Sliding bond yields leave investors guessing
Bond yields made headlines around the world this week as observers debated whether the current low levels signalled an impending recession or were simply an unusual vote of confidence in the ability of central banks to curb inflation.
Although shorter-dated bond yields have risen in tandem with rate rises, longer-term yields have fallen, which traditionally implies the market is pricing in a potential recession.
After unexpectedly weak US jobs data on Friday, the 10-year Treasury yield was 3.807 per cent, a 14-month low.
Typically, rate rises lead to higher bond yields, both short-term and longer-dated, as borrowing costs rise and investors price in the risks of greater uncertainty.
Short term (overnight) interest rates are at 3% per annum, which means that you get almost the same interest rate for lending your money over 10 years than you get for lending it for one day. That means little or no inflation is expected (priced in) in the coming 10 years, and the usual way to get no inflation over 10 years is through a recession, when there are no growth prospects and your money is better parked long term in safe, and decently paid US Treasuries than invested in anything else.
Yield curves in the UK, Australia and New Zealand have already flattened or inverted, meaning it costs the same or less per year to borrow for 10 years as it does for two, in spite of the greater risks of loaning money for longer.
In the US, the difference between two- and 10-year notes has narrowed to about 0.4 of a percentage point from 2.2 percentage points a year ago. Since the 1970s, yield inversion has preceded every recession.
The yield curve is the curve showing the interest rate depending on the maturity of the debt. When it's flat, it means that you get the same interest rate for lending short term as you get for lending long term, and it's not a sign of good health. It also kills the "carry trade", whereby investors borrow short term money (usually cheap) and invest in long term money (better remunerated) - the risk being of course that your short term rates (at which you need to refinance every 6 month (or whatever short period you're using to fund yourself)) go up while your long term remuneration remains stuck. That's one of the things killing the hedge funds these days, and it's not a good omen for the stability of the financial system.
And this happens in a context where the twin deficits are about to set new records this year (of up to 7% of GDP for the budget deficit, totally unprecedented for the world's reserve currency)
Less to the Dollar Than Meets the Eye
The US Treasury's latest report on International Capital Flows shows that since last August, the Japanese have reduced their holdings of US Treasury bonds by $19.4 billion. Not a huge decline. But importantly, they are not increasing their buying of US bonds. Across the Sea of Japan, and the Chinese have increased their holdings, but not by much, from $201.6 billion in August 04 to $223.5 billion in March 05.
The most notable increase in fact comes in London, or rather, the UK including the offshore tax havens of Jersey and the Isle of Man. These holdings of US Treasury bonds DOUBLED over the 8 months to March. Across the Atlantic, meanwhile, Caribbean Banking Centres - or what I call off-shore US hedge funds - have also increased their holdings of US Treasury bonds. The Caribbean is to Wall Street what Britain's offshore havens are to the City of London. Since August, the US hedge funds have increased their Treasury holdings by 44%.
But unlike the UK's steady accumulation of US Treasury debt, the Caribbean's holdings actually fell between August and December, down to $71.4 billion. Then, since December, US hedge funds have increased their offshore Treasury holdings by a whopping 92%.
Were the City and Wall Street funds out to support America's consumer spending habits? Not likely. In the great hunt for yield, 4% on a US bond is better than zero percent in Japan. But here's the important fact for dollar bulls: hedge funds, unlike Japan or China, have no interest in a strong or a weak dollar. They are merely out to make money where they can.
And that's fine. But here's what investors cannot afford to forget: hedge funds will sell when a better trade comes along OR, when they are forced to liquidate.
The mainstays of the US bond market, China and Japan, aren't buying. Hedge funds are. But their support for the dollar, which has the effect of keeping interest rates down, is merely a trade, not a policy. When the hedge funds sell, or quit buying, who will pick up the slack? No one.
Interest rates will go up. Puff goes the American housing market. Down goes the dollar.
All of which is to say that there is a lot less support to the dollar than meets the eye. The dollar is simply GM in waiting. US bonds are distressed debt owned increasingly by fund managers desperate to eke out a few basis points here and there. This is not the bedrock of a strong rally in a currency.
And meanwhile, in the background, oil prices remain stubbornly high, again above 55$/bl for the WTI, and this at a time when the euro is particularly weak, which means that oil prices are increasing in a strenghtening currency, contrary to what has often happened in recent years, when the oil price in euros was fairly stable.
- oil prices are high and are slowly translating into inflation, which requires higher Fed rates, and they are also sapping the strength of all Westenr economies;
- low rates had until now made money abondantly plentiful, and returns on investment consequently low. This has caused companies to invest less, and everybody (starting with hedge funds) to pile into ever-riskier ventures to earn a better yield;
- now that these investments are proving to be too risky (cf the GM bonds becoming "junk"), some funds have lost money and everybody is switching back to safer havens, such as the US Treasuries, whose yields are therefore dropping;
- everybody is thus caught between the higher short term interest rates and the still incredibly low long term rates;
- in come the US deficits, which require a steady stream of money into long term US Treasuries. It appears that the Asian central banks are becoming increasingly reluctant to add to their already huge pile of such assets. This has been hidden for the time being by the welcome arrival of "hot" hedge fund money, but that money is not invested there for the long term, and it could leave as quickly as it arrived, triggering a bond crash and a brutal increase of the long term interest rates that underpin so much of the US housing prices - and of US debt-fuelled consumption and GDP growth.
People are already suggesting that the Fed stop increasing its (short term) rates to avoid that outcome and fuel another round of happy spending, but (i) that may not be enough in view of the funding requirements of the US and (ii) it's not reasonable in the face of existing inflationary pressures.
So, the current atmosphere in the markets is best described as fear:
GLOBAL FEAR... DON'T FLINCH
by Randolph Buss, Der Invest Informant, 3 June 2005
(...) the overlying tendency which I sense right now is fear. The fear I sense is slowing creeping all over the marketplace(s). It is a fear which is oozing into every major market and marketplace in the world. Let us just take a look and some of these. I will not go into long statistical aberrations and charts and what have you but rather I will simply point out what the markets are looking at.
- The much talked about triple deficits within the USA are still increasing and show no signs of abating. 2005 estimates now put the budget deficit at near 7% of GDP - unprecedented for the world's reserve currency nation.
- Congress shows no signs of serious budget reforms or cutbacks in key social transfer reform or military spending reforms
- The Iraq War is now costing unprecedented billions of USDs combined with a complete loss of face amongst its Allies.
- Due to technological improvements, once safe white-collar jobs are now under scrutiny of being outsourced while the blue-collar jobs have since gone to low paid and illegal aliens.
- A drip-feed diet of low interest rates has given rise to a citizenship now accustomed to "all play and no work" as home mortgages are now practically given away to anybody with a heartbeat and can sign a form. This has been accompanied by a near savings rate of zero, in actual fact, latest statistics point to a rate of 0.4% or $4 on every $1000 earned - imagine that.
Under the veneer of this is the creeping and ever present fear that this whole housing and deficit scenario, or as some call it, sham, cannot go on.
I am on record saying that we will have a major problem on the oil supply/demand balance before the end of the year and that prices will literally shoot upwards. This is still to me the most likely trigger of the coming crisis, but who knows if something else in the currently unbalanced financial markets triggers it before...