Cross Currents For US TBonds and Interest Rates
Interest-Rates / US Interest Rates Mar 29, 2007 - 08:13 PM GMTBy: Jim_Willie_CB
Volatility for US Treasury Bonds has risen markedly in the last several months. A rise in such bond yields creates a favorable background for gold prices. A fall in such bond yields leads to strong competition for gold as safe haven, in a manner which actually supports the USDollar.
Gold takes great advantage of rising bond yields. Cross currents point to both higher yields and lower yields, thus more volatility. Uncertainty abounds.
Numerous factors have contributed to this increase in volatility. From summer 2004 to winter 2006, the US government bond market had been sleepy at best, and comatose at worst. Much changed in 2006, possibly in response to Hurricanes Katrina and Rita, but also a rise in MidEast tensions with the US Military unable to follow the Shock & Awe with much more than civil war and instability in the Persian Gulf region.
Now the TNX chart shows the early signs of a W-shaped reversal pattern, which could take long-term interest rates up toward 5.0%, unless the domestic spread trade unravels further. That domestic unravel in my opinion is the predominant factor in recent weeks. The many bond factors act as cross currents for USTBonds. Some factors are bullish, others being bearish. Some are more important now, but just a few months ago, they were critical.
UNWIND OF DOMESTIC BOND SPREADS (bullish for bonds)
As US-based bond spreads unwind, USTBonds are bought back. The typical trade has been to grab the higher yield from a mortgage bond, and sell short the USTreasury. If not the higher yielding mortgage bond, then the object has been the corporate bond. For high risk appetites, the object has been the junk bond for companies with troublesome past histories. As these domestic bond spreads fail, lose money, and are liquidated, as seen in the past few weeks, the USTreasury is bought back just like a short covering of a stock. At that same time, the object bonds lose value and rise in yield, as they should in an environment of poor credit conditions. During the entire duration that the spread trade has been on the books, the trader has been long a high yield bond and short the USTBond. The unwind produces demand for USTBonds, thus a bond rally, a rise in principal value, and a falling bond yield.
Note how the TNX fell (10-yr TNote yield) in the second half of 2006, when massive liquidation of energy contracts took place. Many of these speculative trades might have also contained an anchor in the USTreasury, and object in crude oil or natural gas contracts. Their heavy liquidation encouraged a bond rally. Furthermore, this effect was also seen in summer 2005, when General Motors bonds cratered in value. The spread trade for GM bonds over USTBonds also unwound, leading to a USTBond rally of unexpected nature. Even worse, many offset trades were set up to GM credit default swaps, also anchored in USTBonds. When those unwound, with huge profit on their bond insurance premiums, they added to the force of the USTBond rally.
US ECONOMIC RECESSION (bullish for bonds)
As the economy falls apart slowly, which it is, despite all manner of cheerleading, deception, and falsified statistics, the market sees corporate profits on the wane and prospects for recession gathering force. As the housing market implodes further, consumers will retrench, unable to tap their primary source of funds, namely their home equity. As the mortgage sector implodes further, banks will retrench, tighten lending standards, and worsen their own problem. Refinanced mortgages stuck in a troubled state are not easily rescued. A score of related industries suffer from job loss, extending from home construction & supply, to lending institution and loan approval (inspection, title search). The onset of recession leads to bond rallies. Some might make meaningful arguments that this Roman Empire is decaying from within, extended abroad, and likely to break down on the home front much more readily than from any over-reach in foreign lands.
COST INFLATION EPISODE (bullish for bonds)
Despite the claims, even made within the gold community, the rise of price inflation has been primarily on the cost side. My label is “cost inflation” since it is hardly systemic in nature. As long as the Chinese are competing with manufactured goods in the global village, and the Indians are competing with services in the global village, a severe price ceiling is imposed and enforced. The squeeze remains on profit margins, thus the pressure to outsource functions with associated jobs. The end result is that capital moves abroad, jobs move overseas, businesses adapt and/or suffer, and the aggregate USEconomy shrinks. In fact, a good argument can be made that the USEconomy has been undergoing a perverse liquidation for five years. Its chief trait is job outsourcing and business investment in Asia . The end result is a greater attractiveness for bonds, since the economic pool is in reduction, with fewer fish, less nutrients, and more brackish waters.
UNWIND OF GLOBAL CARRY TRADES (bearish for bonds)
Also a bond spread, this is the exact opposite of the domestic spread cited above. The Japanese easy money has been the provider of the cheap borrowed money. The trader will short the 0% Japanese Govt Bond, or borrow at near 0% interest rates, then grab the higher yield from the USTreasury. That yield has been in the 4.5% to 5.2% neighborhood for a long time. Also sources of cheap money have been the Swiss franc, whose official interest rate is now at 1.75%, having lifted in recent months. In fact, the Swiss have managed to keep pace with the Euro Central Bank official rate, in such a way as to maintain the bond yield differential. That keeps their carry trade intact, under certain setups. As the global carry trade unwinds, the object USTBond is sold, the opposite from above in the domestic spread. Both the USTBond and the USDollar lose value typically. The buy back here is for the borrowed source, like the Japanese yen or Swiss franc, which consequently rise in valuation. The unwind produces sellers of bond, thus a decline in bond value, and rising bond yield.
SYSTEMIC PRICE INFLATION (bearish for bonds)
If employment costs and wages do indeed continue to rise, this will require bonds to reflect the inherent erosion. If end product prices do indeed continue to rise, this will add pressure for bonds to reflect that same erosion. The rise in final product and final service prices has been more tame than with commodities, materials, supplies, and food. Thus, both businesses and households have been pressured in the continued nightmare called the Middle Class Squeeze. If systemic price inflation shows its nasty teeth more than in the last few years, that would be highly destructive for bonds, higher beneficial to gold, and a true return to the conditions seen in the 1970 decade. So far, very little evidence can be cited for parallels to that past decade, despite pronouncements. See how long-term rates have stayed low in the last few years, the exact opposite of the 1970 decade. That could change, and thus deliver a powerful blow to hurt bonds, lift interest rates, and encourage investors to hedge against price inflation.
CHINESE TRADE WAR (bearish for bonds)
Much can change, and change quickly, if a trade war with China erupts. That has been my call for three years running, an open ratcheted inevitable and destructive trade war. Such a war would inhibit the flow of traded finished products, even provided services, in a manner to cut down supply. The end result is higher domestic prices, higher price inflation. Bonds would reflect it. Politicians are anxious to seize upon voter angst over lost or insecure jobs. Protecting them would involve higher final product prices and higher wages. Worse still, the war would induce China to take punitive action and retribution and retaliation by selling USTBonds.
They hoard $1000 billion in USTreasurys , US mortgage bonds, US corporate bonds, and more (like in euro-based securities, and sterling-based securities). Nothing good would come to USTBonds in such a climate of trade war, where tariffs are imposed, protective sanctions are put in place, dock worker strikes are ordered, consumer boycotts are enacted. Tit for tat would become the order of the day, and both sides lose out. My view has been that this trade with China since 2001 has been one-sided to be sure. The US loses jobs, loses its investment base, hemorrhages its capital, suffers decline, while China gains jobs, builds its investment base, collects capital, and enjoys expansion. Any economist who finds this trade with China as mutually beneficial is compromised at best (from paycheck & employer influence) and incompetent at worst (poor analysis, inept thought process).
LONG-TERM VIEW
The ten year chart for the 10-year USTreasury Note looks as though the lower rail has been touched. We are at a critical juncture. The stochastix cycle shown in the lower portion of the chart indicates that rates have a potential for a decline. Chartists call it a possible stochastix crossover, indicative of an upcoming decline. That fall would be of the bond yield. So we have a bullish USTBond signal here, but in a state of flux since at the trendline.
GEOPOLITIC RISK (???)
Here are the wild cards. Many have incorrectly, in my view, regarded the recent USTBond rally in March as a flight to safety, a flight to quality, or some such careless description. The US Federal budget deficit will hit the next $Trillion limit soon, despite lies about a shrinking deficit. The current account deficit has stabilized at a level easily described as a lethal hemorrhage. The trade gap has come down a bit, only from reduced imports which manifest a slower USEconomy. When the US bank system, 40% of whose assets are tied to mortgages, suffers from the ongoing growing cancer, the US financial system can hardly be deemed loaded with safety. With mortgages in default and foreclosing in rapid fashion, the US home front look like an archipelago of cancer wards. Then the US Military is busy in foreign lands, in the view of some instigating conflict or having great difficulty quelling it, but whose activities make few friends or influence people positively.
The entire world sees the US as possessing an unrivaled military power, but also an unrivaled financial vulnerability. Forget for the moment that the weakness is from chronic monetary inflation, federal deficits, a lost manufacturing base, emphasis on consumption, and a heavy tilt toward unproductive military spending. Instead, focus upon the potential for retaliation by enemies to the United States on its financial flank, the great Achilles Heel. Selling oil in euros or rubles has become increasingly fashionable.
Even Norway sells Brent Crude in euro transactions. Perhaps the Iraqi War was in part motivated to stem the sale of oil by Saddam Hussein in euro terms. Could the Iranian practice of selling oil in euros hasten a military attack? Possibly. One can conclude that geopolitical backlash against the US might come in the form of selling down the USDollar. Its flip side is embodied within the financial markets in the form of USTreasurys. This is probably a net negative for USTBonds, eventually overwhelming any safety or quality perceived.
WILD CARD – MORTGAGE BOND LAUNDRY (???)
Lastly, with no proof, only deep suspicion, my contention is that Goldman Sachs and the Dept of Treasury have for over two years been engaged in laundering Fannie Mae and Freddie Mac corporate bonds. Bear in mind, they do so for the greater good, but that benefit might contain far more lucrative payola for Wall Street firms than payoff for the public at large. When the dust clears, if it ever clears, expect more rescues of big New York City banks and big Wall Street firms, and some tokenism for the US public and its homeowners. The inner workers of fat Freddie and fatter Fannie might never come to light. After two years of sequestered accountants and hidden examination of a nightmarish set of balance sheets, we still know precious little about F&F fat, grease, and lard. Suspect the worst and you are likely closer to reality. While laundering might miraculously transform F&F bonds into stable USTBonds, (precisely what Alan Greenspan once wished publicly), it is unknown what such an illicit practice might do to the credit markets. For one thing, it might undermine confidence in the USTreasury complex and the USDollar itself. That aint bond bullish, since the true nature of USTreasurys might be closer to Third World debt.
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