Bond Market to Obama: Oh No, You Can't...

While the long end of the US bond market has been selling off for several weeks now, with 10 year yields over 3.9% and approaching twice the levels seen at the peak of the depression / deflation hysteria, late last week 2 year bonds also began to slump dramatically. Yields surged 34 bps on Friday and the market is now implying a Fed rate hike by end 2009, and a series of quarter point moves every couple of months through 2010. This move, if sustained, has major implications across asset markets.

Click to enlarge

It would prove broadly dollar positive and commodity and equity negative. I wrote a couple of weeks ago that the Fed might be forced into a premature rate hike to defend its credibility, and the bond vigilantes are demanding a clear exit strategy from the emergency actions taken last Autumn. Bond markets globally are following suit; even German 10 years are above 3.7% and 2 years above 1.7%.

Is this just bond market 'normalization' after yields were pushed to unsustainable levels by a flight to safety in recent months, or does it represent a more sinister funding crunch?

Globally, we have about $12trn in government bond issuance this year, and the heavy auction schedule, even through the usually quiet Summer season, makes the odds of a major auction failing uncomfortably high. It's notable in this context that only about $22bn of the $787bn Obama stimulus plan has been spent so far, and there must be a growing risk that the plan will have to be scaled back to reassure bond investors.

Given that the multiplier effect of government spending is only marginally positive at best, and the offsetting 'crowding out' impact it creates on private capital, that may be no bad thing. This avalanche of supply, competing with a surge in equity issuance and other private sector capital demand, is clearly one key issue driving higher yields. Another is rising medium-term inflation expectations, as reflected in commodity markets.

It's notable that foreign central banks from China to Brazil have avoided long duration US bonds in recent months, focusing their purchases at the short end. This, I think, clearly reflects a growing inflation risk premium being attached to US assets. Not only have CPI expectations, as reflected in the TIPS market (which I called as a bargain last December when implied inflation was zero) risen to about 2% annualized, but both Germany and China have openly criticized the risks inherent in Fed reflation policy, notably the experiment in quantitative easing to boost money supply.

Given the likely anemic nature of a recovery, it seems a bit early for bondholders to panic about an imminent tightening move, but if this sell-off doesn't stabilize soon (and technically the 10 year looks poised to test 4%), it will certainly act to undermine the euphoria apparent in emerging markets and commodities, and curtail the Obama administration's more ambitious spending plans.

Disclosure: None

Comments

[The Geoffster:]

I'm not sure BHO will listen. His agenda seems much too ambitious to worry about funding costs. He certainly wont hesitate to raise taxes, now would he hesitate to intervene in any private market to accomplish his goals. He's just getting started. The only thing that can stop him is Congress.

Jun 08 08:43 AM

[Prudent Man...:]

To BHO economic growth is not important control is. No one but the power greedy would have this Socialistic agenda had it not been for the economic/financial crisis manufacture by and assisted by the Left in the U.S. Congress who is using this crisis to grab power and have an otherwise week Chief Executive who is more than willing to go along with the mob.

Jun 08 08:50 AM

[MarkitWacha:]

BHO is going to sap $1 trln for the health-care plan soon. That's a travesty, given that they still haven't fixed the root of the problem of rising costs. I spoke with an OB/GYN, and he's paying over $60,000 a year in malpractice insurance. I spoke to an insurance broker, and they see huge pain and suffering jury awards. I spoke to a young radiologist about to graduate, and she has $350,000 in student loans. No, the REAL fix, if the Congress REALLY wanted to fix the healthcare problem, would be to put a cap on the value of human life in the courts. That would lower the malpractice insurance premiums, it would encourage more doctors, thereby increasing supply, and it would reduce volatility. Less volatility to the doctors means less cost passed on to the consumers. This will never happen with a Democratic Congress because the trial lawyers need high jury awards to pay the campaign contributions. The insurance companies like to see the high premiums, because they get a percentage.

We're seeing the effects of a vicious cycle, and either the interest rates will continue to go up, or the rates will stabilize because of QE, and commodity prices will go up.

long: DBC and TBT

I read that put options on TLT would be more efficient and less volatile than long options on TBT, and I'm convinced, so I may do that instead.

Jun 08 09:28 AM

[whidbey:]

In an historical context the bond market may be the critical player; it may help a recovery to take place, and do so much sooner than the Administration foresees. In spite of the Administrate and Congress.

Never trust Congress and watch the President like a hawk, he is not interested a recovery - as his chief of staff said "Never waste a Crisis", they are looking to reshape the US and the World. Nuts I know.

Jun 08 09:30 AM

[The Geoffster:]

Trial (plaintiff) lawyers are one of the largest donor blocs to the Dems. Harry Reid is one! Remember John Edwards?


On Jun 08 09:28 AM MarkitWacha wrote:

> BHO is going to sap $1 trln for the health-care plan soon. That's
> a travesty, given that they still haven't fixed the root of the problem
> of rising costs. I spoke with an OB/GYN, and he's paying over $60,000
> a year in malpractice insurance. I spoke to an insurance broker,
> and they see huge pain and suffering jury awards. I spoke to a young
> radiologist about to graduate, and she has $350,000 in student loans.
> No, the REAL fix, if the Congress REALLY wanted to fix the healthcare
> problem, would be to put a cap on the value of human life in the
> courts. That would lower the malpractice insurance premiums, it
> would encourage more doctors, thereby increasing supply, and it would
> reduce volatility. Less volatility to the doctors means less cost
> passed on to the consumers. This will never happen with a Democratic
> Congress because the trial lawyers need high jury awards to pay the
> campaign contributions. The insurance companies like to see the
> high premiums, because they get a percentage.
>
> We're seeing the effects of a vicious cycle, and either the interest
> rates will continue to go up, or the rates will stabilize because
> of QE, and commodity prices will go up.
>
> long: DBC and TBT
>
> I read that put options on TLT would be more efficient and less volatile
> than long options on TBT, and I'm convinced, so I may do that instead.

Jun 08 09:59 AM

[Henry Buttal:]

It an interesting problem for the administration, and a conundrum for investors. BHO has significant ambitions - but to fulfill those ambitions, which everyone knows, the Administration and taxpayer has to pay an increasingly high rate to fund the efforts, AND it will negtively effect the goals in any case.

Just think of the BHO Administration as a sub-prime borrower spending money while hoping for a decent reset when the lockup expires!

Jun 08 11:03 AM

[inflation:]

Watch how it plays out. They are talking today about how 9 of the 19 banks are going to be able to repay TARP funds. The reason they are doing that is likely because they know when round two of the crisis hits, and the banks have to go back for more money, they can point to the fact that the banks paid back the funds the first time so lets do it again. Except this time it will be bigger and badder.

Jun 08 12:48 PM

[sportsguy:]

since the US outsourced its mfg to china, its only fair that China buy the huge treasury demand to subsidize its customers and its customer's health care program. China should want its customer base to survive, correct? . . .

sportsguy

Jun 08 10:04 PM

[Bundee:]

I realize this must have been posted by another poster, but here goes-

www.reuters.com/articl...

Top China banker calls for U.S. sales of yuan bonds
NEW YORK -- A top Chinese banker on Sunday called on the U.S. government and the World Bank to sell yuan-denominated bonds in Hong Kong and Shanghai to encourage the development of debt markets in those centers and to promote the yuan as a major international currency.

"I think the U.S. government and the World Bank can consider the possibility of issuing renminbi bonds in the Hong Kong market and the Shanghai market," said Guo Shuqing, the chairman of state-controlled China Construction Bank (CCB), the world's second-biggest bank by market value.

....Guo said he is confident that the yuan will become a global currency in the medium-to-long term. He said that China is likely to continue to progressively ease controls on the convertibility of the yuan, with cross-border direct investments one of the next targets.

My take on this-
If China starts selling its own bonds,
and bond buyers worldwide percieve Chinese bonds as a safer bet than US Bonds
(What with China being a creditor nation and its people saving so much of their pay and all)
what do you suppose this will do to demand and interest rates for US Bonds?
Thoughts? Comments?

Jun 08 10:41 PM

[punk_ash:]

Obama does not know economics, George W did not. These are Presidents we are talking about, they can stand on a podium and address 100s of millions of people, and give them false hope.

Do not expect much from Obama and do not blame him either. He can not "not spend", this is what governments do when recessions hit.

Jun 09 02:34 AM

[The Czar:]

I am confused. I am not sure if the following statement is accurate. Can you please reveal the source?

Thanks

"Globally, we have about $12trn in government bond issuance this year"

Jun 09 06:43 PM

[Jason Rines...:]

I believe you are correct good sir, they will come hat in hand after the summer as the losses on CRE begin to accelerate. And this will be important for the too-big-to-fails to squeeze in the fall prior to 2010 and the election focus. All of these actions dumped on the taxpayer over time means the USA is heady for credit downgrade, loss of reserve currency status, eventual hyperinflation but not overnight. The people in our government and banking that committed and still committing the biggest swindle in history and investing it in the East would likely be happy with a civil war in America. Less competition for there Chinese investments.


On Jun 08 12:48 PM inflation wrote:

> Watch how it plays out. They are talking today about how 9 of the
> 19 banks are going to be able to repay TARP funds. The reason they
> are doing that is likely because they know when round two of the
> crisis hits, and the banks have to go back for more money, they can
> point to the fact that the banks paid back the funds the first time
> so lets do it again. Except this time it will be bigger and badder.

Jul 31 04:37 PM

[VennData:]

Well now the 10 year is a 3.5% so you were totally wrong.

Aug 28 08:37 AM