The Sound and the Fury of the Bond Market Vigilantes

In Hamlet, Shakespeare wrote “Life is but a tale, told by an idiot, full of sound and fury, signifying nothing.” Would that it were so with the recent bond market sell-off. Instead, we see a move away from the flight-to-safety trade but also increasing inflation expectations, un-sustainable debt levels by the US government and severe distortions of the fixed income market by the Fed’s quantitative easing program. The latter has led to large amounts of convexity-related selling. These unwinds of Fed distortions have further to go, so fasten your seat belt.

Recently bond yields have been moving higher in the US. The yield curve has been steepening in dramatic fashion. Implied break-even inflation rates from the TIPS market have been rising steadily. Long-term swap spreads have begun to re-normalize. For example, the 10 year swap spread has moved from 10 bps to around 35 bps. Several reasons exist for the wild moves in fixed income markets. A continuation of these trends could stop any nascent recovery in its tracks. Unfortunately, it doesn’t look the US government or the Fed or any other governments or central banks are likely to react to these moves in the bond market until after it is too late.

First the good news: Recent economic data releases, both in the US and abroad, support a picture of moderating economic contraction. In other words, the rate at which the real economy has been contracting is slowing even if it’s not yet expanding. In fact, some forward-looking economic releases might even signal the end of recession. Historically, an upward sloping 10 year yield less 3 month bill yield spread has been the best predictor of 1 year forward GDP growth. An unwinding of the flight to safety back into risky assets was inevitably going to lead to higher bond yields.

Now the not so good news: The sell-off got started in recent weeks when bond market investors saw that the Fed would not cap certain key yield levels by accelerating its bond purchases. Had the Fed not engaged in quantitative easing on Treasuries, these yield levels would have been breached earlier in the year. As it was, this move was simply deferred. This shows the lack of control the Fed has over longer-term rates despite its massive quantitative easing program. Only if the Fed were willing to enter into full-scale monetization of debt could yields be pegged.

More not so good news: The force of the sell-off gained pace once the UK was warned about a downgrade to its sovereign credit rating. The secret message (which the rating agencies deny) was that the US would be next. US debt-to-GDP ratios will rise less quickly than the UK’s. Nevertheless, as John Taylor, the noted Stanford University economist, has stated, debt to GDP ratios for the US are set to rise from 40% to 80% under Obama with no reduction of those numbers in sight. Niall Ferguson, the Harvard University economist, has made the point that when debt held by foreigners grows to un-sustainable levels, governments will either default or monetize the debt through inflation. Politicians are just not willing to make the sacrifices in spending or taxation necessary to pay down the debt. The one great exception, of course, would be the first US Treasury Secretary, Alexander Hamilton. Who is willing to wager that Timothy Geithner is prepared to stand up to Obama and demand that the US government end its move toward socialism and come up with a realistic plan to pay down the debt in the out years?

More not so good news: Several prominent economists including Greg Mankiw of Harvard are calling for the US government to run significant inflation in order to reflate the housing market (and devalue the debt). While this has just started, once the magnitude of the pain of paying back the profligacy is established, more voices will call for a similar policy. Perhaps US government bond holders will be excoriated for their failure to agree to “shared sacrifice” as were the Chyrsler and GM creditors. In fact, the recent run up in yields has seen longer-dated TIPS break-even inflation rates rise. In other words, nominal yields have risen much faster than real yields at longer maturities. The break-even inflation rate curve is strongly upward sloping indicating that there is little risk of inflation for now but increasing risk in out years.

More not so good news: Chinese and large sovereign holders of US Treasury debt may actually be the part of the bond market vigilante posse. There is suspicion that the recent 2 year and 3 year Treasury auctions went well, as these sovereign investors chose to invest in short-term paper, and not longer-term, Treasuries. The image of bond market vigilantes conjures up gun-slinging prop traders hailing from Montana but working on Wall Street. What if they are actually Chinese, Japanese and Middle Eastern sovereigns? The leader of the Japanese opposition has called on the government to no longer purchase dollar-denominated Treasury debt just Yen denominated Samurai bonds. While this may only be campaign talk, it does show the level of concern. During the 2004-2006, with the Chinese reminbi significantly undervalued and pegged to the US dollar and the consequently large trade surpluses being run with the US, the Chinese bought large amounts of longer-dated Treasuries. This led to an abnormally flat or inverted yield curve, one normally associated with an impending recession but in this one that instead stoked the housing market bubble.

More not so good news: Large supplies of government debt around the world are weighing on markets as almost all major developed economies look to issue debt. There are only so many buyers of this debt. Most buyers have expressed a strong preference for shorter-term maturities. However, governments can not fund themselves all in short-term debt and need to have long-term debt in order to reduce the rollover risk. In fact, European countries have been relying too much on short-term debt due to difficulties with longer-debt issues. They are expected to shift debt issuance to longer maturities in the second half of the year. This will put further pressure on long-maturity governments. So the fiscal position of the US is compounded by every nation trying to do the same thing simultaneously.

More not so good news: The Fed’s quantitative easing interventions in the mortgage market, through its program to purchase $1.3 trillion worth of mortgage debt, has distorted the market for mortgages-backed securities severely. By artificially lowering yields on this debt, the Fed increased refinance rates and created a shortening of effective durations, implicitly supporting the 5-7 year sector of the US Treasury curve. As yields went higher, the Fed was successful in keeping down mortgage rates. As a result of Fed purchases of mortgages, mortgage-backed pass-throughs’ option-adjusted spreads (OAS) came into to -16 bps. Because mortgages yields are more correlated to swap yields than to Treasury rates, mortgage investors often hedge their positions by paying fixed on swaps. With rates pushed artificially low, mortgage duration shortened. Hedgers needed to cut their hedges and started to receive fix. This caused major distortions in the Treasury and swap curves. 30 year swaps spreads went to negative 45 bps while 10 year swaps were at 10 bps over Treasuries even as 5 year swap spreads were at 60 bps. However, mortgage investors woke up to the unsustainability of this situation, and in a few days, mortgage yields jumped close to 50bps. This rise in yields caused OAS to increase to 1bps. The increase in mortgage yields caused effective durations of mortgages to increase significantly. In order to hedge their portfolios, mortgage investors had to pay fixed on long-dated to swaps to match this duration increase. This caused fixed rates on long-dated swaps to blow out, with 10 year swap rates moving from around to 10 to 35 bps in just a few days. 30 year swap spreads also widened to just -10bps.

More not so good news: The move to 1bps OAS on mortgages is still artificially low. Look for this to widen out significantly more, leading to more duration-related selling and yet still higher yields (as well as a steeper swap spread curve). The Fed through its purchases of mortgages has caused a massive distortion that is now being unwound. As mortgage duration extends, future mortgage purchases by the Fed will support longer maturity Treasury issues. This has caused the 5 to 7 year sector of the market, in conjunction with large issuance, to trade very cheap relative to 2 year and 3 year paper and relative to 10 years and out.