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.