Spike in Bond Yield Challenges Stocks

Although the broad stock markets indices were little changed, last week was eventful for the ongoing carnage in the banking sector and a major sell-off in global bond markets.

Contrary to the notion that the credit crisis was behind us, bank indexes sank to new bear market lows last week and have plunged over 20% in the past six weeks. The percentage declines from peak price levels in some of the largest financial stocks is remarkable:

Lehman Brothers	-68.3%
Wachovia	-66.1%
Citigroup	-62.4%
Merrill Lynch	-58.7%
Morgan Stanley	-54.9%
AIG	-53.4%
Bank of America	-43.8%

Although these declines are consistent with prior troughs in the banking sector, it is difficult to have any confidence that bank stocks have reached a selling climax and are making an important longer-term bottom. According to recent data from the FDIC, banks are still behind the loan-loss curve. Despite massive write-offs and record provisioning for bad debts, banks' loan loss reserves as a percentage of non-performing assets fell to a 15-year low at the end of the first quarter. Based upon this data, it is hard to make the case that the bottom of the credit cycle is near. The repair of bank balance sheets following the bursting of the credit bubble will be a protracted process, and there will undoubtedly be more write-offs, dividend cuts, distressed capital raises, and outright bank failures in the months ahead.

Contributing to the woes of the financial sector last week was the major sell-off in the bond market, especially at the short end of the yield curve. The two-year Treasury note yield shot up 66 basis points last week to 3.04%, which was the largest weekly gain in yields in 26 years! The 10-year Treasury yield jumped 34 basis points to 4.26%. Since mid-March, the two-year Treasury yield has spiked 150 basis points and the 10-year Treasury yields has risen nearly a percentage point. Bond prices are falling not just in the U.S. but around the world as investors and central bankers have been forced to confront the worst global inflationary backdrop since the 1970s.

The timing of this spike in interest rates (though certainly warranted given the global inflation problem) could not come at a worse time. Higher borrowing costs represent another major headwind to the economy and the stock markets, which are already struggling with (1) record energy and food prices; (2) rising unemployment; (3) the repercussions of the unwinding of the bubbles in credit and housing; and (4) declining household net worth.

Markets are now expecting that the Fed will begin hiking interest rates in August and that the fed funds rate will be a full percentage point higher a year from now. With the government's CPI statistic registering a year-over-year inflation reading of 4.2%, which means that the current "real" (i.e. inflation-adjusted) fed funds rate is a negative 2.2%, a return to a more responsible monetary policy is certainly needed, but given the Bernanke Fed's easy money track record, we wonder whether it will actually begin hiking rates while unemployment is rising, the banking sector is under such pressure, and home prices are still falling.

It should now be perfectly clear that the efforts of the Fed and the government to fight the unwinding of credit and the real estate bubbles through inflationary measures (i.e. aggressive rate cuts and deficit-spending) have been counterproductive. In their attempt to "paper over" the problems in our financial system and the basic issues of excessive debt and overvalued assets, the Fed and the government have created an inflation problem without doing much to alleviate the inevitable corrections in the banking and real estate sectors.

The decline we are seeing in housing prices was unavoidable for the simple reason that housing became highly overvalued and over-leveraged. At the peak of the housing bubble in late 2005/early 2006, the price of the average home in the U.S. reached 5.2 times average household income. Housing had consistently been valued at 4 times income in the 1990s, implying a 20% overvaluation nationally at the peak. The problem of excessive leverage in housing is illustrated with a single statistic: over the past twenty years, owners' equity as a percentage of home values in the U.S. has fallen steadily from 66% to an all-time low of 46.2%. Over the past ten years, total mortgage debt in the U.S. nearly tripled from $3.7 trillion to $10.5 trillion.

Although debt excesses were certainly most pronounced in the household sector, the credit bubble we are now suffering from also involved the government and corporate sectors. Government debt (federal, state and local) is at a record high 86.2% of GDP and non-financial corporate debt is 45.5% of GDP, very close to the all time high of 46.6% reached in 2001. According to Ned Davis Research, total U.S. debt this decade has grown by $24.3 trillion while nominal GDP has only risen $4.7 trillion from its level at the start of the decade. This works out to a ratio of $5.17 of new debt for every $1 increase in GDP. In the prior decade of the 1990s, GDP grew by $3.9 trillion while U.S. debt grew by $12.5 trillion - a ratio of $3.21 of new debt for every $1 increase in GDP.

Following these debt excesses, the economy has clearly entered a much needed de-leveraging phase. Efforts by the Fed and the government to forestall this de-leveraging, which is a longer-term positive for the economy, have created an inflation problem. In retrospect, it would have been preferable (from the standpoint of the average U.S. household rather than the average Wall Street bank) to accept the consequences of the bursting of the credit and real estate bubbles without resorting to inflation as an attempted quick fix.

Comments

[Nidhi Kadalbal:]

Wait till you see the inflation in the aftermath of the "helicopter money drop" .. that is the stimulus package.

2008 Jun 16 01:06 PM

[buyitcheap:]

Agreed. We should see the first half in June for electronic filers or have we already with the slight pop in retail(?), with the remainder in July for June stimulus recipients.

2008 Jun 16 02:13 PM

[oroloco:]

Excellent overview. Telling it like it is clearly and succinctly. Fasten your seat belts and enjoy the ride!

2008 Jun 16 11:12 PM