Blogs Cover Possibility of Higher Rates

Posted by urbandigs

Sun Nov 2nd, 2008 09:20 AM

A: Readers of UD know by now my thoughts on the long end of the treasury curve; my expectations for a multi-year rise of longer term yields. In the past few days, some very prominent bloggers have been discussing this 'endgame' side effect in detail. Since this in my view will likely be the 5th or 6th chapter of the general slowdown (that is, rising borrowing costs), it is very important to both discuss and prepare for.

DISCLOSURE: I own shares of Ultra-Short Treasury ETF's (TBT, PST) as a medium to longer term hold. Nothing discussed here is investment advice. As always, talk to your financial planner before making any speculative equity investments and understand the risks involved and your tolerance for losses.

Lets get right to it. First, I have argued that the 25+ year secular bull market in Treasuries may be nearing an end, topped out with a massive supply of treasury issuance upcoming to fund the rescues and bailouts stemming from the credit crisis. For a visual, take a look at what 10-YR Treasury Yields have done since 1981, with a peak yield of 15.84%:

*NOTE: As bond prices rise, yields fall and vice versa. Therefore, when looking at this 27 year chart dating back to 1981, the downward move in yields brought with it a rise in the price of the bond; a secular bull market in treasuries.

We are at now now. Calculated risk discusses how the US slowdown may affect demand for Chinese exports. China holds a large amount of US treasuries, in essence, funding our debt. If our friendly funders, for whatever reason, decide not to be friendly anymore a situation may arise where purchases of our treasuries slow, stop, or worst of all, reverse and holdings are sold. CR discusses the possible impact of Contracting Manufacturing in China:

vicious.jpgAs China tries to stimulate their economy, this could have an adverse impact on U.S. interest rates. Let me explain ...There is a strong correlation between increases in mortgage debt and increases in the trade deficit. GDP in the U.S. is now contracting, and imports are falling and the trade deficit is shrinking. And as foreign CB invest less in dollar denominated assets (and also try to stimulate their domestic economies) this could lead to higher interest rates for intermediate and long term U.S. assets. As I noted in 2005, the result could be a vicious cycle with higher intermediate and long term rates further depressing the U.S. housing market and consumption.
The premise is simple. China is eager to fund our debt, buy our treasuries, and continue exporting their goods to us as long as our economy is thriving. As our housing market busted, our mortgage equity withdrawal faded and our consumption slowed, we import less from China and others. This lowers the trade deficit but more importantly, also lowers the attraction of our treasuries by these outside monsters. Less foreign investment in our treasuries at a time when supply is about to go through the roof, could lead to the end of artificially low yields, especially at the longer end of the curve where the fed has little influence. CR shows a visual of this vicious cycle above.

The second blogger discussing this 'endgame' is Paul Amery of in his piece "The Credit Crisis Endgame" published Friday:
It looks increasingly likely that the endgame in the credit crisis will be a bloody standoff between investors and governments. Their battlefield will be the market for government bonds, where countries all around the world finance their deficits.

On the surface nothing remarkable is happening – the 30 year US Treasury bond yield recently hit an all-time low of 3.88%, as investors sought a safe haven during equity market turbulence. Yet while nominal bond yields have declined, the credit risk component of US Treasuries has been on an increasing trend since last year. According to data provided by CMA DataVision, the credit specialists, the 10-year credit default swap spread – a form of insurance contract against issuer default – has risen steadily - from 1.6 basis points (0.016%) in July 2007, to 16 basis points in March 2008, to 30 basis points in September, to over 40 basis points on October 27 – see the chart below for the spread history so far this year. In other words the cost of insuring against a US government default has risen by 25 times in little over a year. Similar trends have been evident in the UK and German government bond markets.

In both the US and UK, budget deficits are poised to explode, for a number of reasons. The recession is hitting tax revenues, while government entitlement programmes should soar in cost. Then there is the steadily increasing bill for the wars being fought in Iraq and Afghanistan. But the really big impact is coming from the rescue packages being thrown at the financial sector. Signs of strain in the US Treasury market are already there, despite the current low yields. Recent auctions have shown poor bid-to-cover ratios, and long tails (the difference between the average accepted yield, and highest yield), both signs of shallow demand. Delivery failures in the secondary market have also hit record levels, a sign of poor liquidity. Market observers should keep a close eye on the progress of future auctions, particularly as the issuance schedule picks up.
While a default by our government is highly unlikely and would be the equivalent of Financial Armageddon, we do not need it to happen to see higher yields in treasuries. All that needs to occur is a loss of confidence by the markets of the US's ability to rollover and repay these debts at attractive levels. Remember, the yield that is paid at the long end is driven by the market players, NOT central banks! So, this yield is exposed to market forces and the yield tied to longer term treasuries is what the market is willing to buy them for. If demand slows, the yield will have to rise to make it more attractive!

I'm a contrarian investor, and I like to sell near tops and buy near bottoms. Right now, the treasury market seems to have some forces against it that could lead to higher rates for all of us. Forces include:

a) a 27 year secular bull market
b) massive upcoming issuance (supply) to fund the rescue of our financial system
c) markets questioning credit worthiness of US resulting from this crisis and actions taken; rising CDS premium on 10YR treasuries as an example
d) effect of US slowdown on China and other exporting countries that hold massive amounts of our treasuries and have been funding our debts
e) flood of interest into treasuries over the past year as a safe haven driving yields to ultra low levels; when market turns, reversal could be dramatic
f) introduction of Ultra-Short Treasury ETFs; hmmmmmm....

Feel free to offer further market forces I may have missed, or chime in on your thoughts about this very important topic. Always look ahead, invest wisely by knowing when to sell and when to nibble, and prepare yourself for multiple scenarios that may lie in front of us!