Ten Points — Mainly About the Debt Markets

1) Why have long interest rates been rising?

  1. Increased supply.
  2. Mortgage bond/supply hedging. (also one, two)
  3. Belief in a strengthening economy.
  4. Long-term inflation expectations have been rising.
  5. Some foreign investors are selling.
  6. Flight to trash.

Number 1 is incontrovertible.  Number 2 is close.  Number three is true, though the economy is not strengthening that much in inflation adjusted terms.  As for 4, yes, TIPS inflation breakevens have been steadily rising, both short- and long-term.

The last one is the most interesting.  It is the analogue to the equity investors that are buying financials.  Since the financials have been hot, equity managers lagging in performance have encouraged the purchase of hot financials.  Same for junk bonds among broad mandate bond managers.  Many managers are buying long financial corporates for speculative gains, while selling long Treasuries to fund the purchases.

With a few exceptions, it has paid recently for bond managers to play on the riskier areas of their mandates, with the exception of high quality long duration bonds, which were the big winners last year, and the big losers this year so far.

So when you look at the rise in high-quality long rates (prices down), and the rally in junk (prices up), etc., realize that these are part of a larger phenomenon.   There is not one simple reason for the recent moves, there are many, and they are loosely related.

2)  That’s not to say that the Fed publicly understands this (one, two, three) .  When they announced their plan to buy long Treasuries, Agencies, and Mortgage bonds, there was some hope that they could keep mortgage rates down and stimulate the economy by making cheaper to finance homes.  That dream is in tatters now (one, two, three, four, contrary opinion from Paul Kasriel, who I generally respect).  The six forces listed above are bigger than the Fed’s ability to control.

3)  Will the Fed start tightening rates in 2009?  Yes or no?  When you phrase the question that way, most thoughtful observers will answer no, saying that the Fed would never start acting when a recovery is barely underway, if it is underway at all.

But maybe that’s the wrong question.  Ignoring the Fed funds futures market for a moment, ask this question instead:  Subjectively, have the odds risen recently that they might tighten sooner, and maybe even in 2009?  Certainly.  There have been other times when the Fed has acted, tightening when conditions were less than optimal.  I’ll give you two of them:

  • After the dollar tanked in 1986, with inflation still pretty benign, starting in December of 1986, the Fed began to raise rates, primarily to defend the dollar.  Not realizing all of the second order effects that would take place, the tightenings led to a bear market in bonds, and eventually the crash later that year as bonds became compelling compared to stocks.
  • From 1973 to 1982, the Fed often raised rates when the economy was less than strong.  Inflation was out of control, and it didn’t much matter whether industrial capacity or labor capacity were fully used — there was still inflation, and thus, stagflation.

It’s possible we may run into the same thing here, though if the only thing we experience is commodity price inflation because the dollar is weak, that doesn’t feed back into consumer prices that much,  because raw commodity prices play a small role in consumer prices.  Labor costs are much more important.  Would it be possible to get rising wages when unemployment is high?  Yes, look at the ’70s.

4)  But maybe the Fed can tighten without tightening.  They can begin lightening up on their credit easing programs.  Might work.  Maybe they could reverse their trade in long Treasuries, Agencies, and Mortgage bonds.  Uh, yeah, unlikely, but maybe they slow down a little.  In a case like this, moving the Fed Funds rate might be the least painful option.

So maybe a move in the Fed funds rate isn’t impossible in 2009.  The difficult part here is forecasting:

  • What conditions will be in the real economy will be like
  • How well the global economy turns
  • Whether the large amount of incremental Treasury debt and guarantees will be readily digested on favorable terms
  • Whether the financial economy won’t hit a few more roadblocks from commercial mortgages, corporate and personal insolvencies, unemployment, etc.
  • Whether there is some “bolt from the blue” like a new war, weakness in the Chinese economy, etc.

What isn’t hard is looking at the overall debt levels relative to GDP, and realizing that we have only rationalized a part of them.

5) Residential Housing is still weak, and getting weaker, but the pace of the decline has slowed.  The market still has issues in front of it:

As I said in an old CC post:

David Merkel
Hear Cody on Housing
8/24/2007 1:25 PM EDT

Much, but not all of the upset in the lending markets (which, if you look at swap spreads, the current manifestation of the crisis seems to be passing — down 4 basis points today), is from deflating values in housing. My estimate for how much further real estate has to decline on average in the US is 10-20%. We need to find owners for about 4% of the US housing stock that is vacant. The pain that has been felt in subprime and Alt-A loans will get felt in prime loans, and possibly conforming loans as well. Fannie and Freddie won’t get killed, but they will take credit losses.

So, listen to Cody. Residential real estate markets do not clear as rapidly as a futures exchange. The illiquidity and variations in lending standards tends to lead to markets that adjust slowly, and autocorrelatedly. I.e., if it went up last period, odds are it will go up next period, and vice-versa.

It will take a while for the residential real estate market to clear. When the inventory gets down to 3% it will be time to start speculating on homebuilders and mortgage lenders again, but real estate prices won’t start rising in aggregate until the inventory of unsold homes gets below 1.5-2.0%.

Position: none

In hindsight, I was way too optimistic, but I could never bring myself to write that things could be much worse, because then you get labeled a “perma-bear,” and then you get ignored.  So, if you want pessimism, here it is from T2 partners.  We may be near fair value now, but given that our housing stock is misfinanced (too much debt, terms that are too short), we will definitely go below fair value.  The only question is how much we go below fair value.

6)  Regarding the US Dollar fixed income, who is right?  The Russians, who are selling?  The Chinese, who are kvetching, but still buying?   Or the Japanese, who possess unshakable trust in US bonds?   Only time will tell.  Transitions from one currency regime to another can be messy in the absence of an anchor like gold.  There is some point where if the US keeps borrowing, and there seems to be no end in sight, that foreign creditors will finally write off their losses, and move on to some new arrangement.

In the short run, it is not in the interests of China or Japan to ditch the Dollar.  It would take something notable to get them to change, and I can’t see what that would be.  It certainly won’t be Yuan-denominated bonds from the US.

7)  Buy Corporate Bonds Now.  Aren’t we a bit late here?  The time to buy was back in the end of 2008.  Investment Grade Corporates are at fair value now, and I would reduce holdings of BBB corporates to below benchmarket levels. High yield is still a little cheap, so I would reduceallocations to high yield now to benchmark levels.  We still have significant financial stress ahead of us, and there is a lot of room for lower-rated credits to underperform.

8 ) As another example of this, consider how many junk-rated senior loans will need to be refinanced over the next five years.  Perhaps the bid from CLOs will come back, or the the banks will heal and bring it onto their balance sheets.  But absent that, there will be upward pressures on yields when refinancing senior loans.

9) I knew that I wrote something with respect to the Fed and Treasury using force to make banks take TARP funds.  I finally found it.  So, this isn’t hot news that the banks were forced to take TARP funds, (and here) but it’s nice to see that I guess right every now and then.  Barry was quite possibly right that the TARP was a ruse to protect Citi, but the bigger surprise would be how much Bank of America and Wells Fargo would need it.

10) Final note: if banks are opaque, regulators are more so.  Glad to see Matthew Goldstein continuing to put out good work on financials.  He was great at TSCM, and I’m sure will be great at Reuters.