The Bond Market's China Syndrome
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.
Wednesday's FOMC meeting policy release hit the tape with a big fat thud keeping the status quo and offering no hints of any new initiative:
Thanks, folks, but we already knew that. Nevertheless, the various pundits, economists, and strategists all chimed in that they were leaving the door open to a September launch of some sort of QE III and that we would likely hear more about the policy options at the Jackson Hole Fed Symposium coming at the end of August.
In 2010, Ben Bernanke used the Jackson Hole summit to telegraph the launch of QE II, and there is an interesting parallel between now and then that should be noted. To get an understanding of what led the Fed to launch QE II, you must recall the backdrop of events during the summer. The equity market, still fragile from the 2008 crisis, had been recovering, but started to crack in April as QE I ended at the end of March. Then the markets were hit with the double whammy of Greece and the Gulf of Mexico BP (BP) well disaster.
In April 2010 after rallying from the March 2009 666 crisis low, the S&P topped at 1220, but more importantly the 10-year yield also topped at 4.00%. The following months into the summer would see the S&P fall to a low of 1010 in early July with a corresponding move in the bond market sending the 10-year to 3.00%.
Despite the market responses to what were largely headline events, the economic data was holding up pretty well. Between March and July the economy created 600K private sector jobs, ISM manufacturing was running in the high 50s and nominal GDP was growing north of 4% all near recovery highs. Stocks actually found support in July and started to grind out of the hole but bond yields continued to fall and in August just prior to the Jackson Hole speech the 10-year had reached the 2.50% area matching the lows seen during the depths of the financial crisis in 2008.
At 4.00% the 10-year was trading at fair value in line with historical discount of nominal GDP but as it rallied to 150bps below this growth rate the bond market was sending a very loud message to the Fed that deflation risk was rising. Or was it?
With the 10-year at 4.00% in the spring of 2010, the large speculators were heavily short the 10-year Treasury futures contract (IEF) and the flight-to-quality bid that resulted from the Greece and Gulf of Mexico double debacles ignited what I believe was a spectacular short squeeze. Between April and August the large spec went from short over 250m contracts ($25b) to basically flat as price rallied from a 115 handle to over 125. The Fed saw this move as rising deflationary risk but I believe they got head faked and it may be happening again.
In April of this year I posted on my firm's blog that the bond market was set up for a similar move to 2010. In Something's Got to Give:
Thus far the ex ante analysis has been on target as the scenario has been playing out according to plan. We got our new highs in bonds (all-time) on stock market weakness and it appears to be prompting more Fed action. Then on Friday I got what I've been waiting for since April (as reported by Sedacca). The CFTC commitment of traders report showed that for the first time since we noted this potential squeeze in April large specs were finally net long. The question for investors is whether this sets up for a market top and intense reversal.
The COT report survey ends on the prior Tuesday so it's probably not a coincidence that specs covered to get long in front of Wednesday's FOMC meeting potentially expecting some sort of action forthcoming, and "they" are not alone. Wednesday's Stone & McCarthy money manager survey showed that real money investors are the longest against their benchmark they've been since November 2010 when the Fed launched QE II. Then on Thursday CRT's Ian Lyngen reported his Nonfarm Payroll Survey found investors to be very BULLISH.
From a Reuters MacroScope blog post:
In a post-non-farm payrolls rally, we found 23 percent of respondents willing to chase a rally - much higher than the 10 percent average and the highest since April 2012. Very few participants were willing to sell strength: just 19 percent versus a 40 percent average, the lowest on record.
Wow. No one wants to let them go because they think the Fed's going to come get them. But will the Fed buy them all? They might have to. I don't dispute that QE III is coming in fact as I stated last week that the nuclear option is on the table (see Bernanke's Astonishingly Good Idea):
In the July 21 issue of Barron's Macro Mavens Stephanie Pomboy pointed to the risk in what she implied would be perpetual QE.
This week the US Treasury announced they would need to increase their borrowing needs above previous forecasts. During the July-September quarter the Treasury expects to issue $276b in marketable debt, $12b higher than announced in April. During the October-December quarter the Treasury expects to issue $316b. So inline with the $1t run rate. But when does this need to continually expand debt outstanding end? With Congress or the fiscal cliff? I don't think so.
The truth of the matter is the federal government could cut discretionary spending to zero and not put a dent in the debt. According to the last GDP report federal spending (ex entitlements and interest) amounted to $1.2t up from $1.0t in 2008. Over the same time frame our Treasury debt has grown from $5.7t to $10.5t.
As mentioned in The Cycle of Fortune Invades a Confederacy of Dunces, foreign holdings as a percent has kept up with rising Treasury supply staying at 50% of outstanding. Because foreign governments largely represent an uneconomic buyer of Treasuries, i.e. one not sensitive to price, they have maintained their allocation as supply expanded. However they now control an amount equal to what our outstanding debt should be. That's a problem.
But now at the zero bound with the Fed devaluing the currency to keep it there, presumably there is a point the uneconomic foreigner could become economic.
In March of 2009 People's Bank of China's Governor Dr. Zhou Xiaochuan let his concerns be known in an IMF speech.
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.