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Bond Market Convexity: Objects in Mirror Are Closer Than They Appear


It's uncertain whether we're seeing a trend change in interest rates or the continuation of the deleveraging process.

FX volatility was front and center last week as rhetoric from the G7, G20, and Bank of Japan dominated headlines and yen price action. With US stocks grinding higher, the bond market has been bearing the brunt of the yen volatility with the US bond futures contract continuing to vibrate the 143-00 level I cited as a price objective in my year-end 2013 Bond Market Prognostication:
What Are the Levels to Watch for in 2013?
I think 143-00 is a huge number. It was a climax top in 2008. It was made support in 2011 and 2012, and it's very close to two standard deviations in the rising channel. If violated to the downside, a bond market top could be in place, but don't expect it to go quietly; it will likely put up a tough fight.

US Bond Futures Tick

Clearly the market has recognized the 143-00 pivot as the consolidation is in its third consecutive week and there's no doubt that a bull/bear battle is underway as participants jockey for positioning. The key factor for me in determining who wins this battle is whether economic growth and the demand for credit is increasing, or whether recent optimism is simply a function of rising stock prices on the back of a depreciating yen.

As I wrote in Analysts Missing Key Ingrediant of Economic Growth, one of the financial metrics I follow to monitor the demand for money is the commercial banking system's aggregate total credit assets broken down between securities and loans. You can see on the chart below the ratio of securities held on the balance sheet to total credit assets tends to cycle with the implied carry earned by investing in mortgage-backed securities (MBS) which I use as a proxy for all depository investable assets.

Loan-to-Deposit Vs. Securities

The loan-to-deposit ratio, which tends to run inverse to the ratio of securities, is a function of the demand for credit, and the correlation with the velocity of money (M2) demonstrates whether this credit extension (and expansion) gets turned over in the economy. (In the aforementioned article I dig a bit deeper into this relationship citing work by Dr. Lacy Hunt and Van Hoisington of Hoisington Investment Management.)

If you think about it this makes perfect sense. In a normal cycle when the demand for money is strong, the curve flattens from the short end in anticipation of tight monetary policy. Banks reduce their holdings of securities due to narrowing carry rotating into loans which increases the velocity of money as credit expands in the economy. When demand for money is soft the curve steepens in anticipation of easy monetary policy. Banks reduce their extension of credit, rotating into securities to take advantage of wider carry, which in turn decreases the velocity of money as credit sits idle in securities.

I believe one of the primary goals of QE is to flatten the curve from the long end to reduce the carry earned on depository institutions' pool of investable assets, making them uneconomic to hold. I wrote the following on November 19 in How QE is Impeding the Economic Recovery:
There has been much discussion on the intentions and effectiveness of QE. It has been my contention that the main objective is not to reflate asset prices but rather to stimulate credit creation and the velocity of money. According the Fed's H.8 Release banks are holding over $2.6 trillion in cash that's sitting idle on their balance sheets in securities portfolios.

[Ben] Bernanke is trying to flush the banking system out of these bloated securities positions and into extending credit by lowering bond yields to levels where banks can no longer afford to hold them. As banks replace securities with loans credit expands, the velocity of money increases which in turn will increase economic activity, employment, and corporate profitability.

If QE has been successful in increasing the supply of credit, you would expect to see banks increasing their loan books while decreasing their securities portfolios if the demand was there. Well, it's not happening. In fact, over the past year, banks have actually been increasing the ratio of securities purchased as a percent of total credit assets.

Bank Securities Vs. MBS Yield

When the Fed launched QE III in September 2012 -- which targeted virtually 100% of newly issued MBS, sending spreads and outright yields to historic lows -- you would have thought banks would have backed off purchasing securities. However, according to the Fed's H.8 data, between 8/29/12 and 11/28/12, total bank credit increased by $81.8 billion with securities representing a whopping $51.9 billion or 63% of the increase. I expanded the sample size to remove any short term anomalies and found a similar trend. In the second half of 2012, total credit assets increased by $266.2 billion with securities comprised of $132.6 billion for a still robust 50% allocation.

I went back through 20 years of data looking at an apples-to-apples comparison for the second half of the year and there was only one six-month period that saw a greater dollar amount increase in securities purchased. In 2002, out of the $378.7 billion increase in total credit assets, banks bought $142.6 billion in securities but representing only 38% of the increase versus a $236 billion allocation to loans. In fact, the only years where securities comprised over 50% of total credit increase in the second half of the year were 1991, 1992, 2001, 2009, and 2010 -- basically all during or coming out of recession.
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