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Blogs Cover Possibility of Higher Rates

Posted by Noah Rosenblatt on November 2, 2008 at 9.20 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:

As 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 PrudentBear.com 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!

Comments (16)

Interesting point. On Friday I sold all of my shares of V and FDX due to the ridiculous run-up since I bought them. I am becoming more and more concerned about the equity market the more I think about things. If this next week brings more run-ups in the Dow, I will sell all of my equities for about a 15%-20% profit for about 4 weeks of investing, depending on when I sell. If things go down, I will continue to hold, but I will be waiting to see if the market hits around 8200 again before I begin buying again.
The bottom line is, an Obama presidency is going to have a very negative impact on equities, and with his tac plan and spending plan, he could easily send us into a prolonged and deep recession, far deeper and longer than the one we are surely in for. I am happy to be a buyer between 7500-8200, and even higher if the vix were lower, and wait to receive my return, but when I see things go up to 9300 for no good reason excpet for panic buying, I don't like the fundamentals any more. What say you, Noah.

Posted by mh23 | November 2, 2008 11:45 AM

mh23 - I think the markets are emotional now. Acting on impulse, fear, greed, and short term headlines and govt interventions. I think stocks have not fully discounted troubled earnings for the next 1-2 years globally.

I sold 75% of my longs midway through the rally Friday, and I started buying some EEV, SKF, and SDS. Granted it may be early, but no one can time these things perfectly.

I thnk the market knows Obama will win, and actually are pricing in this win. Not sure if you will get that selloff though on the news.

I think the next round of forced selling will be when the new wave of alt-a, prime, and other securities get downgraded (yes this is till happening), and there will be more capital raising in a very tough lending/deal environment. The first wave of forced liquidations was hf redemptions, margin calls, and tax loss selling by HFs. I think there will be more of these by years end.

People sometimes are way too easy to get complacent. They should understand how tough this environment is for business and the road ahead. I just dont see the end of the pain yet.

Posted by Noah | November 2, 2008 12:13 PM

Whats peoples thoughts on buying tax free munis, since tax rates look to shooting up would this be a good idea.

At this rate, even 401k may look like a scam since its highly possible tax rates in 30yrs will be significantly higher

Anyone looking to sell stocks this year just to avoid the massive tax hike coming, esp for those in the 250k (or is it 200k or 150k or 120k)

Posted by uwsider | November 2, 2008 2:21 PM

uwsider - Is 4 to 5% really a MASSIVE tax hike? I believe investors did OK under the same tax % under Clinton (right up unitl the end, anyway). If you want to figure out how to best navigate in these rough waters - you have to lose the visceral and embrace the intellectual. Don't believe the hype - or the Hannity (or the Colmes) - and look for the truth. Now, Grasshopper, are you ready to try to snatch the pebbles from my hand?

Posted by Uhh What? | November 3, 2008 12:05 AM

Uhh What - It's not that 4 or 5 percent is unmanageable; it's the fact that over half of the purported targets of "tax relief" already have a zero or negative tax rate. at what point does a politician call a spade a spade? Obama is clearly heading towards some variation on social market theory and that's the issue. The real travesty is the bankruptcy of our political process by the Obama Money Machine. In many ways I feel that their script for this whole thing has been 'West Wing'. It's just so over the top populism that I've had to check my passport to make sure I wasn't in 1950s Argentina or worse....

T-Bills and China: The US can live without demand for T-bills; China needs food, energy and FDI. You are right to focus on the relationships between consumption and trade and central banks' abilities to operate profitably, but the real inflection point I feel, will be around the socio-political consequences of their being less of everything - in the US, that means credit; for the emerging world, that means basic staples, which is the most direct route to social unrest and a testing of any country's political structure. The US will be sending aid to China long before China has any negative impact on demand for our T-bills.

Posted by Fred | November 3, 2008 8:48 AM

Fred,
C'mon, are you kidding? You really think Obama has bankrupt the political process? Think with your head - not with your pundit influenced heart. You don't have to look to far back to see the process has been bankrupt for a LONG time (Carl Rove wasn't nearly the first but he has done much more than Obama has (or has had the time to, yet). You, me, all of us, are just a part of the bewildered heard. The fact is we wont know what either candidate will really do until the are in office (and what effect that will have on the markets). Now quit taking me off topic!

Posted by Uhh What | November 3, 2008 9:54 AM

Two things, Fred.

1) What, exactly, is "social market theory"? I looked it up on both google & wikipedia & found no direct matches. I assume that when you say "Obama is clearly headed toward some variation on social market theory" you mean that Obama supports heavier regulation of markets than a Republican would. That is certainly the case, but let me remind you that a) markets will always face some sort of regulation in the US--in other words, there is no such thing as a truly free market here, & b) corporations have shown that without gov't safeguards in place, they will engage in overly risky, potentially destructive behavior.

If, however, by "social market theory" you mean that Obama is a quasi-socialist, please read Karl Marx. The notion that the difference between capitalism & socialism corresponds to the difference between a top marginal tax rate of 35% & a top marginal tax rate of 39.6% is sheer lunacy, yet right-leaning pundits & the McCain campaign have been perpetuating this lie. Obama is not proposing that the gov't control our means of production.

2) Please tell me how the "Obama Money Machine" has "bankrupted" the political process. I would think that, as a fiscal conservative, you'd applaud anyone who, through self-reliance, exercises their financial advantages for their own benefit. It seems that you support policies that favor the wealthy, but only when the wealth is on your side. And don't respond with baseless accusations of campaign finance fraud.

Posted by Louis | November 3, 2008 10:03 AM

Louis -

Makes sense that you don't want to talk about Obama's obliteration of Campaign Finance and, to use your words, when the chips stack in your guy's favor, spend spend spend. Fact is Obama is a Money Machine, having now spent more than the entire combined budgets for 2004 spent. To think that the Dems aren't making a lot of money off of this is pure nonsense.

Re: social market theory, read up on German history and social market economics. Why bother bringing Marx into the equation? Has no place here. Obama is not just raising taxes, he's expanding the government coffers. Please tell me when it became fashionable to entrust government - who can't even balance its own budget - to be the provider of capital investment in the economy?

Gettin' ready for four years of spend spend spend! BTW, if you are reading this blog, it means you are at least interested in NYC real estate: how, please tell, do you think that making government bigger and artifically propping up assets values at the individual homeowner level is going to somehow or another make things better? Obama = Hoover.

But it could be worse, Biden may in fact get his chance at the Oval Office, god forbid.

Posted by Fred | November 3, 2008 11:27 AM

well after 8 years of republican rule, our national doubled to around 11Trillion.

Posted by Noah | November 3, 2008 11:43 AM

Noah,
I posted about an hour ago and it never showed up - I may have forgotten to put the nyc in the keyword box. Do I have to search the depths of my imagination one more time - or can you find it somewhere and post it? Thanks.

Fred - spend spend spend? for the NEXT 4 years!? Where the F have you been living?

Posted by Uhh What | November 3, 2008 11:58 AM

hold on Ill find it

Posted by Noah | November 3, 2008 12:01 PM

Fred-

Your complaints about campaign finance all stem from the fact that the candidate with the financial advantage isn't yours. If the situation were reversed, I'd be bothered as well, but I wouldn't be crying foul when there is none.

As for social market economics, I had never heard of it before, as I'd imagine most people haven't. When I read your first post, I googled "social market theory" (your term) & got no relevant hits. Googling "social market economics" does get relevant hits & I'm glad I now know a little bit about it. In fact, if conservatives were to label Obama as a proponent of social market economics, I'd be much more tolerant of their claims. But we both know that it's more sensational - & also false - to call Obama a socialist.

We're obviously going to disagree on how big gov't should be, how much it can be trusted, etc. But portraying liberals as evil because they "spend spend spend" is disingenuous. Both parties spend spend spend. Oftentimes, it is a good, desirable thing. Other times it is wasteful. But there are so many items in the gov't budget that are considered fixed expenses, both by the public & by elected officials, that neither candidate can make a significant dent in gov't spending. I therefore choose to vote for the candidate whose proposed spending is more in line with my own values. McCain, for example, wants to raise military spending; I'd much rather see the money go towards health care.

And yes, I read this blog b/c I'm interested in nyc real estate. But I read it because 1) I don't have any background in the topic, & 2) it's analysis usually seems very sophisticated. So I have no idea whether making gov't bigger artificially props up nyc housing values, but, even if I did, I wouldn't cast my vote based on which candidate I think will be marginally better for my own situation vis-a-vis the nyc real estate market.

Yeah, you're right, that Biden would be terrible in the Oval Office, WAY worse than Sarah Palin.

Posted by Louis | November 3, 2008 1:45 PM

Louis -

uh, no.

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Posted by Betty | November 11, 2008 11:01 PM

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