The Sound and the Fury of Bond Market Vigilantes

In Hamlet, Shakespeare wrote “Life is but a tale, told by an idiot, full of sound and fury, signifying nothing.” Would that it were so with the recent bond market sell-off. Instead, we see a move away from the flight-to-safety trade but also increasing inflation expectations, un-sustainable debt levels by the US government and severe distortions of the fixed income market by the Fed’s quantitative easing program. The latter has led to large amounts of convexity-related selling. These unwinds of Fed distortions have further to go, so fasten your seat belt.

Recently bond yields have been moving higher in the US. The yield curve has been steepening in dramatic fashion. Implied break-even inflation rates from the TIPS market have been rising steadily. Long-term swap spreads have begun to re-normalize. For example, the 10 year swap spread has moved from 10 bps to around 35 bps. Several reasons exist for the wild moves in fixed income markets. A continuation of these trends could stop any nascent recovery in its tracks. Unfortunately, it doesn’t look like the US government or the Fed or any other governments or central banks are likely to react to these moves in the bond market until after it is too late.

First the good news: Recent economic data releases, both in the US and abroad, support a picture of moderating economic contraction. In other words, the rate at which the real economy has been contracting is slowing even if it’s not yet expanding. In fact, some forward-looking economic releases might even signal the end of recession. Historically, an upward sloping 10 year yield less 3 month bill yield spread has been the best predictor of 1 year forward GDP growth. An unwinding of the flight to safety back into risky assets was inevitably going to lead to higher bond yields.

Now the not so good news: The sell-off got started in recent weeks when bond market investors saw that the Fed would not cap certain key yield levels by accelerating its bond purchases. Had the Fed not engaged in quantitative easing on Treasuries, these yield levels would have been breached earlier in the year. As it was, this move was simply deferred. This shows the lack of control the Fed has over longer-term rates despite its massive quantitative easing program. Only if the Fed were willing to enter into full-scale monetization of debt could yields be pegged.

More not so good news: The force of the sell-off gained pace once the UK was warned about a downgrade to its sovereign credit rating. The secret message (which the rating agencies deny) was that the US would be next. US debt-to-GDP ratios will rise less quickly than the UK’s. Nevertheless, as John Taylor, the noted Stanford University economist, has stated, debt to GDP ratios for the US are set to rise from 40% to 80% under Obama with no reduction of those numbers in sight. Niall Ferguson, the Harvard University economist, has made the point that when debt held by foreigners grows to un-sustainable levels, governments will either default or monetize the debt through inflation. Politicians are just not willing to make the sacrifices in spending or taxation necessary to pay down the debt. The one great exception, of course, would be the first US Treasury Secretary, Alexander Hamilton. Who is willing to wager that Timothy Geithner is prepared to stand up to Obama and demand that the US government end its move toward socialism and come up with a realistic plan to pay down the debt in the out years?

More not so good news: Several prominent economists including Greg Mankiw of Harvard are calling for the US government to run significant inflation in order to reflate the housing market (and devalue the debt). While this has just started, once the magnitude of the pain of paying back the profligacy is established, more voices will call for a similar policy. Perhaps US government bond holders will be excoriated for their failure to agree to “shared sacrifice” as were the Chrysler and GM creditors. In fact, the recent run up in yields has seen longer-dated TIPS break-even inflation rates rise. In other words, nominal yields have risen much faster than real yields at longer maturities. The break-even inflation rate curve is strongly upward sloping indicating that there is little risk of inflation for now but increasing risk in out years.

More not so good news: Chinese and large sovereign holders of US Treasury debt may actually be part of the bond market vigilante posse. There is suspicion that the recent 2 year and 3 year Treasury auctions went well, as these sovereign investors chose to invest in short-term paper, and not longer-term, Treasuries. The image of bond market vigilantes conjures up gun-slinging prop traders hailing from Montana but working on Wall Street. What if they are actually Chinese, Japanese and Middle Eastern sovereigns? The leader of the Japanese opposition has called on the government to no longer purchase dollar-denominated Treasury debt just Yen denominated Samurai bonds. While this may only be campaign talk, it does show the level of concern. During 2004-2006, with the Chinese renminbi significantly undervalued and pegged to the US dollar and the consequently large trade surpluses being run with the US, the Chinese bought large amounts of longer-dated Treasuries. This led to an abnormally flat or inverted yield curve, one normally associated with an impending recession but in this one that instead stoked the housing market bubble.

More not so good news: Large supplies of government debt around the world are weighing on markets as almost all major developed economies look to issue debt. There are only so many buyers of this debt. Most buyers have expressed a strong preference for shorter-term maturities. However, governments can not fund themselves all in short-term debt and need to have long-term debt in order to reduce the rollover risk. In fact, European countries have been relying too much on short-term debt due to difficulties with longer-debt issues. They are expected to shift debt issuance to longer maturities in the second half of the year. This will put further pressure on long-maturity governments. So the fiscal position of the US is compounded by every nation trying to do the same thing simultaneously.

More not so good news: The Fed’s quantitative easing interventions in the mortgage market, through its program to purchase $1.3 trillion worth of mortgage debt, has distorted the market for mortgage-backed securities severely. By artificially lowering yields on this debt, the Fed increased refinance rates and created a shortening of effective durations, implicitly supporting the 5-7 year sector of the US Treasury curve. As yields went higher, the Fed was successful in keeping down mortgage rates. As a result of Fed purchases of mortgages, mortgage-backed pass-throughs’ option-adjusted spreads (OAS) came to -16 bps. Because mortgage yields are more correlated to swap yields than to Treasury rates, mortgage investors often hedge their positions by paying fixed on swaps. With rates pushed artificially low, mortgage duration shortened. Hedgers needed to cut their hedges and started to receive fix. This caused major distortions in the Treasury and swap curves. 30 year swaps spreads went to negative 45 bps while 10 year swaps were at 10 bps over Treasuries even as 5 year swap spreads were at 60 bps. However, mortgage investors woke up to the unsustainability of this situation, and in a few days, mortgage yields jumped close to 50bps. This rise in yields caused OAS to increase to 1bps. The increase in mortgage yields caused effective durations of mortgages to increase significantly. In order to hedge their portfolios, mortgage investors had to pay fixed on long-dated to swaps to match this duration increase. This caused fixed rates on long-dated swaps to blow out, with 10 year swap rates moving from around 10 to 35 bps in just a few days. 30 year swap spreads also widened to just -10bps.

More not so good news: The move to 1bps OAS on mortgages is still artificially low. Look for this to widen out significantly more, leading to more duration-related selling and yet still higher yields (as well as a steeper swap spread curve). The Fed through its purchases of mortgages has caused a massive distortion that is now being unwound. As mortgage duration extends, future mortgage purchases by the Fed will support longer maturity Treasury issues. This has caused the 5 to 7 year sector of the market, in conjunction with large issuance, to trade very cheap relative to 2 year and 3 year paper and relative to 10 years and out.

Comments

[Bruce Krasting:]

I am going to disagree with you on the impact of QE on interest rates.

When the Fed first announced that it would buy $300 bil of coupons the bond market had its biggest day in 15 years. It has been downhill every day since. The shock of the announcement made shorts run that day. But they came back. Look at the results of the buy backs. The Fed bids to buy $15 bil they get offers for 45 bil.

My bet: If the Fed announces that they will expand QE from the current limits set the bond market will fall big time. If they announce they will not expand the program the bond marekt will rally.

QE was an emergency measure from last year. It is old school today. QE is now working against the Fed and Treasury. The scary thing is that I do not think they are aware of this fact yet. They still think they can control the market. Nothing could be farther from the truth.

brucekrasting.blogspot.../

Jun 10 07:39 AM

[MinAkkar20:]

I agree with Bruce. The Fed has lost its credibility with the markets. They have in essence created a slew of contrarians because nobody trusts their ability to reverse the money supply excesses - especially if it is politically inconvenient. Future bond issuances will be like trying to sell ice to someone in Antarctica.

The worst part of all this is that when rates skyrocket, the corporate bond market will not be able to roll over short term liabilities. They will cherish their current 10yr liabilities at 5-7%.

Jun 10 08:03 AM

[MarkitWacha:]

Great article. I completely agree.

All signs point north for TBT. On the days when TBT ticks down, DBC will tick up.

Long: TBT, DBC

Short: Career term of Barney Frank

Jun 10 08:54 AM

[Eye Forget:]

Good article.

"Greg Mankiw of Harvard are calling for the US government to run significant inflation" Assuming I understand the context, a bigger concern is he probably "educates" our brightest.

"More not so good news: Chinese and large sovereign holders of US Treasury debt may actually be part of the bond market vigilante posse." Not sure I agree that this is not good news. Someone has to run this country. The electorate certainly has chosen not to.

Jun 10 09:10 AM

[Leftfield:]

I'm down to hoping the Chinese bond vigilantes actually wake us up or that Geithner becomes Hamilton. Our best and brightest in DC are not apparently aware of "pushing on a string."
I guess the hope of our leaders is just enough inflation to spin a moderating contraction as growth. They've already given us almost 4 decades of decreasing middle class income and sold that as boomtimes.

Jun 10 10:07 AM

[Bull Run:]

More not so great news: I guess that's just a reflection of very bad recession. Interest rates should of been raised several years ago to stem the roaring '90's , but instead Greenspan kept the foot down on the gas. To stem inflation in the roaring '70's Volker raised rate until our noses bled, that produced a big recession but it was quick and the country recovered to grow again. ( Pay the piper and move on). This recession it's different.. No one wants to bite the bullet, so the Fed is doing the opposite and expanding and inflating this economy,(NO recession on my watch). What are the results? No recovery, just another bigger recession coming. Currency fallout, treasury fallout, hyperinflation, and a destroyed middle class..

Jun 10 10:13 AM

[Night_Rider:]

Any one notice that TBT seems to correspond more to the inverse of the 10 yr. bond than the 20+ yr. as the Funds name implies?

Jun 10 10:20 AM

[morph366:]

Just want to echo the comment from Bruce Krasting about the misconception that the Fed and Treasury really have long term control of the direction of long term rates. This illusion, which is vital to preserve if you are a financial technocrat (otherwise you'd be out of a job) is one of the serious disconnects of the current fascination with finance credentials.

Jun 10 10:34 AM

[Mad Hedge F...:]

Much food for thought. First of all, let me warn you that reading this paragraph is a complete waste of time. Still interested? There is chatter about that the Fed is considering raising interest rates at its next meeting. After all, where can they go from zero, but up? The bond market is certainly telling us that rates should go higher, with yields on ten year Treasuries jumping from 2.45% to 3.95% since March. This is the usual kind of gibberish you get from financial journalists, who deep into a summer with no real news, resort to making stuff up out of thin air. US industrial capacity utilization is terrible and still falling, while unemployment is still rising at a record pace. Sure, commodity prices have doubled this year. But this is happening because investors are looking for an alternative to the sick dollar, not because there is huge underlying demand by end users. This is one of the reasons why I have recently become cautious about all of my long positions. So I can say with complete confidence that the chances of an interest rate hike are less than zero for the foreseeable future. This discussion did have the one benefit that it did enable me to fill this space in my newsletter.

Jun 10 10:43 AM

[ain't no fo...:]

“Life is but a tale, told by an idiot, full of sound and fury, signifying nothing.”

Two big auctions coming up today and tomorrow - what will THEY signify?

Meanwhile prices on the long end continue their inexorable march downward, Bernanke's options (if he ever had any) become even more limited, and the ephemeral housing market recovery sits frozen, with bated breath, wondering what all the idiots will do next.

Looks like GS just put the final pump into its overnight futures gap-up trade last night, and now Lloyd has rung the bell.

Jun 10 11:21 AM

[Marli:]

Imprimatur. Great assessnent of the finer dynamics of the yield curve-mortgage rate relationship going forward.

Off topic, by the way, your 'sound and fury' quote is Macbeth, not Hamlet. Common mistake.

Jun 10 01:33 PM

[Toney:]

The piece would have more credibility for me if the author knew the difference between Hamlet and Macbeth.

Jun 10 01:53 PM

[Thomas J. G...:]

So the commenters on this board are now in charge. What do we do to clean it up? Balance the budget? Set the money supply growth to 2%? Become Alexander Hamilton (minus the duel)?

Jun 10 04:12 PM

[Bull Run:]

And to think I thought that was a William Falkner novel..

Jun 10 05:46 PM

[popey:]

This market has stagflation written all over it. High rates, inflation and tepid growth (if any). However, when traders realise that zero growth = constant fed deficits, the dollar will crash and the bond market will implode. The USA is heading for a major catastrophe.

Jun 10 06:06 PM

[Michael_Cohen:]

The government isn't worried about inflation. The clearest result of a weak dollar, higher oil, will be blamed on evil oil companies and an oil tax will be instituted.

They will overestimate the proceeds of this tax, just like they are hopelessly underestimating future budget deficits.

The bond market will call this bluff, rates will continue to rise. Within a year, it'll be the 'monetization/inflation vs. depression' debate due to a 7%+ long bond yield. I'll bet inflation will win out...just replace Bernanke with some Obama stooge they push through with their 60 vote majority.

Jun 10 07:50 PM