Monday, August 24, 2009

Why Aren't Bond Yields Higher?

Macro Man is still shaking his head over Friday's crazy equity squeeze (as well, it must be conceded, to clear the lingering after effects of a day spent watching cricket and quaffing Pimm's on Saturday.) Why oh why can't the US release housing data at 8.30 NY time, rather than 10 am after equity options have already expired?

Still, Macro Man can't complain too much. His back-book SPX hedges managed to reap a windfall gain, courtesy of the absurd settlement price procedure of the CBOE listed index options.

While it's tempting to write today about the apparent break-out in stocks, and wonder whether it's a low-volume sucker's rally or a straight shot to 1100, Macro Man has other things on his mind today. Specifically, bond yields and why they aren't higher.

After all, since the onset of the crisis a couple of years ago, there's been a pretty strong positive correlation between stock prices and bond yields. To be sure, the relationship is not and cannot be a linear one ad infinitum, as you're comparing a trending series (equity prices) with a mean-reverting one (bond yields.)

But still, on shorter-term horizons, one can characterize bond yields as trending, which renders a side-by-side comparison somewhat more apt. And what we can see is that bond yields are closer to their three-month lows than their three month highs, despite the fact that the S&P is now at its highest level in ten months.
The bid for bonds seems all the more perverse given that we have another glut of supply this week in the US. Oh sure, the auction sizes are not quite as big as feared in some quarters, which may have given a temporary fillip to bond prices. But the amount of supply is still bloody enormous in absolute terms. And the pattern of the last several months is that dealers either demand a tasty concession (i.e., drive prices lower) ahead of the auction....or they get steamrollered after.

So far there's been no concession to speak of judge for yourself what may happen after the auctions. Perhaps dealers are holding out hope that the foreign CB bid will be back throughout the week after they finally showed their hand a couple of weeks ago.

One mitigating factor for the valuation of Treasuries has been the ongoing decline of LIBOR, where the key 3m setting fell more than a basis point per day in the second half of last week.

Running a simple two-factor model of equity prices and LIBOR suggests that bond yields should not, after all, be north of 4%...though the model admittedly is at its high setting for the year.

Still, it suggests that fair value for US 10 year yields is well north of current levels. Macro Man wouldn't be surprised to see us there sooner rather than later, and prefers to concentrate his long fixed income bets at the shorter end of the curve.

Oh, and as for equities: perhaps it's time to revive this playbook for valuing and trading equities? Sure feels like it...


Nemo Incognito said...

I'm seeing so much range compression and so little conviction we've got to be getting to the end of this sooner rather than later. Consumer numbers at week end could be an interesting catalyst to play.

Viz bonds - absolutely. And on the point of ags, how about that drought in China? And the El Nino? Nemo has his longs set for some fun since EM inflation is likely to hit before the developed world.

Skippy said...

Congratulations to England on the Ashes... bugger

Macro Trading Ideas said...

We're living in an excess liquidity environment, but i think that current bond-equity situation can't coexist: that's the reason for what i'm short equity/short 5yr bonds.
Someone has to cede.
But about govt yields we have continously media and bank support, also today on BBG TOP an embarassing bullish story.
Do you have necessarily to wait multi upside prints on CPI to begin to move on about CB rethoric?
Everyone now is scrambling for yields' pick-up. I bet on a huge return of structured EMTN.

Anonymous said...

I've been puzzling the same question. Perhaps this is how QE initially presents itself? As stagflation?

Theory goes like this: central bank dumps cash into bond market. Market players swirl this extra cash around pushing up all financial asset prices regardless of valuation metrics.

Inflation hawks get killed because the timeframe for this new cash to leak into CPI numbers is way way over the horizon. Meanwhile markets appear to cut loose from the fundamentals.

Maybe the path to equilibrium after QE causes equities and bonds to ramp up before commodities and forex can influence bond prices?

Anonymous said...

I believe that one should look no further than the Japanese example. But I'll bet you that someone is going to say that the Japanese economy is far more different than the US. Is it?

Macro Man said...

Well, the structure of the economies, demographics, and domestic savings are different, 'tis true. But I'd argue that the bigger difference is/was in the timing and magnitude of the policy responses. Japan only introduced ZIRP 7 years after y/y nominal GDP growth went negative (and that after trying to raise rates in the meantime!), whereas the Fed did QE the same quarter that nom. GDP dipped below zero y/y.

While that might well suggest that "rich" bond yields are apporpriate near term, I'd suggest that it also makes a Japan-style deflationary spiral much less likely in the intermediate term.

But hey...maybe equities are the only market allowed to look that far into the future! ;)

pj said...

Anon @ 12:22 - Japan is different in that they were net savers and exporters, the US net borrowers and importers. Japan could fund its debts at 0%, and so it made sense for creditors to accept token payments and delay collection, with a 0% discount rate they can afford to wait. And the nation's vast cohort of elderly savers benefited from deflation. So Japan has embraced a deflationary status quo for 20 years.

The US does not have that option. Outstanding debts are far beyond the country's ability to fund internally. Some will have to be liquidated, others will be refunded at high rates. Either way, the drag on the economy is going to be much sharper and more severe in the short run (i.e. next 5 years). And political authorities will be much more open to inflation -- disaster though that would be. Debt liquidation through bankruptcy is the most desirable course, but that requires accepting bad news -- something that is out of style.

Steve said...

Great post, interesting points all.

On the overlay, it depends on your point of reference. If you were to align the two on April 2, for example, that would create a better fit for the spring rise in which you now show the blue line to be substantially below the red line. If you do so, stocks and bonds would be roughly aligned today.

Also, who is to say that bonds are wrong? Maybe the S&P belongs at 925 today, consistent with bond yields.

On the Japan question, I put the comparison to Dave Rosenberg (admittedly an uber-bear), and he said, no you can't compare, the US is WORSE.

Japan's 10-year JGB yield bottomed at around 0.50%. If you concede a 1% structural difference, that would indicate a US yield bottom of 1.5%. We haven't gotten there--yet.

Japan's debt to GDP peaked at around 200%. We are way under that level.

I lost a lot of money shorting JGBs when they went sub-2%. I won't make that mistake again.

leftback said...

Bond yields are not higher because the credit markets are wiser than the equity markets, and the bond market professionals know that this is a massive short squeeze. Loss of foreign buyers is less of a concern if domestic institutional and individual investors move into Treasuries, for example, during a second crash in the stock market. But for the time being, it is August and we are watching Momo Man control the market!

Skippy, it was a great series, well played on both sides.

Anonymous said...

Fed buys T:s. Countries with currencies pegged to USD buy T:s. The more USD falls, the more they have to buy.

The conundrum.


Donlast said...

I believe the key data point is G.19, Consumer Credit. It is falling steadily with personal deleveraging. Allied to this there is no discernible drop in excess reserve, though they have stopped rising. If there is little new credit creation and personal savings are rising it equals deflation. In one sense it does not matter what the CPI says: this is a deflationary environment.

Participants in the money market, bond and FX markets are far more canny than those in the equity markets. The latter are the clowns in the circus.

leftback said...

Agreed. We will get a double dip no matter what, because the strongest market forces are deflationary and we are so far from equilibrium in the present situation. Extra stimulus would lead to an increase in interest rates - which would then slow the economy. No more stimulus means that when the hot money injection runs out - the economy will slow. As in Japan, the focus will probably be on cycles of QE to prevent runaway deflation from taking hold.

Stefan said...

Baltic dry index significantly lower, China falling, bond yields low... And stocks are up, up, up?

Anonymous said...

I am actually even more baffled by the relationship between yields and the US$ - I ran a granger causality test between DXY and EURUSD vs SPX (admittedly the design could have issues) and end up with the conclusion the currencies are following, not leading equities for the last 3-4 weeks. Since when did the most liquid market in the world start currency markets start looking at equities, nay Chinese equities, for clues?????

Macro Man said...

Oh, about 1999 I think (seriously!) , if not earlier.

Nemo Incognito said...

Anon, since Chinese equities were the best indicator of WTF is going on in Chinese money supply since all the data are either crappy, rigged, or otherwise deeply and profoundly wrong.

Lets be honest, there's a big economy out there for which the best source of info is credit trading mofos in Asia making calls to guys onshore or bank managers to find out whats going on.

Houston we have a data problem.

Charles Butler said...


Exactly. Net new credit to businesses in Spain, last time it was reported, came in uncannily close to the amount guaranteed by government agencies under various programs for the same period - and much of this for operating expenses. There is no growth and none on the horizon.

As for equities, the first law of speculative thermodynamics states that you can't raise the rent money at the race track, no matter how good a handicapper you are. Equities collapse when the pension funds jump back in.

Anonymous said...

this is a short squeeze


David Pearson said...

The question is what are real bond yields? Low or high?

With cpi at -1% and JGB's at 1%, real yields in Japan were 2%. Not a killer, but no help getting out of deflation either.

What about the U.S.? Ignore TIPS for a moment. We could be facing a deflationary or an inflationary spiral. Real long term yields could be strongly negative (5%+ on a trailing 12 months basis) or strongly negative.

So it comes down to this: if you believe in deflation, Rosenberg is right and yields are bargain. If inflationists are right, run from Treasuries. If they are both right (sequentially), but you don't know the sequence, then...what? How much would you pay? My answer is, there are better deflation hedges (short stocks) and better inflation hedges (precious metals) out there. Why bother with Treasuries?

Now, back to TIPS: they are the median of a very fat-tailed distribution, and therefore carry very little information value.

Nemo Incognito said...

Not sure about precious metals but the industrial complex looks rich.... double top in copper.

Anonymous said...

Equities are offered, bonds are bid, yet risk currencies are squeezing higher. The kiwi is the new safe-haven.

Anonymous said...

The Baltic Dry Index is down 43% from highs at the beginning of June.

Furthermore, China are due to reopen coal mines that were closed for safety concerns. Already, the amount of Coal imported into China, contracted 17% in July.

Shouldn't the commodity currencies be taking a hit by now?

Anonymous said...

Great post MM. Thanks. You may be missing the point- Rate markets, specifically treasuries led the way while the crisis was in progress and they have been following on the recovery in risky assets. There's a bid to the long end, whether QE, excess bank reserves, IB's, etc. but the outlook now is for a bull flattener- precisely what the market is not looking for. The market knows short rates will remain low for a long time as the CB's give banks a chance to recapitalize, whether this is enough to ameliorate the declining cmbs portfolios and NPL's as the economy remains contracting is a major question but besides the point for the moment- viz. that since short rates are already near the lowest levels, in the absence of inflation and growth the market will be inclined towards longer duration to pick up yield- in effect pricing out the hikes embedded in the curve. I don't know how analagous the Japanese situation is, but consider that after rates went to zero, the yield curve collapsed. Such an event I think may happen here. Should the economic pessimism be confounded then short dated rates will underperform as the market prices tighter policy thus also flattening the curve though this miracle is not the primary expected outcome. I have been buying deep otm call spreads in usz and selling 2/30's.

Stefan said...

What are 2/30s? thx

Crisis Management said...

Who needs a vacation at Niagara Falls when you have the intra-day gold chart?

Never fails to astound how financial professionals so scrutinize the minutiae of bond spreads, various currency rates and whatnot, but nary a glance at the quizzical patterns in gold/silver.

MM, the more pertinent question would be why aren't bond prices lower? Mr. Kohn seemed to be as enthusiastic as ever on QE this weekend. It's he who has his finger on the trigger.

Stock market rally? As the late Notorious BIG remarked, "it was all a dream."

Crisis Management said...

Correction: pertinent question would be why aren't bond yields lower?

Anonymous said...

Not sure why you think LIBOR should affect US 10yr rates. Swap rates theoretically should be the expected value of currnet and future expected LIBOR, but govies should be related to the current and future expected GC rates, or roughly Fed funds. So, the deline in LIBOR-OIS explains falling swap spreads, but really shouldn't contain any info regarding US 10yrs.

leftback said...

Agree with Ed's analysis - very good.

The curve steepener happens when the economy is becoming stronger (or less weak) than bond market participants have expected, (as seen in the famous World is Not Ending trade this spring) whereas when an economy is actually weakening or is less strong than the market has anticipated the curve becomes shallower, and (in the case of an approaching recession, e.g. 2007) actually inverts.

So the question is indeed, why aren't long rates lower, since we are in a recovery-less recovery?