Treasury Selloff: We May Be Approaching Bailout Limits

Yesterday’s market crash was triggered by the U.S. and European financial sectors reporting tumbles in earnings and asking for billions more in aid from governments. The need for capital infusions is still so overwhelming — despite the hundreds of billions already poured in — that it appears there will be no stabilizing the crisis until more radical solutions are adopted.

These include nationalizing the sickest banks (e.g. Royal Bank of Scotland in UK), setting up “an aggregator bank” to swallow toxic assets, and injecting government money into the banks through huge equity stakes. The measures seem to imply substantial dilution of existing equity holders. So the latter shoveled out positions onto the market yesterday, dragging the S&P Financials index down by over 16% and the S&P 500 over 5%. Investors in many institutions were worried, to put it another way, that the U.S. will follow the example of the UK and introduce a rescue package that wipes them out. That’s not quite the source for the sell-off expected, but it will do.

Interestingly, though, the S&P 500 is still up about 7 per cent since the November 20 low while the financials are down more than 13% since. The market seems to be betting the more radical policies on the way will draw a line under the debacle. Bank investors may suffer but investors outside the sector could be okay since their companies should be better assured of having access to credit. In Canada (as an aside), I still remain a little worried about the chartered banks being able to avoid further drops in share prices, with the world around them in flames (it shouldn’t be a decline anywhere as bad as elsewhere, though).

A dissonant note was the sell-off in U.S. government bonds. The flight to safety lost out to concerns that the requirement for greater government assistance will finally result in too many bonds being issued. That development is a little disconcerting because it hints the capacity of the U.S. and Europe to bail out its banks is near its limit.

When added to existing debt and commitments, the debt burden will be so huge that it could mean it’s not possible to finance it in a non-inflationary way. This may not be entirely evident in the near term with deflationary forces still strong, but if the world economy is to keep climbing out the hole without unnerving interruptions, central banks may feel compelled down the road to allow more inflation than what their targets allow. We shall see; a clearer picture will emerge in months ahead. Anyway, shorting government bonds still seems to be one way to ride out the crisis.

Comments

[Socialism c...:]

Stagflation, here we come!!!

Jan 22 06:55 PM

[Truefire:]

Ding, ding, ding, ding, ding!!!! Thats exactly whats going to happen. These psycho central bankers want inflation & thats how they are going to get it.

There will be little to no new treasuries purchased and most if not all of this bailout money will be printed. The monetization will be in long term treasuries (warping the yield curve to ridiculously low yields) causing a mass exodus out of treasuries (which also will be monetized by the Fed) as nobody else would buy these devaluing IOU's.

Wahlah!!! Inflation errrrr. Hyperinflation, uh oh!!!

Jan 22 08:25 PM

[MarvinMBA:]

Yes, we are going into a higher rate of interest environment even as the country swoons. Looking for 6 to 10 percent as lending risk due to the coming inflationary pressures start to increase. MarvinMBA

Jan 22 08:25 PM

[Alex Filonov:]

'finance it in a non-inflationary way'

Why? We are in deflation. Inflation is exactly what we need!

Jan 22 08:27 PM

[Mr. Cynical:]

Watch out for the second tranch of bailout...bonds surged after the first half of TARP because that's what the banks bought with their bailout dough!

Jan 22 10:02 PM

[Moon Kil Woong:]

So far the inflows of cash from the Treasury, government, and Fed have not offset the decreases caused by de-leveraging. A $850 billion stimulus on top of that may help draw government stimulus closer to de-leveraging in the short term but it's still far from any semblance of stagflation at this point. The real risk is the fact that government always fails to full the cash spigot when the economy eventually turns around.

Systemic deficit spending and constant stimulus in good times and bad is the real value destroyer. The author is right to point out that if the amount of deficit spending continues at the inflection point upwards we will run into terrible inflation. But inflation during the downturn is not happening.

As for TARP, the money so far is only plugging the loss hole in banks balance sheets and does 0 for the real economy. The cash is just offsetting losses which keep banks paying existing bills and obligations. Anyone saying this is economic stimulus is fooling themselves. It's a only a bank bailout.

Jan 22 10:11 PM

[Tradememe:]

We need to stop worrying about bank investors. They know they have been wiped out. And to those who invest in the banking sector right now, well it's their right to gamble, but they should stop clamoring for bailouts.

Jan 22 11:23 PM

[2bz:]

On Jan 22 10:11 PM constructe wrote:
> It's
> a only a bank bailout.

And a poor one at that. Rather than propping up rotten banks the govm't "should" fund new banks with squeaky clean balance sheets. It doesn't matte that much that the same people would run the new banks as the old banks, at least the balance sheets would be clean. Propping up (a better description of what's happening than "bailing out") is a near bottomless pit. The bank's creditors may get their money from the govm't, but that's where the buck stops. Yes, the govm't may make some money on the bad paper, but I'm not betting on it. I think all of it will go to the creditors.

Jan 22 11:39 PM

[SoYouThinkY...:]

Take a look at the 1 year chart for TLT(20+yr treasury ETF): finance.google.com/fin...

Right now it is at 108. I posted back on the 11th that I think it falls into the 80s: soyouthinkyoucaninvest...

Shorting is one thing, but at the least get the heck out of long term treasuries. High risk with little upside.

Jan 22 11:50 PM

[kelm:]

I agree we may be approaching limits. there are a number of posts today on the Fed's apparent inability to drive mortgage rates any lower. That seems to speak to a limit being found. The enormous volume of sovereign debt that is headed towards the market this year will almost assuredl drive inerest rates much higher across the board.

Jan 23 10:47 AM