I have changed the color scheme of the blog - it is less dramatic but hopefully it improves "readability".
Yesterday's drop in equity markets is being blamed on the bond market, which supposedly sank because the economy is "improving". I don't know about the "economy improving" part, but historically the most potent poison for financial markets was higher interest rates - and more so in this Debt Bubble Era.
10-Year Treasury RatesTen year Treasury rates are at 5.10%, very near a 5-year high. I think we can safely say that mortgage refinancing for all real estate purchased and financed during the Real Estate Bubble period of 2002-2005 is now near impossible: The yield curve is flat as a pankace and painful all over. This removes the last refuge of the highly-indebted consumer, who now faces rising interest rates to go with already high fuel and food prices.
April and May retail sales were weak to begin with; given the above I think June - traditionally retailers' second most important month after December - is going to be soft, too.
But if the economy is soft why are long interest rates rising? I don't for a second buy the "stronger global economy" argument - I think what is happening is more technical and with broader consequences for markets. The Debt Bubble of the past 5 years has created trillions in new non-government debt, particularly in longer maturities. US mortgage debt owed by households alone increased by $4.4 trillion during 2002-06, all under extremely low interest rates. Most of it became securitized as CMO/CDO's and further derivativized through CDS's. This process has created a huge new mass of bonds, all vulnerable to losses as long interest rates rise; hedging them against interest rate risk is most commonly accomplished through selling short the 10-year Treasury (cash and/or futures).
What may be going on is a rush to hedge this huge pool of relatively newly-issued mortgage-backed bonds, thus creating its own vicious cycle of persistent selling. Nothing to do with the economy...
I like the colors - but the font is a bit hard to read.
ReplyDeleteAnyway - could the increase in Treasury rates be due to less foreign demand, as they get sick of financing our profligacy?
I was wondering the same thing. Foreigners are becoming sick of financing our spending spree and are looking for returns GREATER than inflation. The influx of cheap money dries up and rates increase. What ya think?
ReplyDeleteBut the US Dollar is mostly rising. Not what I'd expect in a run on the dollar.
ReplyDeleteA small blurb on mortgage-related selling
Maybe margin calls on the CDO/CMBS market?
We invest in CMBS and CDO bonds, which were purchased at prices that are based
in part on comparable Treasury rates. The fair value of these bonds may change
as interest rates change over time. We have entered into transactions with
financial institutions to hedge against movement in Treasury rates on certain of
the higher rated CMBS and CDO bonds. These transactions, referred to as short
sales, involve receiving the proceeds from the short sales of borrowed Treasury
securities, with the obligations to replenish the borrowed Treasury securities
at a later date based on the then current market price, whatever that price may
be. Risks in these contracts arise from movements in the value of the borrowed
Treasury securities due to changes in interest rates and from the possible
inability of counterparties to meet the terms of their contracts.
I suspect the recent rise in long term treasury yields is attributable to an orchestrated effort on the part of the world's central bankers to tighten liquidity in order to avoid further bubbles in global equity markets. Of late, there have been a number of statements by central bank officials concerning the mispricing of risk and the potential for systemic crisis arising from the failure of banks to adequately monitor hedge fund counterparty risk.
ReplyDeleteWhile the federal reserve normally limits its action to the front end of the yield curve, I believe there has also been an on-going coordinated effort between the federal reserve and other central banks, including the BoJ and likely the PBoC as well, to influence long rates and perhaps prevent the dollar from devaluing further as well. I would offer the massive quantitative easing of the BOJ in 2003 after Bernanke's visit as exhibit 1 evidencing this reality. I would be curious to know the mechanics of the current open market operations used to implement the current monetary policy objectives.
My own gut feeling is that a decision has been made to see how far the central banks can let long rates rise before something breaks. The current situation looks very similar to the breakdown in global equity markets in june/july last year as 10 year treasury rates hit 5.25%.
It will be interesting to see what if anything happens to yield spreads over the next few weeks.
Great Blog!
ReplyDeleteAs for foreigners getting sick of financing our profligacy, think about that for a second and you will realize this is not the answer.
The BOJ does not really care what its returns on dollar assets are.
Lets say a Japanese mfg sells some hi-tech widgets into the US. The have their dollar profits, but they can't use them in Japan. So they go to the BOJ and exchange the dollars for Yen.
Where does the BOJ get then Yen? It creates them out of thin air. The BOJ now has a wad of dollars...and they go 'invest' them in dollar assets....but they ARE NOT INVESTORS per se. Why would the BOJ care about its returns? It is almost as if the BOJ created US Treasury bonds out of thin air. If they decline in value...so what?
This can continue so long as inflation does not take hold in Japan. I looked like that might be happening...but low and behold deflation is coming back over there, enabling Japan so suck up even more dollars by creating even more Yen.
As such, I think this game (and subsequent baseline support levels for US debt) only ends when the US enters a recession and stops exporting dollars. In other words, FCBs are not going to pull the rug out from under us. Rather, they will give us enough rope to hang ourselves.