Downunder Daily : Treasury Trouble
Treasury
weakness - like US$ weakness (the two are connected) - hints at the stress that
bailing out the private sector has put on the public sector. This is tolerable if it goes hand-in-hand with
better macro data and reduced private sector stress. Rising Treasury yields are
a red flag when they hurt other risk assets, implying that the rise in yields
is not the by-product of a benign shift out the risk curve, but an independent
source of instability. This risk underscores the strategic caution of our macro
team: This is a cycle where the recovery will likely be tepid, subject to
set-back - not the accelerated affair increasingly priced into equities.
A few thoughts:
First, rising Treasury yields were always to
be expected. Financial stress and economic free-fall had pushed the 10-year
Treasury yield to 2%. As soon as stress levels eased, and the free-fall ended,
the extreme safe-haven Treasury bid was going to moderate. As a result, the
initial rise in yields was not a bearish sign - quite the reverse, it was
bullish: It went hand-in-hand with rising risk assets and falling yields for
private borrowers.
This is typical in the initial phase of a
recovery. Indeed, when investors are fundamentally bearish, it is common to see
bond yields and risk assets moving together. This was typical for Japan
throughout the 1990s (Exhibit 1). It is only in 'normal' times that the
correlation between Treasury yields and risk asset prices becomes inverse (as
was typical through much of the US bull market from the early 1990s).
Second, while the initial rise in Treasury
yields was a bullish sign, what changed this week is that other markets started
to react adversely to the rise in Treasury yields. Notably, mortgage rates are
now rising (Exhibit 2). This, in turn, is likely to lead holders of mortgage
bonds to sell more Treasuries to insulate themselves as the duration of the
mortgage bonds extends (so-called convexity hedging).
This week may mark an important change if
sustained pressure on Treasuries becomes a de facto tightening for all
borrowers. However, it may be short-lived, and the specific problem for
mortgages may be a tactical set-back specific to that market. Early this week
colleague Janaki Rao noted that the spread between mortgages and Treasuries was
at its tightest in over 13 years. He had therefore recommended selling
mortgages versus Treasuries (see The Interest Rate Tactician: Sell Mortgages
Versus Treasuries, 26 May).
Third, it's important to balance the set-back
in mortgages against what's still going right in credit. Corporate yields are
still well-behaved (Exhibit 3). Moreover, at the peak of the crisis, some
borrowing was almost impossible, regardless of the price. Now it's clear that,
say, the investment-grade bond markets have re-opened (Exhibit 4). This, of
course, is the key aim of policy-makers. As I noted in Public Sector Stress,
24 May, there has been a massive saving swap between the private and public
sectors. That should ease rate pressure in the private sector, but increase
pressure in the public sector.
So where to from here? Our US macro team is
bearish on the Treasury market over the medium term. However, Dick Berner
thinks lingering deflation risks and a recovery that will stutter rather than
stride will limit the near-term rise in yields. (See Bear Market in
Treasuries Begins, but Watch for Deflation Risks, 11 May.) The 10-year
Treasury yield is expected to end this year at 3frac12% and next year at
5frac12%.
The risk, flagged first by dollar weakness,
now by the sharp back-up in Treasury yields, is that capital market support for
the US public sector is wavering. The Fed could counteract Treasury market
weakness by stepping up its direct purchases. Jim Caron, our head of rates, has
argued that the Fed does not have a ceiling in mind for Treasury yields,
because the objective is to maintain low mortgage rates. Now that mortgage
rates are rising, the prospect of more aggressive action in Treasuries has
increased.
The Fed could cap yields by stepping up its
printing-press- funded purchases - in principle, without limit. Were that to
occur, the way markets could protest would be to sell dollars. In other words,
it is possible that a crisis in US public finances will be expressed as a
currency problem rather than a Treasury problem. I don't know if the Fed would
moderate its domestic macro-management policies to prevent a rout in the US$.
In 1971, the response was 'our dollar, your problem'. But in practical terms,
serious stress on Treasuries or the dollar could, if it occurred, limit the
powers of even the mighty Fed.
It's not clear how any of this plays out. But
two final points. First, rising public-sector-related stress - one that
undermines the consensus view of 2010 recovery - would unsettle global risk
markets. No US recovery; no global recovery; no risk-asset rally.
Second, these recent hints of stress
underscore the point that investors will likely continue to face serious risks
and set-backs in coming quarters. The deep structural imbalances behind the
deepest downturn in 80 years have not disappeared because a handful of green
shoots have sprouted. This is not a new bull market, at least not in
developed-economy markets. Equities have already reached levels that are likely
to be unsustainable. While near-term optimism and improving liquidity may lead
to further gains in the short term, this will push equities into the sell zone,
in my view.
I'm at Morgan Stanley's India conference next
week. Next DuD will be published 9 June. GM
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Coverage Universe |
Investment Banking Clients (IBC) | ||||
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2,223 |
593 | |||
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