Readers have recently asked for my take on the US Treasury markets. Without a question, that is the hot topic issue of the last few weeks, and inquiring minds are wondering how it "fits" within the larger trend of debt deflation.
I had been a treasury bull for years while many were saying they were worthless trash. In my Themes for 2009 series, I turned cautious:
One area I have my eye on is the US Treasury market. I have been bullish on treasuries for a couple years now. The move over the last few weeks has been stunning. The US Fed has announced that they may start buying these securities as part of their Quantitative Easing programs. Are treasury traders and investors using the same logic as they were for oil in July? Are they using the Fed's intervention threat as justification for believing “prices can't go down?” Just the same as we were hearing “oil can't go down because of peak oil.” Will we all look back at the seemingly bizarre recent occurrence of the US Dollar falling/Treasuries rising as a very obvious hint of irrational exuberance?
I did not have the mettle to short treasuries from those levels, but I am thankful to have recognized the parabolic rise as unsustainable and happily moved out of the way. Now that the market appears to have collapsed despite the Fed's intervention to keep rates low, treasury bears are having their turn in the sun. But most likely not for the reasons they suggest.
It is true that rising interest rates are indicative of increasing inflation expectations. But there are other reasons interest rates rise. They can also rise due to shifting time preferences of investors. If people decide they want higher returns on their capital, they will shift their money to riskier assets in order to try to benefit. In an age where millions of baby boomers and pension funds are realizing they don't have nearly as much as they thought they would, this is a very real potential catalyst. Chasing high returns to make up for previous losses always ends up in tears, but that has never stopped investment managers from doing it over and over again. There is another major reason for interest rates to rise. That is risk of default. And it is a possibility that many have likely not given as much attention to as they should.
With the Fed "printing money" (ie. making credit available) like there is no tomorrow and the treasury spending in kind, inflation seems like a pretty safe bet. But keep in mind that Hoover tried the same thing in '30/'31, and was met with nothing. Ironically, the government's increasing deficits were what had foreign investors so concerned, because they felt the US would not be able to repay their obligations in gold. The Fed subsequently raised interest rates to stem the outflow of redemptions, which eventually killed the economy dead. That increase in interest rates is what Bernanke contends (remember, he is an "expert" on the depression) was the leading cause of the Great Depression.
Foreign concern about a default on gold obligations turned out to be justified. Roosevelt effectively defaulted in '33 when he confiscated all private holdings of gold and devalued it by half. I find it surprising that so many feel such a similar outcome is unlikely to repeat itself. Especially considering that a large percentage of outstanding treasuries are held by foreigners that aren't exactly "friendly." Default could be strategically beneficial. Especially if it were done soon and a majority of it could be blamed on Bush - something Obama has displayed he is fond of doing.
A default would not have to be absolute. Most sovereign defaults are not. They typically just restructure their debt. I can see a situation where the Obama Administration unilaterally decides which holders of which debt are repaid on what terms. He has already demonstrated the will to interfere in contract law in the meddling with Chrysler and GM bankruptcies. If he thinks it fair to stiff the Chinese and other creditors he deems as disposable (hedge funds, for example) in order to free up the funds to provide his dream of socialized medicine, he'll do it. There are no rules in Washington. The messiah will do whatever he wants. And if anyone objects, he can merely defend himself by countering that "Bush did it and the Republicans didn't say anything then."
But the major reason that I do not see the recent drop in treasuries as a signal of future inflation is that there has been little to no follow-through from corporate debt. If the inflation concerns were real, we should be seeing commensurate declines in investment grade corporate bonds and the high yield variety. Investors flee all bond markets when they get a whiff of inflation because they know their purchasing power will be destroyed. There has been no flight from the corporate bond markets.
High Yield Corporate Bond Index
Investment Grade Corporate Bond Index
I don't want to turn this post into another long-winded diatribe on inflation/deflation, but I have heard quite a few suggest that a Treasury default would be hyperinflationary. I suppose it would for holders of the treasuries that were defaulted on. But for anyone else, it would have a deflationary impact. The reason is simple. Less credit in the system means a drop in the existing supply of money and credit.
How does a dollar hold its value if the treasury defaults, when the Fed's main balance sheet component (what gives the dollar value) is treasuries? Simple. The Administration simply orders the Fed's Treasury liabilities to be guaranteed while others are not. After the first 4 months of lawlessness in the Obama administration, does anyone believe he would not do this?
That said, I would not be inclined to bet against the inflation trade as of yet. Interest rates could still rise substantially before Geithner (or his replacement) decides that default is the only real option. Then again, there is a good argument to be made that the current rise in interest rates is simply volatility that has shifted from the stock market to the government and mortgage debt markets. Tyler Durden at Zero Hedge has also been meticulously following the massive short squeeze going on in the junk bond markets comparative to treasuries. Is this all nothing more than the big banks getting money from the taxpayer and using it to bail themselves out by betting against quant hedge funds that had been massively short anything risky? These are questions one needs to ask oneself if they were betting on a looming hyperinflation after the last few weeks of rising rates. Econompic Data has some good illustrations of the above points:
First are the year to date performance of various credit instruments. Anyone long treasuries and short junk has been effectively destroyed.
Next is the year over year spread between treasuries and junk over the last 25 years. "An unprecedented selloff is now an unprecedented rebound," writes Econompic.
I would also point out that with treasury yields spiking, mortgage rates have also risen rapidly. Some brokerages were reporting the costs of fixed rate mortgages rose .75 bps in only two days this week. That is a big difference for someone with a $300,000 mortgage and will certainly not help in preventing foreclosures. The amount of homes entering foreclosure and the number of Americans underwater on their mortgages was already accelerating before the recent events. Surely, if high rates persist, another stunning drop in home prices could result in further economic deleveraging - this time with commercial real estate providing wind at its back. All of this is deflationary and all of this is without mentioning the social and generational trends that suggest deflation is inevitable.
In summary, there seems to be quite a bit of confusion as to what the recent spike in rates means for the overall economic outlook. I don't pretend to know exactly what will transpire. But from what I can see, the risk of a stealth default is being drastically underestimated and its impact is being perceived as more inflationary than a closer look would otherwise suggest.
I anticipate this to be a matter of continuing interest...
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10 comments:
Hi Matt,
Thanks for the treasury default article. That snip of historical record is very nicely put. There are many other points you put very nicely... it greatly helps in giving me more perspective of what all of the recent actions mean.
I'm a bit confused by the & connections & comparisons you made between the treasuries & the corporate bonds to determine in/de-flation threats. The argument is that (sounds to me, at least) corporate bond yields did not deteriorate (rates stay relatively low), so there is little inflationary threats.
However, those corporate bond indices (both high yield & investment grade) deteriorated during the severe deflationary pressures last year.
It sounded like
"corporate bond yields do not increase (stay low), so there is little inflationary threat" but on the other hand "corporate bond yields rose to unprecedented levels because severe deflationary threats".
I guess you catch my confusion there (every argument leads to deflation -- whether corporate bond yields rise or fall)? So, from those bond yields, what do we need to see to lead to the conclusion "OK, it's a big inflationary threat"? Will it be that all yields rise quickly?
Another confusion is... in the case of partial treasury default (like one scenario you mentioned -- treasuries held by China & hedge funds defaulted, while the ones at the Fed is intact), for the dollar itself, I think there will be 2 major forces fighting:
1. lose in faith of the dollar (hugely inflationary)
2. a massive debt default event (enormously deflationary)
There must be a winner of the 2 and most likely force 2 is going to win. Do you agree with this view?
Hope you can elaborate on these issues. Thanks a lot.
The two possible reasons you gave for the collapse in treasuries were increased risk appetite (for other kinds of investments) and/or increased expectation of federal default.
But don't these two work against each other? Don't Treasuries become a riskier, higher-yielding asset as expectation of default increases? If expectation of default were really a driver, wouldn't Treasury holders have to have steady or shrinking risk appetite?
Beyond that, though, isn't there a third, even more obvious reason treasuries are falling? Namely, the enormous growth in the supply of them plus future expectations thereof.
It could be there's no change at all in risk appetite or expectations of default. But with a glut of supply, prices must fall.
Hi matt, thanks for your piece. I'm interested in your take on if default was a key reason for the bond sell off why do you think US sovereign CDS did not move materially and remains amongst the very tightest in the world. Regards Fredrik.
Matt
I agree with almost everything you have said except trying to score points againts the current administration.
The economy is a patient which has gorged itself and behaved in a completely irresponsible manner for twenty years.
The last 8 years the economy had a doctor (Bush) who did not have a proper medical degree and nearly killed the patient. The patient has been handed in a near dead state to the new physician (Obama), he has every right to blame Bush and hold in contempt the excesses of the past, and I dont think you have a right to criticise him, unless you clearly state what you would have done differently.
I think the handling of the Chrysler and the GM (tomorrow 6am) BK were done almost flawlessly. The proof = the market rallying and junk bonds steady despite these unthinkable events.
They were both basically Bk several years ago, Obama was just taking out the garbage.
Roger,
Yes, in order for rising yields to be hyperinflationary, we would need to see all yields rising at the same time. But how do we know that rising yields are not just fears of default, which is deflationary? We would need to look at the prices of other assets like real estate, equities, commodities and art. Another prerequisite for long-term inflation is rising wage pressures. Having only some of those conditions met (and there are many others that are less quantitative) is insufficient to claim inflation as the devil we are facing. There is no one magic indicator that tells us what to do - sorry.
Matt H - re: supply/demand,
I'm skeptical how much weight this has on near-term prices. Obviously over the long-term it has a major impact. However, the Bush Admin spent like drunken sailors over the last 4 years, yet yields fell. Additionally, this increase in supply has been known about for a long time. So why do we get the reaction now? Isn't the market a "forward discounting mechanism?"
Fredrik,
Good question. The CDS market, however, is pretty small (relatively) and easily manipulated. That's the only hole I can think of to poke in that argument.
Fish10,
I have stated numerous times how the Obama Admin could have done things better. For starters, they could have gotten out of the way and let the market work in accordance with the US constitution. I am biased against ALL politicians because I dislike politics and government in general.
Amen on Obama. This mess has very little to do with Bush. That is where the OBamaites have it wrong. It has to do with FNMA and Franklin Raines as much as anyone along with the Democratic Black Caucus. But, the whole thing has its roots in Bretton Woods, which was pretty much an agreement that the US prop up the rest of the world financially with the idea we could continually not balance our trade and keep the dollar on gold. The game has been in end game for close to 40 years now.
It seems to go through air what Obama says. His comments about the deficit being cut in half by the end of his term is absurd. Half is twice what the previous record was. The Reagan deficits had much of their roots in massive interest rates being paid on bonds and money market instruments. Not this one, which has its roots in runaway government spending. When America sees the tax bill and a deficit still in the trillion dollar range, they will realize they have been had. I am in Matts camp that I only dislike the Democrats and their socialist ideas more than the Republicans.
I just finished a paper on John Law and the Mississippi Bubble called "Early Speculative Bubbles and Increases in the Supply of Money" by Douglas Edward French. You can find it on scribd.com if you like to read it. In it, I find an amazing parallel of what John Law did to rescue his bubble with what Bernanke is doing now. The bank today is basically the government and Laws bank was basically the Mississippi company. He was using the Mississippi company to prop up the Mississippi company, along with the government fiat of confiscating gold and silver to force the use of his money. This sound like Roosevelt and Johnson. In any case, his actions sound much like the actions of Bernanke.
I believe the money put out by the Fed, just like the money put out in China has gone into speculation. The bond lost because of a variety of reasons, but the primary one is the speculation. At 2%, a 10 year treasury could only increase less than 20% if rates went to zero. Plus, investment grade bonds didn't go down or stay the same, the spreads only narrowed, which indicates the game had reflated is all. When the treasury was 2%, mortgages were higher than they were in 2003 when the treasury was 3.5%.
I do believe there is an inflation premium. But, I also believe there is not a possible default in the classic sense. Bretton Woods put the world on the dollar standard. Maybe I am mistaken, but I don't believe any other major currency has much of a standing on its own absent the dollar and the US treasury. Matt hit it partially on the head. Government debt doesn't get paid off under fractional reserve banking and anyone who believes that it does is delusional. That not only includes US debt, but all the debt. The only thing I can believe that debt of governments is held for is to draw interest forever. Remember, tbey got even on the US for the low rates going into the 1970's with the high rates of the 1980's. 3.5% is still pretty low. Also, Bernankes idea of qualitative easing might work on a saving economy, but I think it would be viewed as highly inflationary on a consumer economy.
In closing, the real rub comes when the rubber hits the road. Somehow the bulls on CNBC believe the US consumer can go on forever. In light of the recent credit card bill and the collapse of lower end consumer credit, can we really expect the consumption boom to come back. I believe what we are seeing now is the response to inventories being drawn down to a new reality and production picking up from there. We haven't seen the real impact of lower consumption in the economy yet. It isn't out of the question though that OPEC and others might just refuse to sell for dollars if the status quo goes on.
To be clear, I don't support either of the major US parties. In my opinion, they are both the same. To the extent that I support individual members of either party, I typically support Republicans. And those would be the growing minority that consider themselves part of the "liberty movement" (ex. Ron Paul).
Good comment manff.
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