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A message from Mr Bond

Created:

2 June 2009

Written by:

Simon Thompson

Two weeks ago I pointed out that the tsunami of sovereign debt issuance in the US and UK would have very serious implications for credit markets (The Aftermath of The Financial Crisis, 18 May 2009). It hasn't taken long for bond market investors to wake up to the stark reality of the situation.

In the past week alone, the yield on 10-year US Treasury notes has hit a six month high of 3.75 per cent, up from 3.1 per cent at the start of May and just 2.1 per cent in December 2009. According to Mike Shedlock of SitkaPacific Capital Management, ten-year notes have now lost 10.3 per cent in value this year, while 30-year bonds have lost 27.5 percent. Moves of this magnitude might not be exceptional for equity markets, but in bond markets they are the equivalent of tectonic plates shifting.

Moreover, the yield differential between the short end and the medium end of the yield curve has widened dramatically, with the difference between two-year and 10-year risk free US government bond yields hitting a record high of 2.75 percentage points.

This steepening yield curve not only implies a higher risk premium is being demanded by investors to lend to the US government, but it is sending out a clear message that concerns about inflation are intensifying. This is completely rational behaviour because, as I noted last week (All That Glistens, 26 May 2009), the reflationary economic policies being pursued on both sides of the pond can only have one consequence: higher inflation and ultimately higher interest rates to combat these pressures . The index linked government bond market has taken note, with break even on 10-year TIPS (the US equivalent of index-linked gilts) increasing to over 184 basis points, up from under 100 basis points eight weeks ago. The change in inflationary expectations are also being mirrored at the longer end of the yield curve with break even on 30-year TIPS around 237 basis points, the highest level seen since before the fall of Lehman Brothers.

Steepening yield curve

A sharply steepening yield curve may be good news for the profitability of the financial sector, as banks borrow cheaply short-term and lend out at far higher rates long-term. However, it is not good news at all for the US housing market, the finances of hard pressed consumers and, by consequence, the balance sheets of the very same banks.

The fall-out from the spike in government bond yields can be seen in the pricing of 30-year mortgage bonds of home loan giant Fannie Mae, whose yields have risen from 3.86 per cent to 4.7 per cent in the past five weeks. So US homeowners looking to refinance or take out new home loans to make home purchases will have seen a dramatic increase in their borrowing costs. This is the exact opposite of what the Bush administration had in mind when it authorised the dramatic expansion of the Federal Reserve's balance sheet to enable it to purchase $1450bn (£900bn) of Fannie Mae and Freddie Mac mortgages.

Moreover, the higher government bond yields rise, and so putting pressure on borrowers, the greater the risk that the housing market will take longer to stabilise. Not that there are any signs of the latter anyway, with the Standard & Poors Case Shiller housing index falling 2.2 per cent between February and March and the Mortgage Bankers' Association reporting last week that over 9 per cent, an all-time high, of US mortgages were in default at the end of March. Let’s not forget either that rating agency Moody’s estimates that one in five of US mortgages are now in negative equity, a number that can only increase as the housing market falls. And that looks highly likely as long as unemployment – now 8.9 per cent of the working population and increasing at over 500,000 per month – continues to rise. Remember that never once in history has the US housing market stabilised when unemployment has been rising.

Clearly, if bond yields continue to rise, this has worrying implications for the US housing market, consumer spending – which accounts for 71 per cent of US GDP according to the Bureau of Economic Analysis – and the sustainability of an economic recovery on which equity market investors have been heavily banking on since March.

Funding or Monetising Deficits

Unfortunately, there are sound reasons to believe that the sell-off in the US government bond market is far from over. As John Maudlin, President of Millennium Wave Advisors, notes: “The bond market is looking a few years down the road and saying that $1trillion deficits are simply not capable of being financed. And if the debt is monetized, then inflation is going to become a very serious issue.”

Moreover, the Fed’s decision to purchase Treasury Securities – it has so far bought back around a third of the $300bn target – has only exacerbated fears that higher inflation is preferred to higher taxes. It’s no coincidence either that the prospect of the Fed monetising its deficit has fed into renewed US dollar weakness, primarily against sterling and the Euro, and a sharp rise in the gold price. It is therefore critical that the Fed moves quickly to ease these growing concerns, by reiterating the central bank’s anti-inflation commitment and spelling out a cohesive exit strategy from quantitative easing once the US economy stabilises. Failure to do so can only undermine its credibility and fuel the sell-off that is growing pace in the US government bond market.

Investors riding off the coat tails of the global stock market rally since March would be well advised to keep a very close eye on events in the US. If the sell-off in the world’s biggest bond market starts gathering pace there is no way that equity markets will emerge unscathed.

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