Monday, January 12, 2009

Near Sovereign bonds - the next frontier?

We all know 2008 wasn’t a good year for securities markets. Now that the data is trickling in, we can see just how badly things turned out. Foreign investors unloaded almost $90 billion of U.S. securities in Q3 2008 alone – the greatest quarterly sale by overseas shareholders since 1960. In return, US investors sold ca $85 billion worth of foreign equities and bonds, according to the US Bureau of Economic Analysis.

It is too early to tell how much of this $175bn liquidity went into Treasuries and how much into the US corporate debt. But, after a week of weakening fixed income ETFs discounts, it is now looking increasingly likely that the markets are running a bit too hot in the sovereign paper area. This means it is time to look for a new class of 'favorites' and long over-looked US state bonds and municipals might be coming back into play. Maybe on the back of some sort of a Federal Government guarantee.

The reason is two fold: (1) the sovereign debt markets for US and European paper are teetering at what appears to be the zenith of a mini-bubble; and (2) more recent institutional investors’ interest in corporate bonds might be leading to a renewed appetite for some risk.

On point (2) first: Sure the likes of PIMCO and Blackrock will be pushing corporate debt over sovereign, given these fixed income giants have been vacuuming large corporates’ bonds for over a month now (see PIMCO’s Bill Gross’ latest ‘rant’ on TIPS etc here). Nonetheless, there is logic to their strategies, especially the one that Gross is pushing for in his sales pitch - if the US Government is willing to underwrite companies like GM, their debt should be trading closer to the US debt than the current yeilds imply. Yild compression amongst the Washington-'backed' corporates, therefore, might be on the books.

But, there is also a serious concern out there that too much money has now flown into the US Treasuries – pushing the yields to their historical lows. And this brings us to point (1) above.

James Montier, from Société Générale, has found that since 1798 yields on US bonds have never been this low, except under war time price controls in the 1940s. Montier reminds those of us who are quick to forget history (i.e economists in general) that the end of these low yields era of the 1940s was a tearful one. “The Fed drove the 10-year bond down to 2.25pc, much as it is doing today with mortgage bonds”. Post-war inflation did the rest of the damage.

Overall, the historic average for 1798-2008 period is ca 4.5pc nominal yield or 2pc real return. Yields on 10-year US Treasuries have now fallen to 2.4pc, leading one famous bond investor – Jim Grant – to quip that we are now in a ‘return-free risk’ world. In effect, current markets are implying (at present yields) that a decade of deflation will ensue despite the global efforts to re-inflate economy. This is how bad things must get in order to justify current valuations relative to the historic path. The story is the same across the world, with yields at 1.3pc in Japan, 3.02pc in Germany, 3.13pc in Britain, 3.26pc in Chile, 3.47pc in France, and 5.56pc in Brazil.

Thus, globally, investors are betting that deflation will fully offset the effects of near-zero interest rates and over €2 trillion in fiscal stimuli.

A highly unlikely proposition. What is more likely is that the sovereign debt markets are now over-subscribed and the bubble is primed to burst. When this happens, two things will follow:

(1) new sovereign debt issues will become virtually impossible to place (read about the new issues auctions troubles brewing already in my forthcoming Business & Finance article – to be posted here over the weekend), and
(2) first wave of bubble exits will go chasing some new risk in the form of under-priced quasi sovereign debt, a.k.a munis and state notes (ETFs discounts on funds dealing in these are deep now, but if my thinking is right, this is about to change in late Q1-early Q2).

An additional problem with sovereign bonds is that they are also facing a latent glut of supply. China, Russia, Brazil and many other countries will need liquidity for their internal purposes. They are unlikely to continue clinging to their holdings of the US Treasuries. China alone has $1.9 trillion in foreign sovereign bonds and the country now faces a dilemma – issue own debt to pay for domestic stimulus or sell other countries’ debt. It is no brainer that some of the Chinese-held bonds will hit the market at some time in 2009. Sure, they will go about it tactfully, gradually, quietly. But equally one can be sure they will dump somewhere around $90-110bn worth of this stuff in the next 12-15 months - if only to offset currently accelerating capital outflows.

Looking at this from the global perspective, BRICs and Middle Easter oil producers have in effect financed European and American deficits through 2007. In 2008, their appetite for this ‘store of value’ paper has run a bit dry. In 2009, it will turn negative, just as the US and European deficits will balloon to $3.5 trillion.

The only possible response to this is: a helicopter drop of money. The Fed, unlike less experienced and less globally aware ECB, sniffed the trend few months back. Helicopter drop of money – a practice of monetizing sovereign debt by printing money and using it to hover domestic bonds – is a powerful inflationary monetary policy tool. If the Fed was not aware of an incoming opportunity to do so, it would have not ‘unloaded its policy gun’ by cutting rates down to zero. The fact that it did shows that the Fed is more than willing, nay – it is actually happy – to start the printing presses to liquefy the bond holdings.

And just how effective this can get? Look no further than the US mortgage rates, driven – within a span of two months down 150 bps to 4.5pc – by Feds aggressive purchasing of mortgage-linked bonds, some $600bn worth of these. This is dandy, but what happens when the Fed satisfied its hunger for paper and deflation risk abates – possibly toward Q4 2009. The air will burst out of the bond market as the Fed will start gradually clear some trillions of dollars worth of paper off its books.

It will be a bang, not a pop - yields up, prices down, and the current holders of Treasuries belly up. The process will not be complete until the Fed unloads, say $1-1.5 trillion of the bond holdings, implying that no sane person will be buying these in the middle of the lengthy sell cycle. Lengthy because selling such quantity of US paper amidst the world still languishing close to the recession bottom will require care in order to avoid running up the risk of reigniting deflation.

So the longer-term future might be bleak for the US sovereign debt. The near future is also uncomfortable.

The strategy of playing the Fed’s drive into the bonds market during the ‘drop’ phase of money creation is not on the cards for investors, as most likely large purchases will mirror large supply increases from the likes of China, implying limited upside potential early in the purchasing cycle as supply of bonds will always stay near Fed’s demand line.

When to elephants play, stay well out of their way.

All of this means smart money will move elsewhere in advance of the Fed buying cycle (prior to Q3 2009) and munis and state bonds will be just there, at the ‘Welcome’ gate for investors, with some fresh backing from the Feds and a pile of infrastructure projects to finance.

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