Saturday, February 09, 2008

Long Treasuries: Not much there.

So what happened to the 30-year yesterday? The obvious answer is that the Treasury's 30-Year Auction was not well received. That does indeed appear to be the proximate cause of the big sell-off, as things really got going at 1PM Eastern. But a bad auction really can't explain a 3 1/2 point move.

Consider the facts. The Treasury announces to the entire galaxy that its selling $9 billion in 30-year bonds. They get a yield of 4.449%. According to Bloomberg News, the pre-auction trading had indicated the yield would be 4.41%, indicating the actual results were a 4bps miss. Did the auction go poorly? It sure did. Not only was it a 4bps miss in yield, but 89% of it was purchased by dealer firms, which indicates that actual end buyers only stepped up for 11% of the sale.

But what happened next can't fully be explained by those auction results. The 30-year continued to sell off, rising another 10bps in yield to 4.558, or -1.6% in price, over the next hour. It strains logic to say that the Treasury holds an auction, the price is somewhat disappointing, so therefore the price should be an additional 1.6% lower.

Further consider that the 3 1/2 point drop in the 30-year was the largest single day move since April 2004. So what happened in April '04? That was the day that the Labor Department reported that the economy added 334,000 jobs in March of 2004, after only having added 27,000 in February. That data point convinced the market that the Fed was ready to hike rates, then at 1%, which indeed it did that June.

Contrasting the significance of that event with yesterday's auction result, and it becomes more apparent that something more is afoot.

Perhaps the rumor that the ISM services index was miscalculated? Released on Tuesday at a recessionary reading of 41.9, the figure spurned a 370-point plunge in the Dow. The specific rumor of a data error was debunked, but Greg Ip reported on the Wall Street Journal's website that other measures of the service sector don't look as dire. Perhaps this means there was no calculation error per se, but still the released figure was understated for some other reason, which will later come out in revisions.

The ISM story fits a 3 1/2 point sell-off better than a weak auction. Treasury yields at current levels can only be supported if the Fed holds interest rates low for an extended period of time and inflation doesn't become a problem. Traders know this is a very fine line to walk, and confidence in Bernanke's ability to walk that line is, well, not as strong as it could be. It will probably take a pretty stiff recession to keep inflation low despite highly accomodative monetary policy. Tuesday's ISM report supported the idea that we are already in a recession, and therefore supported rates at their current levels. But if it turns out we aren't in a recession, the Fed will have to make a rapid reversal of policy to combat inflation. If so, long rates will be the big loser.

Now I still think the Fed is headed back to 1%. I might be wrong, but until that happens, I'm happy to own duration in the middle of the curve.

But the long bond becomes a question of risk/reward. The 30-year Treasury is within 30bps of its all-time low in yield. So if it is a drawn out period of easy money, and somehow we avoid inflation, that's probably your upside. But if either inflation becomes a problem or the economy is stronger than we think, your downside is much larger.


Deborah said...

Being Canadian and completely uninterested in investing in something like a 30-year treasury bond, I have never looked at these before, but I did try doing some number crunching and it did not work.

So, working backwards, 4.449% would cost $270.94, 4.41% would cost $273.99, and 4.558% would cost $262.59. And (270.94/262.59 - 1)*100 gives 3.2% less and 273.99/270.94 gives 1.1%.

So, how do you get the 1.6%?

Anonymous said...

If the US=Japan, and we are in for an extended deflationary cycle, then a long bond yielding over 4% looks mighty, mighty good.

The point is made by Alan Abelson or Randall Forsyth, I believe, that when credit dries up we get deflation...which I guess is obvious.

And Bernanke is cutting interest rates like Justin Tuck sacking a quarterback, because he fears deflation.

But I'll go with gramps. If the reason credit is seizing up is insolvency, which it probably is, then it simply doesn't matter what Bernanke does with interest rates.

Good news? The Europeans are handling this somewhat differently. In particular, when a guy from the boondocks blew a $7 billion dollar hole in one of the biggest banks in France, the news was all about his hairdresser mother.

Apparently, the price of this insouciance is the ECB taking collateral for lending to banks that isn't worth the btu's in the paper. That doesn't bode well for the euro.

So maybe, just maybe, the US gets out of this with the dollar doing reasonably well. Maybe.

Deborah said...

I looked some more. I misinterpreted reading something to the effect the bond is discounted to pay a certain rate and when it matures it pays face value. I took that to mean that it was the interest payments that was discounting it, not that it pays a stated rate twice per year and the price it trades at causes the yield to change.

gramps said...

I think you almost answered your own question... the 30yr bond is very poor risk/reward trade off (and still is).

1) The belief that the 1% Fed funds rate under Greenspan was a mistake and a contributing cause of the credit bubble is gaining pretty wide spread acceptance. Even Greenspan is getting awfully defensive. Your belief that 1% Fed Funds is likely is increasingly a minority opinion-- especially outside Wall Street.

2) Inflation is a very big problem. I don't think anyone would dispute that there is rampant deflation in financial assets, but if you look at valuations against a very long term trend-- financial assets are vastly over-priced. Its deflation all right, but reversion to the long term mean is hardly justification for Wall Street yelling that the sky is falling.

The purpose of Trsy bonds (and debt in general) is to transfer consumption over time. While financial assets are deflating/reverting to the mean, unavoidable consumption prices (food, energy, property taxes, education expenses, health care etc) are rising 7-8% per year in many areas of the country. If I buy a Trsy bond yielding 4.5%, I am not even holding purchasing power even. I am 2.5% behind, even before subtracting out taxes. If you want to set aside money to pay for health care (or your insurance Co effectively does it for you) -- you cannot buy Treasuries of any maturity and keep up with the cost of health care, not even close. Trsy bonds are a very poor store of value.

I have little doubt that the folks at the BLS calculate CPI exactly according to the formula they are supposed to, and even less doubt that the formula does not reflect the true increase in the cost of living.

If you read papers from other countries, you will see that inflation is seen as a huge problem in almost every country (except perhaps the U.S., where we have our heads in the sand). The marginal cost of producing oil is skyrocketing. Agriculture is heavily water intensive, and many parts of the world have acute potable water shortages. Food prices are rising globally. News flash: the United States is on the same planet as all these other countries, so we face the same price pressures.

Domestically, when you add up all the out of control fiscal spending and planned entitlement spending -- its very questionable how Uncle Sam can credibly raise taxes enough to pay for all this (I am hardly the first person to say America is living beyond its means). We have two military wars (Iraq / Afghanistan), plus a "war" on credit collapse, plus a chronic spending deficit -- and unachievable levels of entitlement spending baked in. The only credible means Uncle Sam has to pay for this is through higher inflation.

None of this is new information. But I repeat it here because many people in the markets are so focused on day to day trading that they forget the longer term situation they face. Everyone *knew* that subprime was a disaster waiting to happen; plenty of people wrote news / magazine articles about it -- and yet somehow Wall Street was "surprised" when the credit bubble collapsed.

So you have a Trsy bond market that is made up entirely of speculators and non economic buyers (investors- people who want to maintain purchasing power and hopefully earn a slight positive return- have been forced to look elsewhere).

Non economic buyers basically means foreign central banks in general, China in particular. The Chinese government is under pressure not to lose any more of "the people's" money -- and a higher Yuan / lower US dollar over time is almost a foregone conclusion. If you make 4.5% on Trsy, and lose 7-8% on foreign exchange -- well, even a Wall Street analyst can do that math. The latest TIC data from the Fed shows China diversifying into Corporate bonds and not reinvesting their Trsy coupons. Obviously, they are buying big chunks of "for sale" American brokerage houses... But they have stopped buying Treasuries at a loss.

So that leaves a Treasury market made up entirely of speculators (aka "fast money"). Speculators tend to trade with a very tight stop loss.

Thirty year Treasuries closed Wednesday around 4.38%; on Thurs dropped to 4.41% by the auction which in turn traded another 3-4bp through... and triggered all sorts of stop loss selling. You saw on Friday 30yrs "rallied" back to 4.43% -- once all the stop losses had cleared the market.

I would expect this sort of volatile trading to happen a lot until real investors return to the market -- but I don't see that happening until Treasuries become an effective store of value. That means they need to yield enough to cover the change in the cost of living, or more like 7-8% yields.

I have argued repeatedly on this blog that lower central bank rates were ineffective in Japan, and will be ineffective in the U.S. as well. You can argue that Fed Funds are going to 1% (and given the "leadership" in Washington, you may be right) -- but "savers" (people with money to lend) are not going to willingly lend you money below cost (we won't even get into the obvious credit risk of lending to a country that spends like drunken sailors).

The only people who are buying Treasuries right now are non-economic buyers -- and they are dwindling in number. Bonds have regained their status as "certificates of confiscation" as they were known in the 1970s.

So the fast money will borrow from the Fed at 1% and then lend it back to the Fed at 4.5%??? Banks get re-capitalized, I suppose. But I hope I don't need to explain that Uncle Sam is losing money on this trade.

Very soon (if not already), the Treasury market will be made up entirely of people who borrow at below market from the Fed, and then lend the same money back to the Treasury. People trading with borrowed money are known in poker as "weak hands" -- and by necessity they will keep very tight stop loss limits.

Banks are very under-capitalized, and quite a few would be insolvent if we assume housing prices revert to their long term average trend. That makes them very weak hands. Why on Earth would they go take credit risk? You can lower Fed Funds to whatever number you want -- the banks would be foolish to put it toward new lending.

Even if they did, why would any economically rational person build another empty condo or vacant shopping strip? Every day a developer turns on the TV, he hears that financial armageddon is here (or coming very soon). Its irrational to borrow money right now, regardless of the interest rate charged.

So go ahead and lobby for 1% Fed Funds. It won't fix over-priced houses. If won't fix people who are over-leveraged and insolvent. And it will never make the un-credit worthy suddenly worthy of credit. It will make people very cautious about borrowing, and it will make savers reluctant to lend.

And the only people who will trade certificates of confiscation will be the leveraged, fast money, day trader crowd.

Until rates back up to economic reality, look for extreme volatility in Treasuries.

john jansen said...

i have recently begun a bond market blog at my site I will paste my opening commentary from February 08 2008 when i discuss the auction result. I will also leave a link to my site and recommend my closing commentary from February 07 2008 entitiled "Tumultuous Trading Tests Traders"

Across the Curve
A daily bond market chronicle
Home About Opening Comments
February 8th, 2008 | by John Jansen |
February 8th, 2008
Prices of Treasury coupon securities have rebounded sharply in overnight trading from the very depressed state which they reached in very late trading yesterday. As I recounted at that time, the post auction trading was a debacle but in retrospect it led to some bargain prices and contributed to the overnight rally.

I have always maintained that short term price patterns are ruled by street positions. Is the street long securities or short securities? It is a simple question but it is the easiest and most efficient way to distill and understand the random noise of moment to moment trading.

Yesterday the street finished bidding the refunding ($13 billion 10 year notes and $9 billion 30 year bonds). The street is risk averse. It is bleeding capital through every orifice. It is early in the year and trading desk managers have no interest in putting a crater in the nascent P and L.

So on the second day of the refunding process, they submit underwriting bids for 30 year bonds and (oh my God I own them….What can I sell)discover to their dismay that they own bonds which they have no desire to hold for more than a few minutes. What follows is the cathartic flush which the market experienced late yesterday. Rough and ugly? Yes, but it clears the air and sets the stage for a rebound because what transpired was the true auction process. New owners emerge and those owners hold the bonds at prices which make them very comfortable. And then the process of distribution begins as it has overnight.

In the overnight session Bloomberg reports that yields on benchmark Treasury paper have declined between 5 basis points and 8 basis points. The largest declines are in the belly of the curve with 5 year yields and 10 year yields declining by a little over 6 basis points.

European equity markets are posting modest gains and futures markets here are indicating that the equity market should open with modest losses.

It is a light data day with wholesale inventories the only scheduled release.


John Jansen

john jansen said...

Addendum: I was just reviewing my work from the day of the bond auction,Thursday Feb 07 2008 and I had two other postings which should also be informative. One is entitled Post Partum Blues and the other simply Bond Result.

John J Jansen

gramps said...

So this is kind of old news, but I finally had a chance to read Warren Buffett's take on things.

He doesn't think there is a liquidity crisis either. People with no income (or no documentation of income) who want to overpay for real estate are quite predictably unable to get loans. Buffett says there was a repricing of risk, and there is now no more "dumb money" available.

There is no liquidity crisis. The Fed lowering rates is fighting a non-existent problem, while creating much bigger problems not too far down the road.

Am I the only one who has read predictions that the next President (doesn't seem to matter for this rumor who it turns out to be) will ask Bernanke to resign next year?

When lower rates fail to fix anything -- someone is going to have to fall on their sword. Bush and Co. will be history, so Bernanke will be the only architect of this mistake remaining to take the fall. Well, him and Wall St.

Anonymous said...

There are two kinds of inflation:

1) supply inflation in which shortages drive the price of a commodity up


2) demand inflation in which the supply of money chasing a commodity goes up and the price goes up

There is, I believe, this balance between how much of a commodity there is and how much money there is chasing it.

Neither the supply of money nor the supply of the commodity is fixed over time.

Gramps, do you agree with the above?

I bring this up, because I think that a rational man could look at the current situation and say, "Look, there is no credit any more, so the supply of money chasing commodities is going down, and the prices are going down too -> deflation."

gramps said...

Anon 6:00

I have heard all the people arguing that money supply (broadly defined to include credit as well) is collapsing, and thus we have deflation.

First, I find it striking that these same people were arguing in 2001-2005, with Bernanke at the front of the crowd, that we had to keep rates really low to avoid deflation. Bernanke earned his Helicopter flight badge by threatening to fight deflation by dropping money out of helicopters... Credit (and thus the broader money supply?) was absolutely exploding by any measure. Why didnt you call that inflationary?

Was Bernanke totally wrong then, wrong now, or both?

Real growth comes from hours worked, productivity, education, technology, capital formation, etc. Any banana republic can tell you that debt does not create growth-- it just transfers it across time.

The "growth" in the U.S. economy from 1995-2006 was really an accounting error, not real growth. Debt/credit (including all the collapsing credit you site) expanded faster than the economy. People who could never afford a house were inexplicably lent money anyways - reality be damned. It was never real, anymore than the earlier dot-com fantasy.

Home prices, and debt, increased (on an accounting basis) by 15% per year. But incomes and GDP were growing by less than half of that -- telling you that there was a serious accounting error somewhere.

You are also trying to measure the performance of a global, diverse economy using an accounting system designed for a U.S. centric, brick and mortar economy.

If you have a company, and you arbitrarily mark your inventory up 40% -- is that really "growth" or income? Your accounting statement claims it is. The next year, your creditors audit your books and make you mark the inventory back down to reality... This is an accounting loss, but it isn't an economic loss. Its just a recognition that your previous year's income was overstated. And it has nothing to do with the money supply or inflation/deflation. Its just an accounting screw up.

I do agree with your statement that commodity supply and demand fluctuate over time-- but I don't agree with your conclusion.

The U.S. historically was so important to the world economy that we convinced ourselves that we ARE the world economy. In reality, the U.S. is now about 25% of the global economy.

The rest of the world's economy (the overwhelming majority 75%) is going gangbusters.

I turn off the TV when they start yelping about whether the rest of the world has "decoupled" from the U.S. It is not black and white, yes or no. The rest of the world has decoupled -- to an extent. They are clearly still dependent on U.S. consumers spending money we don't have-- but less so than in the past. While our savings rate is zero or negative, other countries have massive savings pools-- i.e. they have massive pools of capital to drive their economy even if we are gone.

They aren't 100% decoupled, but they are no longer 100% dependent either.

The other problem is that you are assuming that when the economy "collapses" (1% growth last quarter isn't really Armageddon BTW), that consumers will stop buying food and gasoline.

Admittedly anecdotal evidence suggests that subprime borrowers will default on their mortgage first, and their car payments later. They need the car to get to work (often off the books) -- public transportation in the U.S. is too unreliable. Crude oil prices went from $60 to $90 in the last year, but U.S. gasoline demand was actually **UP** slightly YoY.

In many other countries (China, India, Iran to name a few), gasoline prices are fixed by the local government. Consumers do not see any price increase, so there is no demand destruction.

On the supply side, I don't know about "peak oil" per se -- but oil fields in the North Sea, Kuwait and Mexico have peaked according to their owners. New oil discoveries have a much higher cost per barrel than the older fields. I don't see oil drying up, but definitely getting more expensive at the margin.

One way or another, energy prices work their way into everything.

Food prices are also set globally, and here the rising affluence of emerging economies means **MORE** demand for food. If a nasty blizzard takes out loads of farms in China (like it did earlier this month), do you think the Chinese people will opt not to eat? Or will they demand their government spend some of its reserves importing food? Will the status of imaginary home prices in the U.S. have any effect this decision? Will a Chinese peasant not eat because some American can no longer get a 105% LTV, no doc loan?

Prices for colleges and property taxes (mostly local schools) seem to get set without any regard for what the economy is doing. College costs have risen **EVERY** year for the past 30, recession or not. Government spending (as opposed to taxes) has gone up every single year, recession or not. Government spending alone is 30% of U.S. GDP now. Entitlement spending is set to explode from there -- how many Americans are going to cut back their Social Security and medicare benefits if we are in a recession?

In economic terms, government spending is price inelastic.

Rising demand from abroad and price inelastic demand at home both point to continued (and probably increased) demand, irrespective of what happens to housing credit.

And I don't believe the correction of an accounting error is deflationary or inflationary. Since many people borrowed on imaginary assets, I do believe they are insolvent -- but they will still eat and drive to work.

Accrued Interest said...


I think the Fed is headed to 1%, but they won't stay there for as long as we did in 2003-2004.

Right now, liquidity is greatly improved. I don't view the fact that banks are tightening credit standards as a "liquidity" problem. I view that as the normal pain we feel when we go through a correction like this.

Nothing the Fed does can erase the bad investments made in housing, especially those made in 2005-2007. We'll have to live through a period of bank writedowns. Pricing in those writedowns what the market is working through right now. So we'll see how that goes...

But in my opinion, once the market has indeed priced in the new regime in banking, inflaiton will rapidly become the primary risk, and the Fed will be forced to reverse course.

gramps said...

AI - according to Greeenspan (and many others), there is about a 6 month lag between a Fed ease and when it takes effect... so the effects of the first easing in September are barely kicking in now.

If you are saying that the liquidity situation is better, then not sure why we needed any of the other eases, nor why we would need additional easings to 1%.

But I really want to hear your thoughts on the Fed "re-tightening" once inflation becomes a more obvious problem (I am going to ignore for now that the cost of living already is way up, even if you don't call it inflation).

So Bernanke and Company are going to re-tighten. THey have Congressman Barney Franks breathing down their necks on one committee, while Chris Dodd constantly makes Bernanke give assurances that he will do "anything and everything necessary". Congress is basically bullying OFHEO into raising loan limits.

Now you are suggesting the Fed will raise rates before it becomes clinically obvious that the economy is "back on track" in the humble opinion of Congressmen who cannot balance a checkbook to save their lives.

That just seems rather implausible. I am going to have to call...

And if the Fed did tighten against Congress's wishes, both Franks and Dodd have promised to strip the Fed of all sorts of authority (and the OFHEO thing shows they will override regulators at will). Seems a fair bet the Democrats will retain control over Congress, so this threat is not going away.

So heads, the Fed fails to raise rates. Tails, it loses its independence.

Anonymous said...


Thank you for your reply. It was what I was looking for, and it made sense.

I believe that Italian politicians currently say that Europe will run out of natural gas by 2015. Italy had a natural gas scare a few years ago, and they are sensitized.

The problem with natural gas is that it is a gas. One day you are near full pressure, the next day there's nothing.

So, do I think that the price of natural gas in Europe will go up by a factor of five? Yes, I do. Do I believe that's inflationary? Yes, I do. Do I believe that wages will match the increase in the price of natural gas? No, I don't.

However, I am still not willing to count deflation out. Recall that people in central California starved to death during the depression. They didn't do that because food was so cheap. Yet, that was a deflationary period.

Anonymous said...


scriabinop23 said...

Just watch the ask on the 30 year disappear when this equity options expiration period is over.

A real recession is deflationary, and colds are contagious.

When the enthusiastic buyer slows down, it gets ugly. And the best cure for a commodities blowoff top is a commodities blowoff top; meaning that there will be a breaking point where the *world* consumer can't afford $120+ (pick an arbitrary #) crude and economic growth.

When Australia follows the US into recession, you'll be thinking 4.5% yield on 30 year paper is a steal.

gramps said...

Anon 10:27

If you are still looking for deflation, you should look at the
Fed's own data on M2 (only because M3 is no longer collected). GDP may be growing only 0.5%, but the money supply (even now, several months into the credit contraction) is growing more than 6% YoY.

Also, you should note that consumer prices rose, according to the govt, in every single recession except the 2001 case -- you know the one where Alan Greenspan put the economy on steroids with rates at 1%.