8/7/20: On a Long-Enough Timeline, This Is Not Sustainable

Something will have to give, and on an increasingly more proximate timeline, although we have no idea when that timeline runs its course...

In basic terms, U.S. Bonds yields are only sustainable as long as:

1. There remains a market-wide faith that the U.S. Government will not deflate itself out of the fiscal mess it has managed to run, virtually un-interrupted, since at least 1980 on; 
2. There remains a regulatory coercion into the U.S. Government bonds being 'risk-free' capital 'instruments'; and
3. There remains vast appetite for the U.S. dollar as the store of value instrument for everyone - from migrants and legitimate business people in the politically questionable jurisdictions to drug dealers.

Which puts a serious question mark over how long can the U.S. Treasury afford to escalate weaponization of the dollar.

21/1/20: US Deficits, Growth and Money Markets Woes

My article for The Currency on the effects of the U.S. fiscal profligacy on global debt and money markets is out: https://www.thecurrency.news/articles/7371/the-us-deficit-has-topped-1-trillion-and-investors-should-be-worried.

Key takeaways:

"As the Trump administration continues along the path of deficits-financed economic expansion, the question that investors must start asking is at what point will debt supply start exceeding debt demand, even with the Fed continuing to throw more cash on the fiscal policies bonfire?"

"In the seven years prior to the crisis of 2008-2012, US economic growth outpaced US budget deficits by a cumulative of $1.56 trillion. This period of time covers two major wars and associated war time spending increases, as well as the beginnings of the property markets and banking crises in 2007.

"Over the last seven years since the end of the crisis, US economic growth lagged, on a cumulated basis, fiscal deficits by $928 billion, despite much smaller overseas military commitments and a substantially improved employment outlook.

"These comparatives are even more stark if we are to look at the last three years of the Obama Administration set against the first three years of the Trump Presidency. During the 2014-2016 period, under President Barack Obama, US deficits exceeded increases in the country’s GDP by a cumulative amount of $226 billion. Over the 2017-2019 period, under  Trump’s tenure in the White House, the same gap more than doubled to $525 billion.

"No matter how one spins the numbers, two things are now painfully clear for investors. One: irrespective of the stock market valuations metrics one chooses to consider, the most recent bull cycle in US equities has nothing to do with the US corporate sector being the main engine of the economic growth. Two: the official economic figures mask a dramatic shift in the US economy’s reliance on public sector deficits since the end of the crisis, and the corresponding decline in the importance of the private sector activity."

31/7/19: Canary in the Treasuries mine

Judging by U.S. Treasuries, things are getting pretty ugly in the economy:

The gap between long-dated bond yields and short-dated paper yields has accurately predicted/led the last three recessions (the latter are marked by red averages in the chart).

2/4/19: World Economic Conditions and Yield Signals

Global divergence...

... until global convergence?

More likely, the latter: https://www.reuters.com/article/us-ecb-policy-rates-idUSKCN1R81B3. 

8/12/18: Back to the 1950s: Tracing Out 25 Years of the Credit Bubble

While the current cycle of declining interest rates has been running for at least 25 years, the most recent iteration of the period has been exceptionally benign. Since the end of the global financial crisis, Corporate and, to a greater extent Government, borrowing costs have run at the levels close to, or even below, those observed in the 1950s-1960s.

Since 2002-2003, FFR, on average, has been below the risk premium on lending to the Government & corporates. This has changed in 4Q 2017 when Treasuries risk premium fell below the FFR and stayed there since. In simple terms, it pays to use monetary policy to leverage the economy.
Not surprisingly, the role of debt in funding economic growth has increased.

And, as the last chart below shows, the relationship between policy rates (Federal Funds Rate) and Government and Corporate debt costs has been deteriorating since the start of the Millennium, especially for Corporate debt:

In simple terms, risk premium on Corporate debt has been negatively correlated with the Federal Funds Rate (so higher policy rates imply lower risk premium on Corporate bonds) and the positive relationship between Government debt risk premium and Fed's policy rate is now at its weakest level in history (so higher policy rates are having lower impact on risk premium for Government bonds). In part, these developments reflect accumulation of Government debt on the Fed's balancesheet. In part, the glut of liquidity in the banking and financial system (leading to mis-pricing of risks on a systemic basis). And, in part, the disconnection between Corporate debt markets and the policy rates induced by the debt-financed shares buybacks and M&As, plus yield-chasing investment strategies, all of which severely discount risk premia on Corporate debt.

30/7/18: Annotated History of the U.S. Treasury Yield Curve

Courtesy of the forgotten source (apologies) a neat summary chart plotting the timeline of the 10 year U.S. Treasury yield:

For referencing purposes… 

10/6/17: Cart & Rails of the U.S. Monetary Policy

So, folks, what’s wrong with this picture, eh?

Let’s start thinking. The U.S. Treasury yields are underlying the global measure of inflation since the onset of the global ‘fake recovery’. Both have been and are still trending to the downside. Sounds plausible for a ‘hedge’ asset against global economic stagnation. And the U.S. Treasuries can be thought of as such, given the U.S. economy’s lead-timing for the global economy. Except for a couple of things:

1. U.S. Treasury is literally running out of money (by August, it will need to issue new paper to cover arising obligations and there is a pesky problem of debt ceiling looming again);
2. U.S. Fed is signalling two (or possibly three) hikes over the next 6 months and (even more importantly) no willingness to restart buying Treasuries again;
3. U.S. political risks are rising, not abating, and (equally important) these risks are now evolving faster than global geopolitical risks (the hedge’ is becoming less ‘safe’ than the risks it is supposed to hedge);
4. U.S. Fed is staring at the prospect of potential increase in decisions uncertainty as it is about to start welcoming new members ho will be replacing the tried-and-trusted QE-philes;
5. Meanwhile, the gap between the Fed policy’s long term objectives and the reality on the ground is growing: private debt is rising, financial assets valuations are spinning out of control and 

So as the U.S. 10-year paper is nearing yields of 2%, and as the premium on Treasuries relative to global inflation is widening once again, the U.S. Fed is facing a growing problem: tightening rates is necessary to restore U.S. dollar (and U.S. Treasuries) credibility as a global risk hedge (the key reason anyone wants to hold these assets), but raising rates is likely to take the wind out of the sails of the financial markets and the real economy. Absent that wind, the entire scheme of debt-fuelled growth and recovery is likely to collapse. 

Cart is flying one way. Rails are pointing the other. And no one is calling it a crash… yet…

25/6/2013: What the hell is going on in the markets?

Two charts from Pictet neatly illustrate the ongoing bonds markets correction:

My two cents on what's going on in the markets today:


Wednesday opening last week at the cusp of FOMC statements, US 10 years were  yielding ca 2.15%. and 4 trading days later, these were at 2.61% or 41 bps up. 30 years are up from the nadir of 2.83% on may 2 to 3.56% currently.

And what about the other QE-infused or enthused market? In just over 3 weeks, FTSE 100 is down 846 points, from 6,875 on 22 May.

Equities and bonds are moving same way? Why?

Because of three factors:
1) When bonds go down, with them goes down capital. Mandated investment vehicles and banks take a bit of a shower.
2) When US or other advanced economies bonds take a shower, Emerging Markets take a bath because of liquidity pull out to cover leveraged losses elsewhere.
3) When EMs and bonds tank, capital-backed leverage falls, so liquidity falls in the advanced markets too, dragging down all risk assets.

These are the tripartite consequences of a liquidity trap, whereby intermediated short-term funding underpins investment activities. Put differently, when humans have less cash (real economy slow recovery, coupled with tax and financial repression), while banks and other institutions have more cash (including, for the latter, via access to banks leverage against Central Banks funding), markets become correlated, even where hedges existed before, correlations turn positive. Where there is contrasting access to the same asset via both financial paper and physical or real assets (e.g. gold vs gold coins), the two diverge, with financialised asset moving in synch with other financial assets, while real/physical asset moving in the opposite direction.

Thus, Brazil's 30-year bonds (dollar-denominated) are down now more than 25% in recent weeks, and instead of flowing into safe havens or rather 'safer hells', the cash is being tucked away into reduced leverage, leading to the US bonds compression down and UK gilts erasing all gains made since October 2011 (when QE2 kicked in).

The only thing that behaves predictably so far is VIX, which has gone from low-flat around 13.6-14.0 between March 24th and May 24th to over 20 average since June 20th through today. Short term VXX index is up from 18.03 on May 17th to 22.81 today.

Not quite panic, but pressure… and pressure is a trigger. And FOMC, and the rest of the Impossible Monetary Dilemma, are triggers too. The point is, given the recent drama in bond markets and equities and EMs, triggers are dangerous in trigger-happy times. When you have lots of capital tied up in 'safe assets' and lots of leverage tied up on top of that capital, pulling the rug from underneath capital quality leads to accelerating cascades across the board.

This is bad news for strategies over the short-term, as traditional allocations based on previously stable relations between asset classes are broken down. Gold co-moves with equities and bonds and currencies. The good news: once financialisation of the long positions is unwound, leverage is reduced and repricing of 'bubble'-like assets (aka financialised assets as opposed to real assets) is finished, the stable relations will return. In the long run, we all are… well, in the long run.

11/01/2012: Risk-off or 'Grab that Straw, Man'?

Another day, another historical marker falls under the weight of the euro area mess:

US Treasury auctioned off USD21bn of 10 year notes today achieving the yield of 1.90% - lowest on record for an auction. Cover was 3.19 times the offering, slightly ahead of 3.15 average for previous four 10 year notes auctions. Direct bidders demand was up to 17.4% of sales against the average 10%. 10 year secondary markets yields sliped to 1.91% from 1.97% pre-auction.

Here's the IMF illustration (all charts below are from Cottarelli November 2011 presentation) of the evolution of holdings of US debt:

Which, funnily enough, is pretty diversified when compared to that found in Europe:

But the US yields are, of course, purely irrational:

Then, again, not as irrational as those found in Japan:

Altogether elsewhere, vast... German bund auction - 5 year, €4 billion - attracted cover of 2.24 and the average yield of 0.9%. That is well below inflation - however measured - and even below expected inflation, accounting for the potential slowdown. In other words, investors are now so scared, they are paying German government money to store their cash. In the secondary markets, German 1 year bonds turned negative yield back at the end of November, for the first time in history. German 10-years are currently trading in the 1.87% yield territory. According to FT, 10 year bund yields fell from 3.49% in April 2011 to a low of 1.67% in September last year.

Risk-off raging as EU vacillates... or rather, as its leaders consider how to by-pass Belgian General strike that has derailed their January 30 summit.


Nice one, folks. The insolvent Rome burns, the leaders are having summits galore and the unions are demanding more insolvency, while country output shrinks due to striking.


We are no longer in risk-aversion or even loss-aversion world, we are in a grab-anything-that-might-float world.

Economics 31/12/2009: Bond markets

Food for thought: rummaging through backlogged papers, I cam across 3 notes from our heroic stockbrokers' bonds desks singing songs about the right timings for investment in bonds. These trace back to June and October 2009.

So I asked myself the following question: should I have listened to your brokers' advice to buy Irish or US bonds in 2009?

Well, here are two tables giving a breakdown on bond price sensitivities to changes in interest rates. The US table:And the Irish table is here:Now, in darker blue I marked the cells corresponding to the reasonably plausible scenario for yields for 2010. In lighter blue - the next best predictions. So go figures - should you have listened to anyone pushing Irish or US bonds onto you?

Think of the following numbers - I don't have the same for the Irish markets - in the US, cash inflows into bond funds markets amounted to some USD313 billion in 2009, as yields kept on dropping to artificially low levels on the back of the US Fed buying up Federal paper. At the same time, as stock markets rallied, just USD2 billion net was added to stocks funds. (Numbers are to November 1, 2009). Some has been fooled.

So a Happy New Year for all and best wishes for the new decade!

My next post will be already in 2010 and will show comparative performance for Irish banking sector relative to other EU states - the latest data - for 2008.

Economics 26/12/2009: Interest rates direction - US, Europe and China

One near-certainty that awaits us in 2010 is the return of the higher cost of borrowing. The growth killer pill o higher interest rates will pass into the system before countries like Ireland get to experience growth. And a double-dip, or an extremely prolonged slog at the bottom of a U will be looming for the US and Europe.

Here is how I know: the forces keeping pressures on the policymakers to keep rates low are declining, while the forces that will push rates higher are already in the making.

Two drivers helped to push US and global rates down since 2007. These are the US Fed’s financial crisis busting injections of liquidity and the Chinese desire to keep yuan pegged to the dollar on the way down. The former fuels the liquidity trap in the US, while the latter fuels the circular pump that converts dollar surpluses on trade and investment side into dollar-denominated paper recycling cash back to Uncle Sam.

US drivers

In effect, the Fed has created a massive and unsustainable demand for US Treasuries via:

• Direct purchase of US bonds (over the last two months this amounted to some 22% of the entire pool of newly minted US debt – some US$65 billion, driving the yield to near zero once again. The Fed bought some US$300bn worth of longer-term Treasuries at the end of October), and
• Indirect purchases of US debt via primary dealers and via its balance sheet operations (between January 2008 and December 2009 assets on Fed’s balance sheet grew some 142% to a whooping US$2,240 billion, or more than 16.7% of the entire US GDP).
  

Now, do the maths: over the last two years, the Fed bought into over US$300 billion in Treasuries purchased directly, some US$600 billion more went into indirect purchasing of Treasuries and the balance of roughly US$1,300 billion is sitting in the illiquid and largely non-performing assets such as US$901 billion worth of MBSs. The Fed has US$350 billion more of toxic stuff to buy before reaching its target by the end of Q1 2009. There after, unwinding of liquidity supports will be on order. And this process has already started with the Fed scaling back some 10 asset purchasing programmes.

Aptly, the hosting of the spending party is shifting from the Fed to FedG, or the Federal Government. Per Bloomberg, the amount the Fed and US agencies have lent, spent or guaranteed has fallen 15% to $8.2 trillion between September and mid December, “the lowest in a year”. The FedG spending on infrastructure, tax breaks and other fiscal measures accounts for 52% of the new total, up from 39% in March 2009. So far, the Government spent some US$4,200 billion – or 30% of the US economic output – in 2009. And last week, the US Congress approved a further increase in the Federal debt ceiling – raising it by US$290 billion to US$12,400 billion.

One problem is that this substitution of the Fed with the Federal Government is the sign of the end of the road nearing for massive money creation exercise in the US. While the Fed can print money as long as there is no significant inflation (in the US terms – anything below 4% per annum in the short term will probably be acceptable with current levels of unemployment), the Federales will have to tax their way out of the deficit hole one day. Inflation is a manageable thing, though for now: US consumer prices were up 1.8% yoy in November – well below the 2.6% annual average recorded over the 2000-2009 period.

But the fiscal hole is a formidable one – the US has managed to run 14 consecutive months of budget deficits since December 2007. The only positive on this front is that the Government still holds on to about 50% of the entire stimulus package allocated earlier in 2009 – some US$787 billion in unspent funding. Don’t bank on Democrats-controlled executive and legislature not burning through that in 2010.

Another problem is that reselling the toxic securities pilled up in Fed’s vaults back into the economy will risk draining liquidity out of the system. The Fed might think that’s ok in the short term, since the US banks are now less prone to tap into Fed’s window for liquidity: the Fed stated that since mid-August 2009 there has been no new borrowing at the Term Securities Lending Facility, while Primary Dealer Credit Facility had seen no clients since mid-May 2009. The Asset-Backed Commercial Paper Money Market has been inoperative since May 2009. These programmes, plus the Commercial Paper Funding Facility, the Primary Dealer Credit Facility and other are now set for a phase-out starting with February 2010. And the Fed is set to shorten maturity profile of its primary credit loans from 90 days to 28 days as of January 14, 2010. TALF (Term Asset-Backed Securities Loan Facility) will close on June 1, 2010. More? The Money market Investor Funding Facility (MMIFF) was discontinued on October 30.

China's conundrum

Obviously, the Fed could have swapped these fine ‘assets’ for Treasuries and sold the Treasuries on to the Chinese in a financial scheme that would have allowed it to retain dollar supply intact. Alas, things are much less promising for such a transaction today than they were a couple of years back.

Chart below (from here) shows just how dynamic China’s refusal to buy more into the US assets has been in recent months. And the next two charts confirm the same,
except the last one is an even scarier thing. It shows that even as the Chinese FX reserves were rising, their willingness to buy US Treasuries has been falling. Might it be the case that China has decided to recycle US dollars earned from the trade surpluses back into the global economy? Buying gold or even Euro?

Why not? The latter two operations offer Chinese a happy trip to a devaluation room – push supply of dollars globally up and the value of the dollar goes down. With it, the value of yuan, improving further Chinese exports competitiveness.

The side benefit to this for China is that their anti-dollar rhetoric backed by gold and euro buying also pushes the country reputation as a ‘counterweight to the US hegemony’. Naive Europeans keen on showing euro’s strengths are loving that not seeing that China has no love for the EU or for the euro, just an addiction to cheap yuan. Europeans are not even at the frontline as observers, obsessed with ‘strong euro = alternative reserve currency’ pipe dream.

This beggar-the-US position pays off for China in so many ways with such handsome returns that I am amazed no one so far has pointed out to the internal consistency of what the Chinese are doing through the concerted efforts of their monetary, exports and diplomatic/political pillars.

One spanner in the wheels is that the Chinese trade surplus vis-à-vis the US and Europe is now shrinking, and shrinking rapidly. According to China's General Administration of Customs, country exports in 10 months to November 1, 2009 dropped by 20.5% yoy and 14.8% vis-à-vis the US. Its terms of trade (the export price relative to imports) have fallen over 5%. China’s exports to the EU have fallen even faster – down 18.7% in value in the first 10 months of 2009, opening up a gap in its euro earnings relative to dollars.

This gap implies that any rebalancing of the FX reserves into euros away from the dollar will require direct purchases of euros and selling of dollar reserves. Now, China holds some US$2,270 billion worth of FX reserves – some 33% of this in US dollars, marking a 19% rise in the proportion of FX reserves allocated to dollars within the last 12 months. And China holds some US$791 billion worth of US Treasuries.

So this is another marker suggesting the reduction of China’s appetite for dollar-denominated assets going forward.

As US-China trade deficit shrinks from US$268 billion in 2008 to US$188.5 billion in 2009 China will have four powerful reasons not to buy much more of US Treasuries:

• Falling supply of dollars and even faster falling supply of euros;
• Falling appetite for Treasuries;
• Falling returns to both dollars and Treasuries, and
• Rising demand for gold and euro, both requiring sales of dollar-denominated assets and cash.
  

Summing it up

With record deficit in works for 2010, the supply of Treasuries is bound to go up – some US$1,300 billion will be pumped into the global markets next year alone, plus some US$2,000 maturing will have to be rolled over.

Meanwhile, the demand from the Fed is gone almost completely and the demand from China is dramatically cut back, if not turned negative. Last week, Morgan Stanley boys estimated that by June 2010, potential excess supply of newly minted Treasuries over demand will be US$598 billion or 33% of the new issuance for the year.

Prices are likely to collapse and yields to rise. The US has no other option, but to push yields even higher in order to rid itself of the surplus Treasuries. Overshooting of the rates will follow.

Now, considering the amount of paper already issued during the crisis, we are looking at a bond prices cycle of some 20-30 years (traditional cycle is 18-26 years). In other words, the era of low rates is now over. Firmly.

While back in the Euroland, elves and fairies are…

Oh, well, inhabiting the imaginary universe where the Grand Plan for world monetary domination requires strong euro (even if at the expense of dead exporters) boys in Frankfurt are happy with the dollar and sterling slide. To them, the game is about turning the euro into a worldwide reserve currency – the stuff held by everyone, from grey and black economy’s ‘entrepreneurs’ (why else would a monetary union with anemic income growth need a 1,000 euro note for?) to legitimate sovereigns. This requires stability of value and, as a side-effect, low inflation. It also requires systemic undermining of European exports competitiveness and, as a side effect, higher unemployment.

In the land of elves and fairies, even with a prospect of continued weaknesses in the financial system still looming over the euro area banks (which have so far failed to pass the 50% mark of expected writedowns), the ECB is already on the tightening path. Earlier this month the ECB raised long-term cost of borrowing under its 12-month lending programme and told the markets it will cease lending under this maturity at the end of Q1 2010.

These measures will have a double whammy effect on euro area interest rates – first, pushing the rates directly by forcing the banks back into the direct interbank lending markets, and second – by forcing the banks to rely on milking their borrowers through higher rates and fees and charges to raise funds to repair their balancesheets.

The global changes – particularly those discussed above – will aid the ECB intentions. As the US raises rates, the euro is bound to ease off relative to the US dollar, opening up some more room for interest rates rising in the euro area. As China switches into buying euro to displace its dollar holdings, and cuts purchases of the US Treasuries, euro will be pushed up in value against other currencies, leading to a deterioration in the EU trade balance. Higher rates will help here too, offsetting falling trade surplus with rising capital account position.

In other words, the ECB is an accidental co-traveler on the road to the higher interest rates. A New Brave World that awaits us in the near future is likely to be the one with high, very high cost of capital.