Things have been bad in the bond market of late, but many amazing things happened in the bond market yesterday.? I printed out a number of screens from my Bloomberg terminal near 4PM yesterday:
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And this blast from the past:
It is hard to convey the depth of the panic gripping the bond market of late, but when t-bills are priced at less than 10 bp of yield, and the 30-year bond rallies almost 9 bucks (46 bp) in one day, that says a lot.? The last graphic above is from Black Monday, when the stock market crashed in 1987.? The move in T-bonds was even greater than that day in spread terms, which is pretty astounding, because ther was a lot more spread to grab in 1987.? In dollar terms, that was a $3+ move, so the move today was unprecedented.
Also consider that 30-year TIPS fell at the same time as the large move up in nominal bonds.? Inflation protection is being given away for free in some cases (zero for 10 years), at very nominal fees in other cases (0.7% for 30 years), and being paid in other cases (-0.5% for 5 years).? The forward inflation curve looks pretty bizarre.? If I can find time, perhaps I can put up a graph.
Away from that, 30-year swap spreads closed near -60 basis points.? Swap rates are supposed to be similar? to where AA banks borrow/lend, so something is broken here.? My suspicion is that long duration managers (pension plans, life insurers) have for some reason felt forced to buy fixed-rate? promises through the swap market, rather than buying zero coupon bonds, the longest of which yield more than 3.5%, considerably more than swap rates.? Anyone holding a position to receive 30-yr fixed, pay floating saw it appreciate by 9-10%, which is pretty amazing.
Many of the rates on the Treasury curve are record low yields as far as I can tell. This contrasts against all of the other bond markets, including agencies, where rates are significantly above Treasuries.? Investment grade and high yield bond spreads are at record levels.? My view is that they should be bought selectively, realizing that purchasing power in this market is supreme, and not give it up easily.
Read Across the Curve for how investment grade corporate spreads are moving out.? CMBS spreads have gotten destroyed.? If I were running life insurance money, and my client felt his liabilities could not run, I would be buying AAA CMBS hand over fist, carefully selecting older deals with better credit quality.? That said, you can see the effects of the carnage in the shares of life insurers, which are the biggest providers of long-term credit.? (ouch with tears)
There are still more oddities to the current bond market, most of which involve parties that can’t take certain risks any more.? We can expand that to banks, and toss in Citi.? Citi is trading like it is going out of business.? Now, Citi is one of the “too big to fail” [TBTF] banks, along with JP Morgan, Bank of America, and Wells Fargo.? If they are in trouble, I’m not sure who can buy them; they would probably be too much for even a coalition of the other TBTF banks to handle.? Is there a foreign bank that wants them?? I doubt it.? This would be another area where a new TBTF chapter of the bankruptcy code would be useful.
I’ll have a more detailed response to my piece, It’s Called a Depression later.? I would say that I found the commentary interesting, particularly the places where some suggested that:
- I focused too much on financials.
- Negativity itself is the problem.
- Why don’t you focus on what’s going right?
Aside from the Great Depression, every other recession since that time, the banks, insurers, etc., may have had a large subset under stress, but not to this degree.? Our economy is credit-based, and the amount of credit is a record multiple of GDP.? That credit in the past greased the gears of non-financial companies.? The troubles in financials is affecting the whole economy.? There will be a sustained decline in demand, because much of the prior demand relied on the ability to borrow.
I have long felt that this is no “crisis of confidence” as many in the government will say.? Rather, it is a realization that when one marks many positions to their market clearing levels (at a lower degree of leverage for the financial system as a whole), that many financial institutions are insolvent.? The government can try to reflate the bubble but it is too small to do so.? Reflating bubbles is not generally achievable, anyway, because the negative dynamics around the old deflating bubble preclude it.? Typically we blow a new bubble instead.
Now, I try not to be controversial.? I don’t like trotting out words like Depression or Stagflation for their shock value.? I bring them out when I think they can be useful in clarifying the situation at hand.? I am not a doom-and-gloomer? by nature.? I would much rather be running my “long only” equity portfolio during a bull market.? Relative performance, at which I have done well, is nice, but nothing beats absolute performance.
Ask yourself, though.? If you were at the start of a new depression, what would it look like?? My list yesterday is an example of what I think it would look like.? Given the freeze-up in lending where the government has not intervened, such as A2/P2 commercial paper and corporate bonds, this is a situation where problems in financials are spilling over to nonfinancials.
Now, as for what is going right, I invite readers to offer their ideas.? Please comment.? I will offer four:
- Residential mortgage rates are declining a little (though rates are above the levels when Bernanke and Paulson introduced their “scare tactics.”)
- The dollar is performing well.
- The US government can borrow at amazing rates. (That no one else can touch, unless you are a long term swap counterparty…)
- Commodity prices are falling, hard.
These are all consistent with a depression scenario.? Demand for safety, and lack of global demand for the basics.? That said, it is a lot more pleasant filling up my tank.
In closing, as some of my older friends who have passed on once said to me, “If the locusts eat your crop, at least you don’t have to harvest.”? This is true, but cold comfort.? I would be happier with the economy that I argued was unsustainable for so long.
PS — As an aside, the government, by protecting some sectors of lending, has intensified the crisis in theareas it did not protect.? The rally in nominal Treasuries is a grab for safety at any price.? The crash in corporate bonds is the opposite.? Money runs (so to speak) from unprotected to protected sectors in a crisis, and so, the government helps create crises, and diminishes liquidity by protecting some favored sectors of fixed income.
That said, you can see the effects of the carnage in the shares of life insurers, which are the biggest providers of long-term credit. (ouch with tears)
I wonder if you can provide a bit more color on to whom “the biggest providers of long term credit” lend? Im trying to get my head around knock-on effects.
Thank you
PS: I support your focus completely.
You have been spot on in your broader themed analysis.
I note that and appreciate it. You are one of the few.
David, a lot of your recent articles seem to focus on comparison of historical ratios of debt to GDP. Can you point me to the description of exactly how you figured the components of this ratio, currently and historically?
If the computation was based on U.S. listed credit instruments and U.S. GDP, then I’m wondering about whether the historical comparison is apples to apples with respect to a) monthly payment schedule and b) matching degree of internationalization (i.e. if the credit markets include much more debt from business conducted all over the world then the relevant GDP should be a weighted sum of additional countries).
How about a computer screen tour of Hartford? Seriously.
From a quantitative perspective, you make quite a respectable argument.
With that said, as a money manager myself, is it not prudent to rely less on quantitative methods in an environment that demands more of a qualitative perspective?
Your justifiable use of the word “panic” acknowledges an environment of extreme and irrational behavior. What quantitative method has successfully measured (and consequently made an accurate decision in the face of) extreme emotion?
Sometimes it is prudent to “go beyond the numbers.”
While I disagree with your position, I applaud your courage and seemingly tireless efforts here…
“A likely impossiblity is always preferable to an unconvincing possibility.” ~ Aristotle
I still agree with david. If someone can show me how we are going to get out of this debt trap without a depression or a multi year recession on gov’t life support which is followed by inflation… I am willing to listen. No one can show the way because it does not exist.
The question I have for anyone is which would you prefer?
A) A nasty depression/deflation that inflicts pain among all lasting 2-3 years followed by recovery OR
B) A 5-10yr recession with raging inflation until the gov’t can no longer borrow. At this point interest rates are choking the economy, Taxes are at extremes, public services are degraded, Medicare & SS are impaired. 6-7yrs later our debt to gdp ratio is still at a high 250% but it is because of the denominator. We muddle through this environment for 5-6 more years as interest rates ease downward. When the 10yr Treasury finally drops to 7% we get the 1st quarter of gdp growth and we continue to grow but slowly. A few years of this as debt to gdp gets below 125%, savings are at 15%, the country is still in a general malaise. AND THEN, the “text message” generation gets a huge tax cut and real growth begins and we start all over. Its 2024
It looks to me that the gov’t is attempting scenario B, but I think they will get scenario A.
Scenario A is ugly but shorter, It may have a bout of h-inflation or a tech default on treasuries. If we avoid war it will be short lived and we will grow nicely out of it with exports leading the way.
Pick your poison
Your blog is my favorite. Accurate, insightful and honest. Thanks much! Sounds like I’m buttering up, but just giving you some honest feedback.
Can you share some insight relative to the guarantees that insurance companies have provided in variable annuity contracts and the related risk to the market. Don’t contracts with such guarantees have maximum withdrawals per year in the 10% range, and thus any withdrawal risk on the market minimized?
Or on a larger note, what systemic risks of significance do feel that variable annuities have on the market (eg mass withdrawals due to fear of insurance company solvancy).
As always, David is one of the best writers in cyberspace.
One small point of disagreement: As Todd Harrison has continually pointed out, the stronger dollar is not a positive sign [unless you are travelling to Europe] Note that the crash of the last 4 months has coincided with the dollar rally–it is not a coincidence.
The problem is of course that a weaker dollar poses all kinds of other risks and will be a sign of the inflation scenario coming to fruition.
Such is the Scylla and Charybdis situation we are in.
Very good post David,
For your comfort even Argentina got out of their depression with capital moving out of the country fast, the peso collapsing, business with debts in foreign currencies, the government deep in debt too and runs on the banks. The GDP collapsed but it growth jumped after two years. The same with Mexico 1994, Chile 1982, and several other cases.
You will get out of this fast, but the actions needed are counterintuitive to libertarians. Some of them may even seem reckless.
The USA government can borrow at incredible rates, we foreigners do not have many alternatives to the dollar (yet), helicopter Ben is willing to use unorthodox policies, and a new president with a supporting Congress and political capital will act (you need that infraestructure bill).
And please capitalize the financial institutions and renegotiate lower those mortgages. Recognize the hidden liability fast!
And AIZ was the only financial stock I had snif 🙂
Ultimately, we know nothing with certainty, and even the most improbable scenario can be defended intelligently.
What is most interesting is to observe the intensity at which people continue the attempt to pursue and define something that is not knowable — the future…
“The difference between what the most and least learned people know is inexpressibly trivial in relation to that which is unknown.” ~ Albert Einstein
David, Tim Geithner is a fellow Hopkins SAIS econ guy. What’s your thoughts on him? – Mark
BKM: “””””I still agree with david. If someone can show me how we are going to get out of this debt trap without a depression or a multi year recession on gov?t life support which is followed by inflation? I am willing to listen. No one can show the way because it does not exist.
The question I have for anyone is which would you prefer?
A) A nasty depression/deflation that inflicts pain among all lasting 2-3 years followed by recovery OR
B) A 5-10yr recession with raging inflation until the gov?t can no longer borrow.
“””””
I see inconsistencies in you B scenario. Even if you go with the depression scenario–I don’t buy it but then again I was one who thought Ambac was a good investmetn ;)–it will be a deflationary bust. That’s what the market is saying and that’s what nearly all of the depression proponents say as well. You are not going to face inflation under such a scenario. Inflation is the last thing that will occur and debt/cash will be king. If anything, it will be easier for the US government to issue debt (since everyone else will be going bankrupt.) Just look at Japan. Japan has gross debt equalling around 200% of GDP and investors are still willing to buy its debt–at very low rates as well. Your B scenario is similar to Japan.
Anyway to answer your question, well, I personally am only saying that we are not going to face a depression (I roughly define depression as all sectors of the economy contracting–this is consistent with GDP falling, say, 10%+.) I personally am not arguing we won’t face a somewhat severe recession. I think everyone is saying we are in a recession and very few (outside politics) will ever claim that you can prevent it. What people like me support are mitigating the downside and preventing a depression. Avoiding a recession is impossible.
With the US printing money at record pace, how does inflation not occur at some point after the banks stop hording the money? Won’t there eventually be too much money chasing too few goods? During the US depression the gov’t severely restricted the money supply causing deflation, but won’t the current opposite gov’t action create a different result?
Right, no one knows the future. However as a Trader, I gather information and develope scenerios based on macro events. I don’t use economic models because if I did, I would be broke. Right now I think we are going to have a depression. Is it going to be like 1870’s, 1930’s, or Japan. The answer is no. Nobody knows what this depression is going to be like. Anyone that thinks they do is a fool. A person like myself can anticipate, but that is about all.
The scenerios I threw out above are very backof thenapkin and I would not bet a nickel on either coming to past as presented.
The problems facing the global economy are well documented. For the life of me, I can’t conjure up a scenerio that does not avoid a long deep rolling period of recessions or a depression.
SV,
Sure we can have inflation. If the Fed monetizes more than has been destroyed we will have inflation. The real question is what will foriegn treasury buyers do?
I think we can say the financial sector is trashed and a nasty recession is baked in.
Precursors of a depression:
1) a determined effort to spend as much as necessary to prevent lenders to financial institutions from incurring losses
2) a collapse of international trade and a shift to autarky
What is going right:
1) forex exposure is currently held by foreigners
2) US policy has been so bad for so long it’s hard to get much worse and is likely to get better. For example, if international trade does collapse, US manufacturers will actually benefit somewhat.