The Credit Markets: 2 Apparent Contradictions

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by: John M. Mason

The yield on the 10-year U.S. Treasury bond closed at 2.301 percent on Friday. The dramatic rise in this yield at the end of last week has many analysts worried that the bull market in bonds is over.

The yield on the 10-year Treasury was 2.384 percent at the close on last October 27 and at the end of July 2011, the yield was around 3.00 percent, where it had been for some time.
Note that a large portion of the time that the yield on the 10-year Treasury had been at these higher levels, the Federal Reserve had been operating under a policy of quantitative easing.
What set off the decline in yields in August and September was a series of things that lead to a rush into gold and a flight to quality in the financial markets.
The price of gold had remained relatively stable in the May and June period, but began steadily increasing in July and August. By August 2, the price of gold reached $1660 per ounce and then flew through $1700 on October 8, the day of the S&P downgrade of U.S. debt. By August 18, the price closed at $1828 and almost closed at $1900 on August 22.
Even more startling, the yield on the 10-year TIPS turned negative in early August. On August 10, this yield was -0.155 percent! In late July it had been trading to yield above 0.500 percent.
The 10-year Treasury yield plummeted from about 3.00 percent on July 29 to 2.40 percent on August 4 and about 2.00 percent on August 10.
The stock market was also highly volatile during this July/August period.
And, Treasury yields remained low through the whole Greek debt restructuring that took place throughout the fall into the new year of 2012.
My view: over the past month or so, financial markets have calmed somewhat, primarily due to the Greek situation, and this has been leading to a movement of funds out of U.S. Treasury issues and into riskier “stuff”.
Then we got the news last week from Mr. Bernanke that the Fed was not going to do much in the way of bond purchases in the near future and, in particular, there was no inclination on the part of the Open Market Committee to engage in a new phase of Quantitative Easing.
These two factors, I believe, are leading to a reversal from the previous “flight to quality” in the financial markets.
Since January the ratio of the yields on government bonds relative to Aaa-rated corporate securities has been rising, indicating funds were flowing more freely into other sectors of the financial markets. Furthermore, the ratio of yields on Aaa-rated corporate securities to Baa-rated corporate securities was rising indicating a relative move to less highly rated credit.
Therefore, I am less concerned about an end to the “bull market” in Treasury securities than I am about a market adjustment that has followed the “flight to quality” that took place last summer. The economy continues to expand and monetary policy will continue to be supportive of a still fragile banking system.
I am looking more for a relative rise in the yield on US Treasury securities as an indication that funds are flowing back into other areas of the financial markets rather than for a cyclical increase in yields due to a strengthening of the economy.
There is a second issue I would like to clear up that was brought to my attention by someone commenting on the above mentioned blog post.
In this blog post I discussed the continued deleveraging taking place in the American economy and the rise in bank lending, which I took as a positive sign that the economy would continue to grow. One person who commented on this post stated that the idea that deleveraging was to continue but bank lending was increasing seemed to be contradictory.
As such, the two pieces of information does sound contradictory. In arguing that “both” of these conditions can exist within the economy I draw on a point I have made continually over the past several years. My argument has been that over the past fifty years or so the United States government has conducted a policy of credit inflation. This credit inflation has helped to bifurcate the society as those with more wealth and better access to advice and consulting have been able to protect themselves from the inflation or even take advantage of the inflation to improve their position in the economy. The less-well off have not been able to even keep up with what is going on. As a consequence, the income/wealth distribution in the United States has become even more skewed to those possessing wealth.
As I have described in other places, the current economic policies of the United States government just exacerbate this movement. That is, the economic policies of the United States government are making things even worse. Deleveraging continues, but generally amongst those that are less well off, those who are heavily in debt, those who often find themselves underwater with respect to the ownership of their own home, and those who have little or no savings.
Lending is picking up to others, businesses as well as households, that are not is such a situation.
Thus, you can have bank loans increasing in the economy while many in the economy still have to reduce their financial leverage to even keep going. I believe we are in such a situation.