Dollar's Stunning Drop, Ten-Year Treasuries' Huge Rally - What's Going on?

Something is afoot. The ramifications of this "something" portend to be significant, although what they will be, indeed, what this "something" actually IS, remains unclear.

In previous articles, I have suggested that there is a bubble of sorts in "bearish trades." I have cited spreads in the credit default market that appear elevated beyond fundamentals, and historic put/call spreads. I have cited abnormal volatility as measured by the VIX. As postulated, credit default spreads narrowed somewhat last week. Options spreads have declined, the TED spread is dropping, and as anticipated, the VIX has fallen off a cliff. Meanwhile, mortgage rates have plunged to some of the lowest levels in history, and LIBOR has dropped to its lowest level since June 2004. Taken as a whole, each of the foregoing developments would seem to suggest that the pile of liquidity that various central banks have doused the capital markets with has begun to flow towards borrowers and other end users, and that risk aversion has abated somewhat. This is not surprising because when money is cheap, using it to buy risky stuff is more palatable. This may perhaps explain why the price of equities has bounced up a little wee bit.

It is unclear whether this rosy assessment is illusory, because below the surface, something else, something that is potentially much, much bigger started to happen in the middle of November – quite a bit before the Federal Reserve slashed interest rates to about zero. The value of the dollar, as measured against a basket of other currencies, dropped by nearly 11% in just a month. That's… well…. stunning. But about what you'd expect given the low yield on US assets.

But here's where it gets weird. Over the same time frame, the price of ten year United States Treasuries rallied nearly 100%. And….uhhh……. that's a lot. A really, really, really, unusual kind of "a lot." When investors feast on Treasuries, that are denominated in dollars, demand for dollars is typically rather strong, for which reason the price of the dollar generally goes up relative to other currencies. Not this time around. Why?

And another important statistical correlation seems to have been tossed out the window over the last month. The price of a U.S. Treasury almost precisely reflects the level of revulsion investors feel towards risk. Over the exact time frame during which U.S. Treasuries have staged an unheard of 100% rally, the VIX has collapsed, suggesting, among other things, lower expected volatility and risk aversion ahead. Simultaneously, most major equities indexes have bounced off their lows of the year and settled in nicely at their 50 day moving averages – again, suggesting somewhat less than chronic risk aversion prevails in the market place today. The VIX, as well as the equities markets, are basically saying risk appetite is increasing, while the marketplace for U.S. Treasuries is suggesting a killer asteroid is approaching the Earth. One or more of these markets is a lying liar. Which?

A simple explanation may just be that a gargantuan pile of wealth appears to come to roost in the market for Treasuries. In doing so, interest rates have dropped, which has given some lenders (including the Federal Reserve and, now, the U.S. Treasury itself) the flexibility to put higher risk loans and other assets onto the books, or to originate new lending. Again, it's easier to take risks with cheap money, of which ample piles are sloshing around the system. And when the demand for risk goes up, the VIX drops, and the price for placing "bearish trades" comes down significantly which, it appears, has started to happen. And people start to nibble at equities, too.

The price of the dollar, however, remains a wild card. Having fallen off an 11% cliff, the buck is positioned almost precisely at its long term, 200 day moving average. It would be surprising not to see a bit a bounce in the value of the dollar from here – rarely do assets drop straight down. Whether this bounce will prove fleeting or not, I cannot speculate.

And what it all means is shrouded in mystery. Mysteries, these days, tend to involve bodies in the closet more than gifts under the tree. Mystery, in 2008, is not, shall we say, a good thing. Particularly the ones that offer zero percent financing that seems just too good to be true.

Disclosure: none.

Comments

[Lars39:]

Investors are piling into zero return short term treasuries possibly because of uncertainty about where to put thier money. Could it be because of the SEC's apparent failure to do its job? Could it be that investors wonder how many more Bernie Madoffs are operating ponzi schemes? Maybe it is lack of confidence and lack of clarity in the investment scene, but why else would so many investors run to the sidelines and hold short term paper that pays nothing in return except a little security?

2008 Dec 21 11:58 AM

[Crocodilian:]

There have been many market movements that have made me scratch my head and say "what's going on here?" Mostly, they appear to be symptoms of a market mechanism that has been damaged. One can point to many strangenesses similar to what you cite-- oil in contango and gold in backwardation come to mind.

To assume that they're symptomatic of "something" assumes that the market is roughly "continuous" offering up a price at 3 PM that's logically related to the price it offered at 2 PM

That assumption no longer applies. The pool of funds that was making the market at 2 PM may have been withdrawn, the smart young fellow who sat at a trader's desk at 2 PM may, at 3 PM, be walking out of the building with his stuff in a banker's box. Consequently, the market at 3 PM ain't the same market it was at 2 PM.

As components of the market making infrastructure fail, one side or the other of many trades are simply abandoned. This creates opportunity, but shouldn't be analyzed in a pre-2008 rubric . . . assuming that weird prices are the result of action of market participants, rather than extinction of market participants, is probably a mistake.

2008 Dec 21 12:11 PM

[jepittman:]

I believe one need look no further than the extraordinary policy of today's Federal Reserve for the answers to these seeming anomilies. I think the spectre of the Fed's threat of 'quantitative easing' is primarily responsible for the recent upward price volitility in US treasury securities. There already existed a powerful 'flight to quality' trade occuring in those markets but when you add the not-so-subtle suggestion that the Federal Reserve was also considering entering the markets on the buy side who can be bearish? I think this explains the yield collapse in the treasury markets.

The fall in the value of the dollar is in my view equally due to the recent Fed action. The drop in the fed funds rate to nearly zero has made short term deposits in US denominated accounts highly unattractive to deposit accounts in, say, euros. This created a rush out of dollars to the higher yielding euro, thus causing the dollar/euro exchange rate to fall. A similar reaction occured simultaneously in other currencies with higher short term interest rates.

A decline in the US dollar relative to other currencies is exactly the policy response needed to combat deflationary forces in a recessionary economy. Economic stimulation in required.

A lower dollar makes US exports more competitive versus similar competing products from other countries. This is stimulative.

A lower dollar (remember this is one of the world's primary reserve currencies) aids other countries in their efforts to reduce their interest rates because of its reduced competitive attractivness. This is stimulative.

Higher treasury bond prices (and thus lower yields) raises prices on other bonds such as mortgage backed bonds. This reduces mortgage rates. This is stimulative.

Lower yields on all high quality bonds and notes reduces the attractiveness of these investments to banks. If banks cannot earn a rate in these securities higher than their cost of funds then they must lend to qualified borrowers in order to be profitable. And bank lending is the ultimate stimulus to an economy due to the multiplier effect. Due to the recent Fed actions banks are again flush with excess reserves. There is now an ever growing motivation for banks to make loans because the Fed has taken away all of their alternative investment choices.

There will be an economic recovery when confidence in holding risk assets returns to normal levels. One other thing: History shows that within three months of an economy emerging from recession, the stock market is nearly always advancing strongly.

2008 Dec 21 02:18 PM

[Gregory Orr:]

God, I miss Crazy Eddie. Yeah, the long bond at this price is insane. A taxable investment, tied to nothing but the treasury's ability to raise tax dollars from its loyal subjects, in a recession at best, having flushed the last of its ammo shooting cardboard Citi and AIG cutouts off the fence, when, by my calculations, the only way out for the US economy is massive infrastructure spending. Can anyone say, "Two Trillion Dollar Deficit"? The treasury can print all the money it wants, but still somebody has to show up at the auction and buy the bonds. China? Japan? OPEC, with $33 bbl oil? What about federal debt service as a % of GDP? What will happen if the only takers at next year's 200 days of treasury auctions decide that, relative to the yen or the euro, they won't take anything less than a 10% yield?


On Dec 21 02:01 PM Simmons wrote:

> Jim Rogers says that the Treasuries will be the last bubble to deflate.
>
>
> Let`s see.
>
> jimrogers-investments....

2008 Dec 21 02:56 PM

[Kunst:]

Gregory Orr: "The treasury can print all the money it wants, but still somebody has to show up at the auction and buy the bonds. ... What will happen if the only takers at next year's 200 days of treasury auctions decide that, relative to the yen or the euro, they won't take anything less than a 10% yield?"

That's what I thought until recently. But if the Fed buys those new treasuries with newly-created money, there is no oversupply of bonds to push prices down and rates up. In fact, if the Fed buys existing bonds as they mature and roll over, the amount of externally held debt could actually decrease. At the extreme, the Fed could simply buy back all of the existing national debt from whoever wants to sell it.

This would flood the world with dollars but not US debt, which would be held by the Fed. I guess we could pay interest to the Fed, but that's kind of a wash.

Yes, this is inflationary and lower the value of the dollar. What is the rest of the world going to do about it? They can't make us pay in gold or a currency we don't control. There still is no good substitute for the US dollar.

2008 Dec 21 03:41 PM

[nmelendez:]

Riiiiiiiiiight. So where are you gonna trade? Oh yea, another Bush isolationist. The dollar would not be accepted ever again by any government as a currency.
We could have printed ourselves outta debt long time ago, but that ain't the problem, it's deflation. Too much debt, to little credit left. As far as the fed buying US bonds, thats a given. Watch as the dollar goes down and the yen goes to a 2 on 1 against the dollar.


On Dec 21 03:41 PM Kunst wrote:

> Gregory Orr: "The treasury can print all the money it wants, but
> still somebody has to show up at the auction and buy the bonds. ...
> What will happen if the only takers at next year's 200 days of treasury
> auctions decide that, relative to the yen or the euro, they won't
> take anything less than a 10% yield?"
>
> That's what I thought until recently. But if the Fed buys those
> new treasuries with newly-created money, there is no oversupply of
> bonds to push prices down and rates up. In fact, if the Fed buys
> existing bonds as they mature and roll over, the amount of externally
> held debt could actually decrease. At the extreme, the Fed could
> simply buy back all of the existing national debt from whoever wants
> to sell it.
>
> This would flood the world with dollars but not US debt, which would
> be held by the Fed. I guess we could pay interest to the Fed, but
> that's kind of a wash.
>
> Yes, this is inflationary and lower the value of the dollar. What
> is the rest of the world going to do about it? They can't make us
> pay in gold or a currency we don't control. There still is no good
> substitute for the US dollar.

2008 Dec 21 04:25 PM

[John Lounsbury:]

Excellent article and good comments. I'll pick a few nuggets (dots) and try to connect them.

1. Quantative easing, or the expectation of same (mentioned by jepittman), gives strong support to treasuries.

2. Banks are being pressured to lend more as treasuries rise because these assets do not pay enough interest under these current conditions to keep the banks cash flow positive (mentioned by jepittman). However, banks may still be more concerned with solvency than profitabliity at this point and keep on buying treasuries until their future exposure to toxic debt is better understood.

3. The major problem may still be risk of deflation (mentioned by cruiser 9806), at least for a while. The big question is: How long?

4. The reservoir of dollars that can be released, when when those held in reserves are deemed to be excessive for remaining bad debt exposure, may flood the system, pushing the dollar down and causing treasuries to be dumped at much lower prices before the dollar drops further. This would be the time of sky-rocketing interest rates and hyper-inflation. (See Kunst and Gregory Orr)

4. Stocks may have gone up for the past month, and may be at the 50-day moving average (mentioned by Alex Trias), but charts are showing an acsending triangle pattern usually seen before break-outs. The question is: Up or down? I am an amatuer viewer of candlesticks and see none of the customary bull or bear signals. The only significant pattern I see is a divergence for the S&P 500 rising for the last 3 weeks while volume is falling, a bearish indicator. However, I have long since learned not too depend on individual timing signals. We'll wait and see.

The author has undertaken an ambitious task in addressing the anomalies of the current markets, especially treasuries and the dollar. I think he has done an excellent job of putting issues and questions on the table. It's too bad that none of us has better answers, but the commenters may be doing better than most with these questions.

One last thought, I read somewhere last week (sorry I can't remember the reference) that the sudden drop in the dollar was no more than a 50%-60% corrective pull-back after the rise of the past few months. I'm not ready to buy that, but somebody has to right and maybe its not me in this case.

5.

2008 Dec 22 12:01 AM

[NOWHEREMAN:]

The USD's movement is a precursor of how rapidly it will dissolve when the "Worm Turns" or put another way, when the Treasury Bubble bursts. IMO

2008 Dec 22 09:44 AM

[carey_jim:]

One thing you might be ignoring is a very large elephant in the room which is world politics.

America is an empire, just as Britain, Austria and France were empires before World War I and Russia was an empire before 1989.

All eyes are on the American "economy" now because if we falter, it might be the beginning of something big.

Some people think the Russian collapse was precipitated by their war in Afghanistan.

It could be that the world is holding its breath.

2008 Dec 22 01:33 PM

[secmaven:]

Somebody was buying Treasuries big time as the dollar was dropping. Now who would have had the self interest to do such a ridiculous trade? Look no further than our own Federal Reserve Bank, the master of market intervention.

2008 Dec 22 01:40 PM