"Complacency in Bond Land"

Sydney M. Williams

Thought of the Day

“Complacency in Bond Land”

April 20, 2011

The Treasury market has been subject to a series of jolts over the past couple of months, yet thus far calm has reigned. (The yield on the Ten-Year has risen by five basis points thus far this year, suggesting prices are virtually unchanged.) Last month, Bill Gross of PIMCO, the manager of the world’s largest bond fund, said that he had taken his holdings of Treasuries to zero. Commodity prices have been rising – the CBOE is up 11.3% since December 31 – hinting at the prospect of future inflation. On Sunday, Zhou Xiaochuan, the Governor of the People’s Bank of China, sounding like a persistent seller, spoke at Tsinghua University: “Foreign exchange reserves have exceeded the reasonable levels that we actually need.” On June 30, it is expected that the Federal Reserve will cease buying U.S. Treasuries, ending ten months of quantitative easing (QE2.) Despite being a seller in January, China, with $1.15 trillion in holdings, is still the world’s largest foreign owner of U.S. Treasuries.

And, then, on Monday, Standard & Poor’s lowered their long-term outlook for U.S Treasury Bonds from Stable to Negative. The bond market yawned. That shot across the bow may prove to be a positive omen; for it may encourage productive talks to reduce the deficits. I hope so. When markets ignore bad news, market commentators, metaphorically, say they are “climbing a wall of worry” and that the action bodes well for continued strength. Treasuries rallied on Monday and did so again yesterday, complying with some sort of perverse logic: if it’s bad news, it must be good.

Upward pressure on bond yields poses serious threats to the still-struggling economy and to government deficits. The housing sector remains stuck at levels 75% below the peaks in 2006, despite attractive mortgage rates. Yesterday, the Federal Reserve, in a statement that might have been issued by the Onion News Network, said that they were seeking comment on a proposed rule under Regulation Z that “would require creditors to determine a consumer’s ability to repay a mortgage before making the loan.” Tougher loan terms, as sensible as they obviously are, limit construction. Higher interest rates will limit affordability. With total debt, including inter-agency debt, approaching 100% of GDP, higher interest costs – when they arrive (and they will) – will increase the deficit, already at 11% of GDP – three times higher than it was four years ago.

If China continues to gradually sell U.S. Treasuries (and with PIMCO out of the market for the time being), it may take higher rates to attract new buyers. (Japan, which has been a buyer, has its own problems.) And, if the Fed does suspend QE2 at the end of June, who will become the marginal buyer of Treasuries?

Nevertheless, there remains a lot of liquidity. Many banks released reserves in the quarter just ended. Cash on corporate balance sheets, in spite of record buy-backs and record M&A, remains near 50 year highs. Household savings rates have jumped from zero three years ago to 5% of income today.

However, given the explosion in government deficits, the U.S. national savings rate is lower than it was before the crisis. In fact, according to Daniel Gros writing in the New York Times on February 8, the net savings rate in the U.S. has turned negative, with only Greece and Portugal in Europe in a similar situation. (A negative national savings rate implies that the country is eating into its capital stock, instead of adding to it, putting that country at the mercy of international capital markets.)

It’s beginning to seem to me that, while the Fed may take a breather after June 30, they may not be in a position to aggressively reduce their balance sheet without causing disruption to the bond market and/or economy. Of course, the longer they persist the more difficult it will be to un-wind, and at some point the training wheels must be removed from the bicycle.

Complacency in any market should be seen as flashing amber. It does not suggest that volatility levels will increase or that markets will sell off, but caution seems warranted. It is also worth recalling that following the end of QE1 (end of the first quarter 2010) until the announcement last August 27th of QE2, the risk trade was shunned. The CRB fell 24% and the S&P 500 fell 13%.

Sometimes bad news is bad news. While I viewed Standard and Poor’s change in the long-term outlook for U.S. Treasury Bonds as a warning, the bond market took the news stoically – and complacently. Perhaps they are right. Perhaps factionalism in Washington will be replaced with accord. Perhaps…