The Bond Market's China Syndrome
By Vince Foster Aug 06, 2012 9:45 am
We are blaming Europe for our current economic problems, but in reality they are doing us a favor by providing a blueprint for how a bond market meltdown can unfold.
In March of 2009 People's Bank of China's Governor Dr. Zhou Xiaochuan let his concerns be known in an IMF speech.
When a national currency is used in pricing primary commodities, trade settlements and is adopted as a reserve currency globally, efforts of the monetary authority issuing such a currency to address its economic imbalances by adjusting exchange rate would be made in vain, as its currency serves as a benchmark for many other currencies. While benefiting from a widely accepted reserve currency, the globalization also suffers from the flaws of such a system.
We realize that Bernanke can take down the supply of primary dealers front running his daily tenders, but you are talking about a miniscule amount when compared to the overall size of the market and especially if the devaluated dollar offsets the benefits from foreign ownership. If foreigners simply reduced their allocation back to where it was during the Clinton administration at 30%, you would need to find a substantial buyer to fill the $2t void. No current holder of Treasuries even comes close to having that capacity.
Thus far Bernanke has been basically covering net new supply but that number would presumably need to grow as supply grows. Even with interest rates at record lows interest expense on the debt is rising. In the 2012 fiscal year end we are poised to pay $500b in interest which would shatter the amount paid in 2011 by 10%. With the federal government not increasing spending but increasing borrowing I think a large chunk of the increase is financing interest expense. That is a death spiral.
On July 2 in US Monetary Policy: On a Magic Carpet Ride it was posited that the equity market was poised to challenge the 2007 highs and may in fact be on a mission to prick the bond market bubble. Last week in Bernanke's Astonishingly Good Idea I addressed the overwhelmingly bearish positioning and sentiment that seemed to be anticipating a repeat of August 2011 and suggested that if we didn't crash it could be "melt up city." Staying with the nuclear metaphor theme, I wanted to revise my thesis a bit and admit that we could indeed see a repeat of August 2011, only this year it would be inverted.
Last year the speculative community was long the reflation correlation trade (short the curve and dollar, long everything else) predicated on the Fed extending QE II past June 31. They stayed long into July hoping for an equity market breakout, but it didn't materialize. And with everyone long a very crowded trade, it blew up crashing risk assets and sending the 10-year yield from 3.00% to 2.00%.
This year that trade is inverted. Everyone is long Treasuries specifically duration predicated on deflation risk and QE III, while short if not underexposed to equities due to poor domestic economic and earnings conditions as well as Europe. With the Fed opting for a wait-and-see approach for at least the next 30 days, we have an interesting dynamic in place.
The S&P 500 is only 2% from its cycle highs at 1420. For those fund managers who sold in May and went to the Hamptons over 100 points lower, how long will they need to get if we are at new cycle highs by Labor Day? Conversely, will all those who are long Treasuries at all-time low yields, including the speculative community who finally covered their shorts, want to continue to own negative coupons if stocks are breaking out to new highs?
If you recall in 2010 when the Fed launched QE II in November, they top ticked the bond market, and the subsequent rise in yields -- as they were in the market buying everyday -- was over 100bps. Today, with a similar hedge fund short squeeze coupled with overly bullish positioning and sentiment by real money investors, the conditions are in place for a similar rise in yields. In addition, with long duration coupons substantially below their level in 2010, a move just back to where yields were before last year's August equity market crash would produce a massacre in the bond market, potentially leading to a dangerous self-fulfilling meltdown.
The US fiscal situation is no different than Europe, and you can bet that if our yields start rising, our credit condition will rapidly deteriorate. This will feed on itself. Suddenly sentiment will shift and our reliance on foreign financing will be at risk as the reserve currency status is called into question.
We are blaming Europe for our current economic problems, but in reality they are doing us a favor by providing a blueprint for how a bond market meltdown can unfold. For the US it potentially is more severe because once it gets started the only way to stop it is to print more currency, which will exacerbate the problem.
I believe the main criteria needed to produce a market crash are negative yields on massive embedded negative gamma positions into rising price of expanding supply. All are present in the bond market. Bernanke may be able to hold it together, but it's an accident waiting to happen and as I've said before, he's been prone to blowing up his own trade.
No positions in stocks mentioned.
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