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Friday, July 25, 2003

News From the Bond Markets: Close Encounters of the Dangerous Kind

The great bull run in the bond markets is over, that much is clear. The only detail left to clarify is who has the blame. As I often suggest, pointing the finger is always easy. For many the prime culprit is that habitual re-offender Alan Greenspan. Perhaps there is an argument to be made here. Certainly Roach is cogent when he argues that decisions, on the one hand, to suggest to the markets that 'unconventional measures' (which would of course imply keeping long bond rates down, and hence bond prices up) were becoming less likely, and then to follow this up, on the other, with the insinuation that there was no interest rate floor at 0.75% could well provide us with what the Greek historian Thucydides would have termed the efficient (immediate) cause, but as Roach also argues the real 'final' cause ought 'even handedly' to be located in the difficulties inherent in managing monetary policy in a strongly-disinflationary climate as interest rates progressively drop towards zero.

At 10:30 a.m. on Dec. 7, 1981, a 61- year-old man carrying a .38 caliber pistol, two sawed-off shotguns and a hunting knife walked into a building at Constitution Avenue NW and 21st Street in Washington. The New Hampshire resident proceeded to the second floor of the Marriner Eccles Building, where he intended to take the cloistered members of the Federal Reserve Board hostage to focus media attention on the damage near-record interest rates were having on the U.S. economy. Little did he know that "interest rates had peaked some nine weeks previous and had embarked on their greatest down move in history,'' says Paul McCrae Montgomery, a market analyst in Newport News, Virginia, who publishes Universal Economics. Two weeks ago, a 63-year-old Hong Kong man burned 22,000 Hong Kong dollars ($2,821) to protest near-record low interest rates. His nest egg of HK$346,580.05 had generated a paltry HK$17.50 in interest at HSBC Bank during the past six months. Interest rates have plummeted in Hong Kong, which links its currency to the U.S. dollar. The two sexagenarian interest-rate protesters may be bookends to the biggest bond bull market in history, which started in September 1981 with the 30-year bond yield at 15.31 percent and the 10-year note yield at 15.84 percent. The bull market may have ended on June 16, 2003, when the yield on the 10-year note and 30-year bond touched a 45-year low of 3.07 percent and 4.14 percent, respectively.

"The price structure is compatible with the end of the bull market,'' Montgomery says. "You get confirmation when all markets are moving together.'' What greater confirmation can there be than all the world bonds markets turning in sync? Since last month's low in yield/high in price, bond markets in the U.K., Germany, France, Spain, Canada, Japan and Australia, to name a few, have all declined. "We worry too much about what (Fed Chairman Alan) Greenspan says and what our economy is doing, because the world's credit markets are not nearly that parochial,'' Montgomery says. "Major movements in interest rates are tidal affairs.'' In retrospect, the final leg of the rally that kicked off with the Fed's statement on May 6 about "an unwelcome substantial fall in inflation'' had such force it couldn't have been sparked by fears of deflation. "You don't get a rally like that on a concept,'' says Jim Glassman, senior U.S. economist at J.P. Morgan Chase & Co. "Inflation expectations don't change that rapidly,'' which is something Fed Governor Ben Bernanke pointed out in a speech on Wednesday. Rather, the rally was driven by an expectation the Fed would resort to "unconventional measures'' to stimulate the economy (buy long-term bonds), and by what Montgomery described at the time as the law of increasing returns. Normal market dynamics can be defined by the law of diminishing returns, "wherein a rally in prices and a drop in yields decreases demand,'' he says. "The type of buying that drove bonds to their June 16 top was of a dangerous sort and subject to reverse itself in an equally dynamic move to the downside.'' Higher prices begat more buying as mortgage portfolios were forced to beef up their duration, a measure of risk, by buying non- callable Treasuries to offset the mortgage-backed securities being called away when homeowners prepaid their mortgages and refinanced at a lower rate.

The second kicker came from the pools of commodity trading advisers, whose black-box models are driven by market momentum and other technical indicators. A third supercharger came from the "carry trade,'' with traders borrowing money at low short-term rates and buying long- term notes and bonds to benefit from the steep yield curve. "The problem comes when one isn't satisfied to earn 100 to 200 basis points of spread and decides to leverage up 10 or 20 to one,'' Montgomery says. The force of the rally drove Treasury yields below those on tax-free municipal bonds, a rare occurrence. "Once the market gets leveraged up in this fashion, it doesn't take much price weakness to generate a cascade of selling,'' Montgomery says. And it didn't. Yields rose further, faster than anyone expected. Now there's seven times as much money invested in Treasury bond puts than in calls, Montgomery says. That compares with a 13-to-1 weighting in favor of calls, a bet on higher prices, at the June top. The rise in yields is already sparking the usual warnings that higher rates are going to nip the nascent economic recovery in the bud. To put the 100 basis-point rise in long yields in perspective, for anyone who left the country on May 6 to go trekking in Nepal and came back this week, interest rates are still historically low. That's what the Hong Kong protester was saying when he put match to money.
Source: Bloomberg

Regardless of the ins and outs of who sparked this off, the situation is far from stable. Among other factors, unduly high lmedium and long term rates can adversly affect whatever recovery may be coming. Among those who are worried is, of course, Stephen Roach.

The current rout in the US bond market is starting to reach epic proportions. Yields on 10-year Treasuries have backed up an astonishing 108 bp in just five weeks. Given the record low yields that were prevailing on June 13 (daily close of 3.11%), this sell-off is far worse on a percentage change basis -- a 35% surge in long-term government interest rates. It’s a carnage that is now taking on the trappings of the worst sell-off of them all -- the great bond market rout of 1994, when yields on 10-year Treasuries rose by 44% (or 246 bp from 5.57% in January 1994 to 8.03% in November 1994). Needless to say, if the rout continues, all bets could be off on other asset markets, to say nothing of the nascent recovery in the US economy...........

One of my most seasoned trader compatriots has always warned that a yield curve which “steepens in a downtrade” is emblematic of the most virulent of bear markets. And that’s exactly what is going on today. The spread between 2s and 10s in the Treasury market hit 259 bp at the close on 21 July -- equaling the yield gap last seen in 1992. The traders are telling me that this “bear spasm” is now at risk of feeding on itself -- until or unless it is stopped by an unexpected weakening in the economy or by direct intervention by the authorities.

This is hardly an outcome that the Fed, or any of us, would deem desirable in the current climate. It runs the very real risk of spilling over into other asset markets -- especially given the mounting potential for an a further sell-off in the US dollar as part and parcel of America’s long overdue current-account adjustment. Moreover, a sharp additional back-up in long rates poses a serious threat to a nascent recovery in the US economy -- not only crimping the credit-sensitive sectors of homebuilding, capital spending, and consumer durables but also aborting the home mortgage refinancing cycle that has been so supportive of consumer demand. We tend to forget that the US economy is still closer to the brink of deflation than inflation. Wouldn’t it be ironic -- and tragic -- if the perils of deflation were compounded by a rout in the bond market?

In my view, all this is indicative of what happens when deflationary risks of post-bubble economies take monetary policy into uncharted waters. As short-term nominal interest rates approach zero, central banks start to lose control of financial markets and the real economy. That’s precisely what has happened in Japan under the BOJ’s zero-interest-rate regime. And the rout in America’s bond market may well be a warning sign of a similar fate for the Fed.
Source: Morgan Stanley Global Economic Forum

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