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Futures Trade Desk- Understanding Spreads, Bonds, and Haircuts

Trade Desk Client Note

Global Futures Market Review

Understanding Spreads, Bonds, and Haircuts

When a headline reads "Italian 10-year bonds are now yielding over 7%", what does it actually mean? In reality it reflects an impossible task in achieving economic austerity as most regional lending rates are set around the prevailing 10-year yield. 

As seen in Greece recently, the allure of a high yield comes with the risk of the bond value being chopped when the Government is unable to meet its obligations. Holders of Greek and now Italian bonds will be expected to lose upwards of 70% of their initial value whenever austerity measures are agreed (the Haircut). When yields (rates) go higher the government is forced to pay more to service their debt. The following high-level article explains how bond and interest rate markets work. 

Bonds are traded between investors and institutions as a way of borrowing cash, with government Bunds, Gilts, Bonds, and Treasury notes making up the borrowers side of the market. US Treasury notes are the most liquid of all global bonds, and they are now carrying a AA+ rating, down from AAA, which is prompting the question of when or how long it will be before other regions take a rating downgrade.

The move lower in rating agency outlook has not been seen before in US debt valuations, and is something that other regions have taken an average of nine years to regain. The market now has a massive task ahead of re-balancing risk/asset ratio exposure and finding fair value, as can be seen in the constant headlines relating to daily bond auctions, yield values, and note exposure. Bonds and interest rate markets dominate global asset class trade. Where interest rate go, others follow.

How bonds and Treasury notes are historically used will now change and a new world order will look at the sustainability of the current situation. The Federal Reserve (Fed) historically controls overnight lending rates by increasing or decreasing the flow of US Treasury Notes and that policy was taken to whole new levels with the implementation of Fed quantitative easing (QE) programs.

QE has been an unmitigated failure, by the Fed and other central banks who have tried to print their way out of debt, in spurring economic growth and faith in financial institutions and administration. However, a far bigger issue needs to be addressed in the near-term that could make the 2008-2011 Black Swan events seem insignificant.

The global investment market likes nothing more than 'as-is' stability, and for the foreseeable future the outlook is far from stable as governmental debt is addressed via the bond markets. 

•    When rates need to go lower the Fed historically buys back from the market a swath of existing Treasury Notes, therefore decreasing market liquidity and increasing the existing note values
•    By increasing the value of the note the reaction is for the yield (interest rate) to be automatically decreased 
•    Lower interest rates come from less notes in circulation 
•    When rates need to go up the Fed historically sells more Treasury Notes, therefore reducing existing note values and increasing the yield (interest rate) 
•    That move automatically increases overall market interest rates.

In a final gesture, the Fed should look to bank the cash received from the sale of notes into the Reserves, so it can then be used in the next cycle of rate changes.

That may be the historical way that the Fed controls interest rates, but the fly in the Administration (Treasury Dept. and Federal Reserve) ointment is the fact that there has never been this amount of notes hitting the market. The constant flow of new notes is now going to be questioned, as they are carrying the same credit rating as low-volume bond issuing countries such as Belgium.

The 10-year Treasury note has the greatest impact on the U.S. economy due to its influence on long term interest rates. While the Federal Reserve controls the overnight rate, interest rates paid on long term financing for capital goods, as well as the housing market, are established by asserting a premium over the 10-year Treasury note. 

Whatever the 10-year note is worth determines the rates for mortgages, investments and loans which are set from the 10-year starting point.

U.S. bond traders may feel that the Fed has been withholding vital information regarding the danger of the U.S. economy not easily coming out of the recessionary phase. There has been no public announcement of any new strategy to try to control massive spreads that are likely to build in the value of insuring against default on the notes (read credit default swaps).

Something else to address is cost of banks doing business with each other (read LIBOR the London Inter Bank Offered Rate), because inter-bank credit pipes are freezing over once again. This is a 2008/9/10/ repeat that has no easy answer.

The Fed did its job in creating global liquidity, the Treasury is doing its job of creating government debt and generating cash, and the market did its job of buying notes that were back-stopped by the Fed and regional central banks.

If there are no cash Reserves getting built from the sale and part buy-back of new notes, and no more QE programs, what will be used to stimulate the next business cycle move? More importantly, once the required amount of notes flood the market, and yields have exploded, how is the Fed going to repatriate interest rates?

In a strange twist of fate, it may be that higher interest rates instigate a stronger Usd. The economic cost will remain an unknown as the Fed may have to once again float their QE boat into unchartered waters.

Another relationship of importance is between the Treasury bond’s price and the interest rate or premium it offers at any time. It is an inverted relationship; when bond prices increase, the yield (interest rate) moves lower, and vice-versa.

This all comes from the fact that at maturity repayment of the principle is paid at par value, and not at bond’s market price; Par value = Current Interest Rate/Price.

Example:
•    A $1000 10-year Treasury note with a 2% yield guarantees $20 a year for 10 years 
•     If the note value goes down because of increased amount of notes hitting the markets, from $1000 to $500 for example, the yield increases 
•    The original $1000 bond with a 2% interest rate is still guaranteed to pay $20 a year, even though the note value has decreased
•    With an open market value of $500 and still returning $20 the interest rate, or Par, is now 4%
•    The Note value dropped, and in doing so sent the Yield higher

It has historically been seen that the best way to trade bonds is usually during recessionary times, when note values increase due to interest rate cuts, and in times of equity selling. The variable here is the unknown strategy for the Fed to once again stimulate the economy while still containing interest rates.

Another challenge will be containing bond vigilantes that positioned themselves last week for a potential downgrade. All of which is creating fear of loss and volatility that has no release valve.

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