Wednesday, March 31, 2010


It's the 64 thousand dollar question.

Colleagues who read the blog agree with the logic of the thought process either can't come to grips with the idea that interest rates will ever rise substantially or... as is more often the case... they want to know... WHEN!

When will interest rates climb... even if it only as high as the 20 year historic norm of 8.25%?

My answer, as always, centres around sovereign debt.

Which is why this news article is of particular note.

The London Telegraph was reporting on news last week that the yield on 10-year Treasuries – the benchmark price of global capital – surged 30 basis points in just two days last week to over 3.9pc, the highest level since the Lehman crisis.

These developments are, of course, the trigger that caused Alan Greenspan to make his "the canary in the coal mine" comment.

As the Telegraph notes after the dramatic sell-off moves in US Treasuries last week sovereign debt fears have racheted up amongst investors and many are braced for further sell-offs as fears grow that the surfeit of US government debt is starting to saturate bond markets.

David Rosenberg at Gluskin Sheff said Treasury yields have ratcheted up 90 basis points since December in a "destabilising fashion" ,for the wrong reasons.

Growth has not been strong enough to revive fears of inflation, commodity prices peaked in January, and US home sales have fallen for the last three months (pointing to a double-dip in the housing market).

Rosenberg said the yield spike recalls the move in the spring of 2007 just as the credit system started to unravel. "The question is how the equity market is going to handle this back-up in rates," he said.

It's still unclear whether China is selling US Treasuries after cutting its holdings for three months in a row, or what its motive may be.

And looming over everything is the worry that markets will not be able to absorb the glut of US debt as the Fed winds down its policy of bond purchases, starting with an exit from mortgage-backed securities.

It currently holds a quarter of the $5 trillion of the MBS market.

The rise in US bond yields has set off mayhem in the 10-year US swaps markets.

As we noted last week, spreads turned negative touching the lowest level in 20 years. The effect was to drive credit costs for high-grade companies such as Berkshire Hathaway below that of the US government... it it a just a technical aberration?

Many are now speculating that the conditions are ripe for the bond vigilantes to rebel against the US government's wasteful ways.

Consider what's happening in the market for US government debt.

America remains in deep trouble. The International Monetary Fund forecasts that the world's largest economy will contract 2.8% this year, which is probably an underestimation.

Unemployment is rising fast and new figures show almost 10%c of US mortgages are now in arrears – up from less than 8%c in March and the highest "delinquency count" since records began almost 40 years ago.

No fewer than one in eight American households are now late paying their mortgage or have already endured foreclosure.

Ordinarily, an economic slowdown of this magnitude would bolster bonds – especially the market for Western government debt, which investors traditionally view as a safe haven.

But, despite the vicious downturn, the price of long-term US government bonds has been falling since the start of 2009, pushing up yields.

The reason is that the vast scale of the American government's indebtedness, has made investors less willing to fund US state spending by buying conventional (un-indexed) Treasury bonds.

Last week these fears came to a head, with the markets demanding a 3.75%c yield on 10 year Treasury notes, a six-month high and up from just 3.19%c the previous week.

As a result, 30-year wholesale mortgage rates surged from below 4%c to 4.74%c – again, in a single week – piling the pressure on cash-strapped households, many of whom are living in fear of their jobs.

Since the summer of 2007, when the credit crunch began in earnest, the US Federal Reserve has slashed interest rates from 5.25% to 0.25%.

These cuts were designed to support the economy by taking the pressure off highly-indebted banks, firms and households. But, whatever base rates have been set by the US Federal Reserve, the market is now driving the borrowing costs that companies, individuals and governments actually pay much higher.

For a long time many in the blogosphere have warned that the bond-market vigilantes would ultimately rebel against the Western world's profligate borrowing and spending.

That rebellion is now stirring in the most important economy on earth.

What happened in the US last week – almost a 60 basis-point rise in the 10-year Treasury yield, including a spike of 20 points in less than an hour – marks a significant turning of the screw.

And if interest rates are driven higher still, as the market asserts its authority, Greenspan's 'canary in the mine' comment will loom large.

Why did US Treasury yields rise so sharply last week? One catalyst was extremely soft investor demand for a $26bn (£16bn) issuance of US government debt.

Another was the latest bout of what we must call "quantitative easing" – when central banks create money to buy sovereign debt back off the markets in a bid to recapitalise the banks. Last week, alarmingly, dealers tried to sell the Fed far more bonds than it was willing to buy.

This spooked many bond traders, causing them to re-examine just how much QE the Fed can ultimately afford.

The recent decision by ratings agency Standard and Poor's to warn the UK over a potential sovereign downgrade has also had implications state-side. Many think S&P could end up downgrading the US.

Slowly but surely, global investors are becoming ever more concerned that QE, and massive sovereign debt issuance, than they are about fears of inflation.

And as they do, this will cause enormous Western price pressures.

Core inflation remains stubbornly high and rising oil prices and the destructive impact of the credit crunch on the supply chain aren't helping either.

Despite official warnings of deflation, the swaps market shows investors are increasingly unconvinced. Suspicion abounds that government in the US and UK, in particular, are now stoking inflation in order to monetise their massive debts.

In the 70s, US Treasuries went through a similar period in which confidence in the United States was severely shaken.

Rates on ten year bonds went from under 4% to 14 7/8%.

Overnight money went above 21%.

Confidence is what makes currency value and that is sundering fast.


Watch the evolving story of western sovereign debt. History is playing out before our very eyes.


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1 comment:

  1. Great post and great blog, read it everyday.
    Keep up the good work.