It Works Until It Doesn't Work: Short-Term Bills Are Not The Problem

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Includes: XIV
by: Kevin George
Summary

Market on alert over record auction.

Short-term is not the problem.

Long-term yields are a danger.

Market on alert over record auction

Financial markets were on alert as a record amount of three month and six month bills were auctioned in the U.S. The size of the auction was $51bn $45bn respectively.

(Source: Zerohedge)

As noted on Zerohedge:

...the yields on both were well higher than last week, with the 3M up 6bps vs last week, while the 3M was up 3.5bps compared to last week's auction. Putting the auction in context, this was the highest 3M auction yield going back to 2008.

Short-term is not the problem

Despite the obvious rise in yields from 2015, there is no real threat for short-term yields as the Federal Reserve would simply move to take the heat out of yields if auctions were strained and markets began to panic.

The calm in financial markets over the last few years has been a by-product of Central Banks' ability to soothe market expectations of a sharp unwind in QE programs and balance sheet growth. These expectations have been managed amidst some mild geo-political turmoil but they have never been stress-tested by an economic downturn or shock.

Investors are currently walking on eggshells looking to predict the next crisis or extreme move but they are never easy to predict. Consider the recent crash in the VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV), or the Swiss Central Bank move in 2015, that saw the Franc surge after the Central Bank moved to abandon its exchange rate controls versus the Euro. For a long-time traders had been selling volatility as a free-money trade and expectations of a continuation in that trade led to an over-crowded, and dangerous one-way bet. In the case of the Swiss Franc, the gains in the currency blew a hole in mortgages that had been sold to homeowners in Poland; again expecting a one way trend.

With these market events in mind, investors should be looking very closely at risk and long-held assumptions in the markets that could be turned on their head. Like picking up pennies in front of the steam roller, markets may cheer a three and six month bill auction but the real risks are further out on the yield curve. Nobody doubts that the U.S. would be unable to meet its liabilities over these timeframes or that the Federal Reserve could shock markets to collapse the short-term yield, but the real problem would be in political or financial market instability that saw Central Banks lose control of longer-term yields.

Long-term yields are a danger

As in the case of the XIV and the Swiss National Bank's Euro peg, we are currently witnessing unprecedented market events across the board. Manipulations by Central Banks on a global scale have run into trillions of dollars and their actions have had an effect on every asset class. A slow grind higher in global growth, particularly in the troubled Eurozone, has continued to boost their goals but the problems seem to be building that could find it hard to continue with an orchestrated easing or unwinding. Recent weakness in the U.S. Dollar is possibly another concerted effort as it's been noted that a weaker Dollar "could boost global trade by 3 percent" and also takes the threat of a trade war between the U.S. and Asia off the table in the short-term.

Despite the short-term auction success today, it is starting to feel that the blowback from unprecendented stimulus and debt issuance may be starting. A recent report from Goldman Sachs, calculated that US debt supply will double in 2018, from $488bn to 1,030bn. The growth in the economy is not expected to keep pace with the growth in debt and that doesn't account for a global slowdown. Debt ratios in the global economy have risen to 327 percent of GDP, from 276 percent ten years ago. Continued suppressed yields have made debt interest payments manageable but the trend is simply unsustainable and the market's faith in a managed taper has real risks.

With the recent strength in the U.S. economy and the ability to weather some small rate rise tests by Janet Yellen, the real risk to the global economy would probably be seen in Europe, particularly as Italian elections loom in two weeks time and doubts remain over Mario Draghi's ability to make a smooth unwind from his own QE program. If the Italian elections swing to the populist vote, it could cause tremors in the peripheral bond markets and would cause further problems for the embattled banking sector in that nation, amidst bailout efforts and would create contagion risks for the likes of Deutsche Bank (NYSE:DB) which is still struggling to grow revenues. Recent demand for a Spanish 30-year bond has some calling an end to the global debt crisis. One wonders if it ever really began.

Conclusion

Despite continued success in short-term auctions, financial markets are complacent about the risk inherent in the yields of longer-term paper, such as the 10-and 30-year bonds. Although the market was focused on the U.S., the risk could come from further afield if the Italian election swings to a populist party. Central Banks have been able to navigate some real bumps in the road when managing QE programs but the risk of losing control is still present. With entire asset classes and governments balancing on the fulcrum of low-rate bonds, we cannot rule out the chance of a market event that overpowers QE efforts. As with other market trends, it works until it doesn't work, and an overnight event in Europe or a weekend of Central Bankers could change the entire financial landscape. Investors should consider limiting their exposure to a yield shock in long-term bonds. As we test resistance levels, short-selling is at a record high. A rush to the exits as we saw in the XIV could create a real problem for Central Banks down the line.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.