphing" it to the markets months a head of time.

It's created the perfect scenario for all sorts of leveraged bets. Sub-prime, emerging market, leveraged buy-outs, carry trades, etc.

Eventually, all that debt chasing too few returns is going to squeeze all the profits out of the system. The world doesn't have a production capacity shortage, the world has an income shortage.

Asian central banks are the main culprits. By competitively devaluing their currencies they steal consumption for additional production capacity.

Too much production capacity, high debt levels, and stagnating incomes are a recipe for a deflationary recession.

Hellasious said...

Nothing scares the Fed (and now BOJ) more than a deflationary spiral. Call it the Great Depression bogeyman...and this is why Greenspan got so incredibly aggressive with cutting rates in 2001-04.

So now we have a runaway debt/asset train, but no one is yet truly serious about pulling the brake cord and causing...a deflationary spiral. For the amount of debt created in the past 5 years rates are still incredibly low across the world.

This time no one wants the responsibility for taking the punchbowl away, so the market will eventually sort it out for itself. And the robber-baron market we have right now does not give a farthing who gets hurt.

It's jungle economics once again.

kicker said...

This time no one wants the responsibility for taking the punchbowl away, so the market will eventually sort it out for itself. And the robber-baron market we have right now does not give a farthing who gets hurt.

Right now, the Yen carry trade looks like a one-way bet. Unless the BOJ shows some backbone it's possible we'll see a currency crisis hit Japan and not the US.

It's possible that public debt is so high in Japan that the BOJ can't normalize interest rates without risking the collapse of the government.

That would be interesting. The Asian financial crisis act II.

I wonder what a currency crisis for a country with a huge trade surplus and a trillion dollars of USD reserves would be like?

Would the Japanese government be willing to confiscate the wealth of the world's biggest savers instead of raising taxes and lowering spending? Would the population of Japan be willing to stomach high inflation rates if it meant a soaring asset prices and strong job growth?

Of course, I'm pondering this more since I went long yen a couple of weeks ago. :) I figured that 3.3% growth in Japan and .6% growth in the US would impact the Yen. Silly me.